Problem:
Tom Cruise Lines, Inc., issued bonds five years ago at $1,000 per bond. These bonds had a 25-year life when issued and the annual interest payment was then 12 percent. This return was in line with the required returns by bondholders at that point as described below:
Real rate of return . . . . . . . . . . . . 3%
Inflation premium. . . . . . . . . . . . . 5
Risk premium . . . . . . . . . . . . . . . 4
Total return . . . . . . . . . . . . . . . . 12%
Assume that five years later the inflation premium is only 3 percent and is appropriately reflected in the required return (or yield to maturity) of the bonds. The bonds have 20 years remaining until maturity. Compute the new price of the bond.
Further analysis
a. Find the present value of 2 percent _ $1,000 (or $20) for 20 years at 10 percent. The $20 is assumed to be an annual payment.
b. Add this value to $1,000.