Question

You are considering investing in a standard fixed-rate corporate bond with 25 years remaining to maturity. The bond pays annual coupons of 5% and just made its most recent coupon payment. The face value of the bond is $1000.

a. What is the current price of coupon bond if its current yield to maturity is 4%?

b. In exactly five years the yield to maturity of the coupon bond will have increased to 7% because the Fed has increased interest rates and because the company has become more risky. What is the price of the coupon bond in five years immediately after it made the coupon payment?

c. What is the Internal Rate of Return (IRR) if you purchase the bond now at the price given in part (a), hold on to the bond for five years, and sell the bond after five years at the price computed in part (b).

Answer 1

a). FV = 1,000; N = 25; PMT (coupon rate) = 5%*1,000 = 50; rate = 4%, solve for PV.

Current price = 1,156.22

b). After 5 years: N = 20; FV = 1,000; PMT = 50; rate = 7%, solve for PV.

Price = 788.12

c). Using IRR function with cash flows, we get

Year (n) 0 1 2 6 7 8 10 Cash flow (CF) Semi-annual IRR -1156.22 50 50 50 50 50 50 50 50 50 838.12 1.33% an 00 n et m

Effective annual IRR = [(1+1.33%)^2] -1 = 2.67%