Question

11. A zero coupon bond is selling for $476. The bond has a face value of $1,000 and matures in 8 years. Your friend asks you if he should buy the bond. He tells you his required return is 9 percent. Would you recommend he buy the bond or not? Explain your answer.

Answer 1

The price of a bond is the present value of all future cash flows receivable from the bond discounted at required rate of return

Since a zero coupon bond has the only cash flow of maturity value, the price will be calculated as below :

Price

= Amount receivable x Present value factor

Present value factor

= 1 / ( 1 + Required rate of return) ^ Number of years

= 1 / ( 1.09 ^ 8)

= 1 / 1.992563

= 0.501867

So, the price of the bond should be

= $1,000 x 0.50187

= $ 501,87

As the market price of $476 is less than the price which the bond should have, the bond is available at attractive price and should be bought