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 15 percent. This return was in line with the required returns by bondholders at that point as described below:

Real Rate of Return 4%Infaltion Premium 6Risk Premium 5Total return15%Assume that five years later the inflation premium is only 3 percent and is appropriately refelcted 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.

Solution and Explanation:

Required Return after 5 year =  Real rate of return +   Inflation premium + Risk premium

Required Return after 5 year = 5+2+4

Required Return after 5 year =11%

No of year left to maturity = 25

Annual Interest payment = 15%*1000 = 150

Face value of Bond = 1000

New price of the bond = pv (rate, nper, pmt, fv)

New price of the bond = pv (11%,25,150,1000)

New price of the bond = $ 1336.87

the answer is "b.the increased supply will create a surplus. "

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