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Price of bond when inflation premium changes

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T 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.

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Solution Summary

The solution calculates bond price when inflation premium changes using step by step, easy to understand calculations.

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Real rate of return . 3%
Inflation premium 3%
Risk premium 4%
Total return 10%

To calculate the price of the bond we need to calculate / read from tables the values of
PVIF= Present Value Interest Factor
PVIFA= Present Value ...

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