Unformatted text preview: f two components: a riskfree component and a risk
premium. It is given in the problem that the riskfree rate is 7%, which implies that the risk premium on
Hodge Sports, bonds must be the difference between the effective interest rate of 9% and the riskfree rate
of 7%, or 2%. b. If the risk premium increased from 2% to 5%, the effective interest rate would increase to 12%. A single
bond would now be worth $889.59 to you, as calculated below. (Remember that bonds usually have a face
value of $1,000 and pay interest semiannually.)
Present value (i = 6%, n = 10)
Present value of face value
($1,000 .55839 from
$ 558.39 Table 4 in Appendix A)
Present value of interest payments ($45 7.36009 from
331.20
$ 889.59 Table 5 in Appendix A)
Total present value
c. A decrease in the prime interest rate would probably result in a drop in the effective interest rate used to
discount the future cash flows of Hodge Sports’ bonds. As the effective interest rate drops, the stated
interest rate looks relatively more attractive to investors. Thus, demand for the bonds should increase,
which, in turn, should drive up the selling price of the bonds. A single bond would now be worth $1,040.55,
as calculated below.
Present value (i = 4%, n = 10)
Present value of face value
($1,000 .67556 from Table
$
675.56 4 in Appendix A)
Present value of interest payments
in Appendix A)
Total present value P11–18 ($45 8.11090 from Table 5
364.99
$
1,040.55 a. b. The effective interest rate on the bonds is 8%. The future value of the bond payments are $2,000
(semiannual interest payment based on the stated rate of 4%) for four periods and $100,000 (principal due
at maturity); the present value is the purchase price of $92,994. The effective rate of 8% discounts the
future values to the present value. (The general present value formula of 1/[(1 + r) to the nth] was used in
this calculation.) Cash
2,000
Bond Investment
1,720
Interest Revenue
3,720
Receipt of interest payment on 11/30/2011
(3,720 = Eff. Rate per period of 4% X $92,994) Cash
2,000
Bond Investment
1,789
Interest...
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 Fall '08
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 Accounting

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