Finally the company may repurchase someofitsdebtin an

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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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