In 2012, DePaul University issued $1 million of 10-year debt at 7% to build a small chapel at the Lincoln Park campus. The bonds are due in 2022 which is 4 years from now (today is in 2018) after they make four more interest payments of $70,000 each year. Your great uncle is considering purchasing the notes and asks you how much you think he should pay for them. The "prevailing market rate" has now fallen to 3.5% and he is thinking 7% sounds fantastic! You tell him that bonds have two cash flow streams which you show with the timeline below. Tell your great uncle how much you think he will actually have to pay (Bond Valuation Problem) to buy the bonds given that the prevailing market rate is now only 3.5%. 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 These Interest Payment Have Already Been Paid $70,000 $70,000 $70,000 $70,000 Principal is paid at maturity $1,000,000
In 2012, DePaul University issued $1 million of 10-year debt at 7% to build a small chapel at the Lincoln Park campus. The bonds are due in 2022 which is 4 years from now (today is in 2018) after they make four more interest payments of $70,000 each year. Your great uncle is considering purchasing the notes and asks you how much you think he should pay for them. The "prevailing market rate" has now fallen to 3.5% and he is thinking 7% sounds fantastic! You tell him that bonds have two cash flow streams which you show with the timeline below. Tell your great uncle how much you think he will actually have to pay (Bond Valuation Problem) to buy the bonds given that the prevailing market rate is now only 3.5%. 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 These Interest Payment Have Already Been Paid $70,000 $70,000 $70,000 $70,000 Principal is paid at maturity $1,000,000
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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In 2012, University issued $1 million of 10-year debt at 7% to build a small chapel at the Lincoln campus. The bonds are due in 2022 which is 4 years from now (today is in 2018) after they make four more interest payments of $70,000 each year. Your great uncle is considering purchasing the notes and asks you how much you think he should pay for them. The “prevailing market rate” has now fallen to 3.5% and he is thinking 7% sounds fantastic! You tell him that bonds have two cash flow streams which you show with the timeline below. Tell your great uncle how much you think he will actually have to pay (
Transcribed Image Text:### Bond Valuation Case Study
In 2012, DePaul University issued $1 million of 10-year debt at 7% to finance the construction of a small chapel at the Lincoln Park campus. The bonds are due in 2022, equating to 4 years from the current year (2018). The bonds provide interest payments of $70,000 annually.
Your great uncle is contemplating purchasing the bonds and seeks your advice on the fair price to pay for them, given that the prevailing market rate has dropped to 3.5%. He finds the 7% interest quite attractive. You explain that the bonds yield two types of cash flows, as illustrated in the timeline below.
### Cash Flow Timeline
#### Interest Payments:
- 2018: $70,000
- 2019: $70,000
- 2020: $70,000
- 2021: $70,000
#### Principal Payment:
- 2022: $1,000,000
### Analysis
Given that the prevailing market rate is now 3.5%, we need to calculate the present value of the remaining interest payments and the principal amount due at maturity.
### Graph Explanation
The timeline chart depicts two critical cash flow elements:
1. **Interest Payments:** Labeled between 2018 and 2021, with an annual payment of $70,000.
2. **Principal Payment:** Highlighting that the $1,000,000 principal will be paid in 2022.
### Conclusion
To determine the price your great uncle should pay, you would use the Bond Valuation formula, which involves discounting these future cash flows back to the present value using the new market rate of 3.5%.
This example underscores the impact of market interest rates on bond prices and will allow your great uncle to make an informed investment decision.
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