How much you will pay

Question

33. How much would you be prepared to pay for a $500 bond which comes due in 5 years and pays $80 interest annually assuming your required rate of return is 8% (pick closest answer)?

740

660

608

500

Answer 1

Answer: 660

Plug the below in a financial calculator or Excel:

N = 5 years (because it says annual it is just 5 years)

I = 8% (This is the expected return, YTM, that you expect to earn on the bond which was given to you)

PV = ? (This is what you're looking for because it says what are you prepared to pay TODAY)

PMT = $80 (often it is Coupon * principle amount, but in this case they gave you $80. Because it says annual, it's just $80)

FV = $500 (In 5 years you're receiving the $500 because a bond is essentially a loan your giving, so you expect to receive that amount at the end of the contracted period)

How a bond works: From the investor point of view, a bond is essentially a loan your giving to a company.You would give (invest) a certain amount into a company and in return, the company would give you interest payment (Often semi-annual). At the end of the contracted period, you would receive the original investment amount.

In this example, it says it is a $500 bond so you assume that you invested $500 into the bond for a specific company. So you invested $500 in the beginning and in this problem they already gave you the actual interest amount you will earn by investing the $500 (Rather than coupon rate), which is $80 interest received. You will receive $80 every year (Because it says pays annually) for 5 years and at the end of 5 years, you will receive $80 PLUS the principle amount, $500 (have to remember, a bond is essentially a loan so you will get the original amount you invested into the bond).