Question

When the interest rate in the economy was 10 percent, the price of a bond with no expiration date that paid a fixed annual interest of $500 was $5,000. If the interest rate in the economy falls to 6 percent, the price of this bond will be about
a. $4,700.
b. $5,030.
c. $7128
d. $8,333.

Answer 1

Answer:

Option D $8333

Explanation:

The value of the irredeemable bond can calculated using the Dividend Valuation Model.

The formula for the computation is:

Value of the Bond = Interest paid / rate of return on a similar bond

Value of the Bond = $500 / 6% = $8333.33

Note that initially the bond was worth $5000 which can be calculated with the same formula:

Value of the Bond = $500 / 10% = $5000

The net increase is $3333

So the correct answer is option D.