Question

On January 1, 2008, Deily Corporation issued $500,000 of 10 percent, 10-year bonds at 88.5. Interest is payable on December 31. If the market rate of interest was 12 percent at the time the bonds were issued, how much cash was paid for interest in 2008?

Answer 1

When interest rates rise, the value of existing bonds decreases. To calculate the present value of each cash flow and sum them up in order to find the amount to be paid for the bond, we can use the present value formula.

Step-by-step explanation:

When interest rates rise, the value of existing bonds decreases. This is because investors can now earn a higher return with new bonds, so the older bonds with a lower interest rate become less attractive. In this case, since the interest rate has increased, we would expect to pay less than $10,000 for the bond.

To calculate how much we would actually be willing to pay for the bond, we need to discount the future cash flows from the bond to their present value using the new interest rate of 9%. We can use the present value formula to calculate the present value of each cash flow and then sum them up. The formula for calculating the present value of a future cash flow is:

Present Value = Future Cash Flow / (1 + Interest Rate)^n

Where n is the number of periods until the cash flow is received.

Using this formula, we can calculate the present value of each cash flow from the bond and sum them up to find the amount we would be willing to pay for the bond.