Use the following information to calculate the interest rate on an eight-year bond just issued by Becher Inc.
Inflation: next two years = 2.5%
year 3 and beyond = 4.5%
Pure Rate = 2.0%
Maturity Risk Premium = zero for a 1-year maturity, increasing by 0.1% each year thereafter
Default Risk Premium = 1.5%
Liquidity Risk Premium = 0.0% for treasuries; 0.5% for corporate bonds

A) 7.7%
B) 8.2%
C) 8.7%
D) 9.2%
E) 9.4%

Question

Jason Rider · Accepted Answer

Final Answer : C, Explanation :  To calculate the interest rate on the eight-year bond, we need to add up the different components of the yield.First, we need to calculate the maturity risk premium. Since the bond has an eight-year maturity, the maturity risk premium will be:MRP = 0.1% × (8-1) = 0.7%Next, we need to calculate the total inflation premium over the life of the bond. Since inflation is expected to be 2.5% for the next two years and 4.5% thereafter, the average inflation premium over the life of the bond will be:Inflation premium = ((2.5% + 2.5%) / 2) × 2 years + ((4.5% + 4.5% + 4.5% + 4.5%) / 4) × 6 years = 21.25%Next, we need to add the pure rate (2.0%) to these premiums:Pure rate + Inflation premium + Maturity risk premium = 2.0% + 21.25% + 0.7% = 24.95%Finally, we need to add the default risk premium and the liquidity risk premium. Since this is a corporate bond, we need to add the liquidity risk premium of 0.5%. Therefore, the total yield on the bond will be:Yield = 24.95% + 1.5% + 0.5% = 26.95%Therefore, the interest rate on the eight-year bond just issued by Becher Inc. is 8.7%.

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