Recently, Ohio Hospitals filed for bankruptcy. The firm was reorganized as American Hospitals, Inc., and the court permitted a new indenture on an outstanding bond issue to be put into effect. The issue has 10 years to maturity and coupon rate of 10 percent (I = $100) paid annually. The new agreement allows the firm to pay no interest for the first 5 years, then to resume interest payments for the next five years, and at maturity in 10 years, to repay the principal plus the interest that was not paid for the first five years, but without paying “interest on the deferred interest.” If the required rate of return is 20 percent, what should the bonds sell for in market today? 1. $576 2. $895 3. $362 4. $456

The price of a bond is equivalent to the present value of all the cash flows that are likely to accrue to an investor once the bond is bought. These cash-flows are the periodic coupon payments that are to be paid annually from year 6 to year 10 and the par value of the bond that will be paid at the end of 10 years plus the 5 years deferred interest at the end of year 10.

From year 6 to year 10, there are 5 equal periodic coupon payments that will be made. Given a par value equal to $1,000, in each year, the total coupon paid will be [tex]1,000*0.1[/tex] =$100. This stream of cash-flows is an ordinary annuity.

In summary the expected cashflows can be listed as follws:

year 1-5: $0 per annum

year6-10: $100 per annum coupon payments

Year 10:Par value+deferred interest for the 1st 5 years =1,000+5*$100=$1,500

The required rate of return is to 0.2% per annum

The PV of the cash-flows = PV of the coupon payments + PV of the par value plus deffred interest

=100*PV Annuity Factor for 5 periods at 20%*PV Interest factor with i=20% and n =5

+ $1,500* PV Interest factor with i=20% and n =10

[tex]= 100*\frac{[1-(1+0.2)^-^5]}{0.2(1+0.2)^5}+\frac{1,500}{(1+0.2)^1^0} =362.4444[/tex]