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

Question

Quizplus · Accepted Answer

To calculate the interest rate on an eight-year bond, we need to find the sum of all the premium rates and add them to the pure rate and inflation rates.

Here is the breakdown of premium rates for an eight-year bond:

Maturity risk premium: 0.1% x 6 (years 2-7) = 0.6%
Default risk premium: 1.5%
Liquidity risk premium (for corporate bonds): 0.5%

The total premium rates sum up to 2.6%.

Next, we add the pure rate of 2.0% and inflation rates of 2.5% for two years and 4.5% for six years (years 3-8).

So, the interest rate on an eight-year bond issued by Becher Inc. would be:

2.6% + 2.0% + 2.5% + (6 years x 4.5%) = 8.7%

Therefore, the best choice is C) 8.7%.

Use the Following Information to Calculate the Interest Rate on an Eight-Year