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19 November, 12:25

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.

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  1. 19 November, 12:49
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    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.
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