What is the Maximum Price for an Undervalued Corporate Bond?

B

To determine the maximum price Jefferson Blake should be willing to pay for the bond, we need to calculate the present value of the bond's cash flows.

The bond is a 4% annual pay corporate bond with three years left until maturity and a par value of $1,000. This means it pays a coupon of 4% of the par value each year. Therefore, the annual coupon payment will be $1,000 * 4% = $40.

To calculate the present value of the bond's cash flows, we need to discount each cash flow using the appropriate discount rate. In this case, since the bond is a corporate bond, we'll use the Treasury strip rates as the discount rates. The Treasury strip rates for 1-year, 2-year, and 3-year periods are 4.0%, 4.5%, and 4.75%, respectively.

Let's calculate the present value of the bond's cash flows:

Year 1: Coupon payment = $40 Discount rate = 4.0% Present value of the coupon payment = $40 / (1 + 4.0%) = $38.46

Year 2: Coupon payment = $40 Discount rate = 4.5% Present value of the coupon payment = $40 / (1 + 4.5%)^2 = $36.14

Year 3: Coupon payment = $40 + par value ($1,000) Discount rate = 4.75% Present value of the coupon payment and par value = ($40 + $1,000) / (1 + 4.75%)^3 = $936.43

Now, we can sum up the present values of all the cash flows to find the maximum price Blake should be willing to pay for the bond:

Maximum price = Present value of Year 1 cash flow + Present value of Year 2 cash flow + Present value of Year 3 cash flow = $38.46 + $36.14 + $936.43 = $1,010.03

Therefore, the maximum price Blake should be willing to pay for the bond is approximately $1,010.03.

Unfortunately, none of the given answer options match the calculated value.