Question

New Business Ventures, Inc., has an outstanding perpetual bond with a coupon rate of 11 percent that can be called in one year. The bond makes annual coupon payments and has a par value of $1,000. The call premium is set at $140 over par value. There is a 60 percent chance that the interest rate in one year will be 13 percent, and a 40 percent chance that the interest rate will be 8 percent. If the current interest rate is 11 percent, what is the current market price of the bond? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Current market price

Answer 1

Answer:

Annual coupon = 1000 * 11% = $110

Call price = $1000 + $140 = $1,140

In one year:

If interest rate 13%, bond price will be = Annual coupon / Interest rate = 110 / 13% = $846.15

As $846.15 < $1,140, if in one year interest rate is 13%, bond will not be called.

If Interest rate in one year is 8%, bond price will be = 110 / 8% = $1,375

$1375 > $1,140, hence if Interest rate in one year is 8%, bond will be called.

Hence:

Bond price = (40% * ($1140 + $100) + 60% * (110 / 13% + 100)) / (1 + 11%) = $958.28

Current market price $958.28