New Business Ventures, Inc., has an outstanding perpetual bond with a coupon rat

Question

New Business Ventures, Inc., has an outstanding perpetual bond with a coupon rate of 8 percent that can be called in one year. The bond makes annual coupon payments. The call premium is set at $100 over par value. There is a 60 percent chance that the interest rate in one year will be 10 percent, and a 40 percent chance that the interest rate will be 5 percent. If the current interest rate is 8 percent, what is the current market price of the bond? Assume a par value of $1,000. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Explanation / Answer

First, examine whether the bond will be called if interest rate falls to 5%.

The call price is $1,000 + $100 = $1,100.

Bond price at 5% yield will be:

                $1600 ($80 / 0.05) > call price of $1,100

Bond will be called. The price of the callable bond therefore is:

                [(0.4) * (1100 + 80) + (0.6) * ((80 / 0.1) + 80)] / 1.08

                ($472 + $528) / 1.08

Current price of Bond =                $925.93

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