Problem 15-8 Valuing Callable Bonds Illinois Industries has decided to borrow mo
ID: 2729324 • Letter: P
Question
Problem 15-8 Valuing Callable Bonds
Illinois Industries has decided to borrow money by issuing perpetual bonds with a coupon rate of 8.0 percent, payable annually. The one-year interest rate is 8.0 percent. Next year, there is a 35 percent probability that interest rates will increase to 10 percent, and there is a 65 percent probability that they will fall to 6 percent.
What will the market value of these bonds be if they are noncallable? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
If the company decides instead to make the bonds callable in one year, what coupon rate will be demanded by the bondholders for the bonds to sell at par? Assume that the bonds will be called if interest rates fall and that the call premium is equal to the annual coupon. (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
What will be the value of the call provision to the company? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
Illinois Industries has decided to borrow money by issuing perpetual bonds with a coupon rate of 8.0 percent, payable annually. The one-year interest rate is 8.0 percent. Next year, there is a 35 percent probability that interest rates will increase to 10 percent, and there is a 65 percent probability that they will fall to 6 percent.
Explanation / Answer
Next year market interest rate =.35*10+.65*6=7.3%
Value of bond = interest/r = 8/.073 =109.599
2-coupon rate at call price= face value/ future value
100/109.59 =.9125*100=9.125%
3value of call provisiin = 109.58-100=9.58