Why? KIC, Inc., plans to issue $5 million of bonds with a co Valuing Callable Bo
ID: 2795532 • Letter: W
Question
Why? KIC, Inc., plans to issue $5 million of bonds with a co Valuing Callable Bonds rate of 8 percent and 30 years to maturity. The current market interest rates on t bonds are 7 percent. In one year, the interest rate on the bonds will be either 10 per or 6 percent with equal probability. Assume investors are risk-neutral. a. If the bonds are noncallable, what is the price of the bonds today? b. If the bonds are callable one year from today at $1,080, will their price be great 8. less than the price you computed in (a)? Why?Explanation / Answer
Current YTM on bonds= 7%
Coupon rates are = 8%
Therefore the bond is trading at premium
PV of bond= 80/(1+r)1+ 80/(1+r)2......+n+1000/(1+r)30= 1124.09$
In one year the YTM will be 10% so the PV at T1= 812.61$
Or it will be 6% so the PV at t1= 1271.81$
With equal probablities.
Value of bond if they are non callable= (812.61*0.5 + 1271.81*0.5)/1.10= 947.468$
Value of callable bond, at T1
812.61 the bond will not be called payoff=0
1271.81 the bond will be called, payoff= 1271.81- 1080= 191.81$
Call option value= (0*0.5 + 191.81*0.5)/1.10= 87.186$
Value of callable bond= value of straight bond- value of call option= 947.468 - 87.186= 860.28$$
The value of callable bond is less than the value of straight bond- because in callable bonds issuer can call the bond anytime he wants to which increases it's yeild and therefore it's value is decreased.