Question

1.A bond has the following terms:

Principal amount                $1,000

Annual Interest rate           $75 starting 3 years have passed (that is in year 4)

Maturity                               10 years

Callable                                @ $1,075 (that is face value + one year’s interest)

a) Why do you believe that the terms were constructed as specified?

b) What is the bond’s price if comparable debt yields 5 percent?

c)What is the bond’s current yield?

d) Even though interest rates have fallen, why may you not expect the bond to be called?

1.A bond has the following terms:

Principal amount                $1,000

Annual Interest rate           $75 starting 3 years have passed (that is in year 4)

Maturity                               10 years

Callable                                @ $1,075 (that is face value + one year’s interest)

a) Why do you believe that the terms were constructed as specified?

b) What is the bond’s price if comparable debt yields 5 percent?

c)What is the bond’s current yield?

d) Even though interest rates have fallen, why may you not expect the bond to be called?

Answer 1

a)     The terms of these bonds are designed to reduce the firm's cash outflows during the initial years of the bond's life.

b)     The bond's price is

      

$75(4.3295) (.8638) + $1,000(.6139) = $894.

c)     The current yield is 0%. (The bond is currently not paying interest.)

d)     Even though interest rates have fallen from 7.5 percent when this bond was issued to 5 percent, this bond will not be called because the bond does not currently require a cash outlay and the bond has a substantial call penalty.