Question

Government can seldom realize an economic gain by refunding bonds in the absence of call provision. A government has outstanding $100 million of 20-year, 10 percent bonds. They were issued at par and have 16 years (32 semiannual periods) until they mature. They pay interest semiannually. 1. Suppose current prevailing interest rates had decreased to 8 percent (4 percent per period). At what amount would you estimate the bonds were trading in the open market? 2. Suppose the government elected to purchase the bonds in the market and retire them. To finance the purchase it issued 16-year (32-period) bonds at the prevailing rate of 8 percent (4 percent per period). What would be the ‘‘economic cost’’ (i.e., the present value of anticipated cash flows) of issuing these bonds? Would the government realize an economic gain by retiring the old bonds and issuing the new? 3. Suppose a call provision permitted the government to redeem the bonds at any time for a total of $101 million. Could the government realize an economic gain by recalling the bonds and financing the purchase by issuing $101 million in new, 8 percent, sixteen-year bonds?

Answer 1