Question

Bond Features
Maturity (years)	5
Face Value =	$1,000
Coupon Rate =	3.00%
Coupon dates (Annual)
Market interest rate today	3.00%
Time to call (years)	3
Price if Called	$1,030.00
Market interest rate in Year 3	1.00%

The above bond is callable in 3 years. When the bond is issued today, interest rates are 3.00% . In 3 years, the market interest rate is 1.00% . Should the firm call back the bonds in year 3 and if so, how much would the firm save or lose by calling back the bonds?

A.	yes it should call back the bonds, it will save $8.94

B.	yes it should call back the bonds, it will save $9.69

C.	no it should not call back the bonds, it will lose $9.69

D.	no it should not call back the bonds, it will lose $8.94

E.	yes it should call back the bonds, it will save $9.41

F.	no it should not call back the bonds, it will lose $9.41

Answer 1

Solution:

Face value of bond = $1,000

Maturity = 5 years

Coupon rate = 3%

Calleable price after 3 year = $1,030

Market interest rate after 3 years =1%

Let company after 3 years will call the bond and issue fresh bond for 2 years with coupon rate of 1%

Therefore annual interest saving for 2 years = ($1,000*3%) - ($1,000*1%) = $20

Present value of annual savings after 3 years at 1% interes rate = [$20/1.01] + [$20/(1.01)^2] = $39.41

Extra payment to be made after 3 years if existing bond will be called = $1,030 - $1,000 = $30

Net saving if bond is called after 3 years = $39.41 - $30 = $9.41

Hence company should call back the bonds, it will save $9.41.

Option E is correct.