A Firm Wishes to Issue a Perpetual Callable Bond

question 40

Essay

A firm wishes to issue a perpetual callable bond. The current interest rate is 6%. Next year, there is a 30% chance that the interest rate will be 4.5% and a 70% chance that the rate will be 8.0%. The bond is callable at $1,000 plus an additional coupon payment and it will be called if the interest rate drops to 4.5%.
If the bond is priced at $1,000, what is the cost to the firm of the call provision?

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Definitions:

Downward Sloping

Describes a line or curve on a graph that shows a decrease in one variable as another variable increases, often used in economics to describe demand curves.

Demand Curves

Graphical representations showing the relationship between the quantity of goods consumers are willing and able to purchase at various prices, typically downward sloping from left to right.

Own Price Elasticity

A measure of how much the quantity demanded of a good responds to a change in the price of that good, holding all else constant.

Specific Tax

A tax that is levied as a fixed amount per unit of a good or service, rather than a percentage of the price.