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Determining the Price of O' Meara's Noncallable Bonds

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O' Meara Inc., plans to issue $6 million of perpetual bonds. The face value of each bond is $1,000 The semi-annual coupon on the bonds is 4.5% Market interest rates on one-year bonds are 8% With equal probability, the long-term market interest rate will be either 12% or 6% next year. Assume investors are risk-neutral.

a. If the O'Meara bonds are noncallable, what is the price of the bonds?
b. If the bonds are callable one year from today at $1,250, will their price be greater than or less than the price you computed in (a)? Why?

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Solution Summary

The solution explains how to calculate the price of non-callable bonds given the expectation of future interest rates.

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a. If the O'Meara bonds are noncallable,what is the price of the bonds?

The price of the bond today would be the discounted sum of the cash flows to the investor. The cash flow to the investor are the coupon interest and the price of the bond one year from today. The interest amount is $45 every six months. The price of the bond at the end of 1 year would depend on the interest rate. For a perpetual bond, ...

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