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    O'Meara, Inc.: Price of Callable, Non-callable Bonds

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    O'Meara Inc. plans to issue $8 million of perpetual bonds. The face value of each bond is $1,000. The semi-annual coupon on the bond is 4.5% Market interest rate 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 Preview

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

    Face value= $1,000
    Semi annual coupon rate = 4.50%
    Semi annual coupon payment = $45.00 =4.5%x$1,000.

    Bond price 1 year from now
    If the market interest rate = 12%
    Semi annual discount rate = 6%
    Price of the bond= Semi annual coupon / discount rate = $750 =$45./6.%

    If the ...

    Solution Summary

    The price of bonds are calculated under two conditions: i) bonds are callable , ii) bonds are non-callable

    $2.19

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