(See attached file for full problem description)
Week 4 - Problem 5
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?
The solution explains how to calculate the price of perpetual bonds given the probability of interest rates and whether the bonds are callable or non-callable.