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Callable Bonds

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Bowden Manufacturing intends to issue callable, perpetual bonds. The bonds are callable at $1,250. One year interest rates are 12 percent. There is a 60 percent probability that long-term interest rates one year from today will be 15 percent. With a 40 percent probability, long-term interest rates will be 8 percent. To simplify the firm's accounting, Bowden would like to issue the bonds at par ($1,000). What must the coupon on the bonds be for Bowden to be able to sell them at par?

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Solution Summary

The solution explains how to calculate the coupon rate on a callable bond so that it can be sold at par.

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If interest rates rise to 15%, the price of the Bowdeen bonds will fall, which means the bonds would not be called. In that case, the bond would be worth C/.15 where C is the coupon payment since bonds are perpetual the present value would be the coupon payment/interest rate. The total bond holding would be worth C + C/.15. The coupon payment now and the PV of all ...

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