# Perpetual Bonds - KIC Inc.

KIC Inc. plans to issue $5 million of perpetual bonds. THe fave value of each bond is $1,000. The annual coupon bond is 12%. Market interest rates on one-year bonds are 11%. With eqaul probability, the long-term interest rates will be either 14% or 7% next year. Assume investors are risk-neutral. A. If the KIC bond are noncallable, what is the price of the bonds? b. if the bonds are callable one year from todayat $1,450, will their price be greater than or less than the price you computed in (A)? Why?

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A)

Since investors are risk-neutral, the value of the bond should simply

be the expected present value of the payments of the bond. Let's see

how we calculate this.

The face value of the bond is $1,000 and the annual coupon on the

bonds is 12%. This means that the bond holder receives $120 (12% of

$1,000) each year, assuming annual payments. We're also told that the

current market interest rate is 11%, and next year it will change to

either 7% or 14% for the long term. So we will need to calculate what

would be the value of the bond if the interest rate turns out to go to 7%, and what would be its value if the interest rate goes to 14%.

Assume we are already in the "next year" (we will then discount the

results to get the present -today's- value). Let's also assume that

the interest rate is 7% for the long term. The present value of the

bond would then be:

$120 + $120/(1.07) + $120/(1.07)^2 + $120/(1.07)^3 + ...

until infinity, because this is an noncallable perpetual bond, so KIC

committed to pay $120 forever, without the option of redeeming it. The formula that solves ...

#### Solution Summary

The solution is in a word document format that explains how to calculate the price of bonds.