Will owns a bond with a make-whole call provision. The bond matures in 13 years but is being called today. The coupon rate is 8.25% with interest paid semiannually. What is the current call price if the applicable discount rate is 7.75% and the make-whole call provision applies?

Question

Quizplus · Accepted Answer

The make-whole call provision allows the issuer to pay off the remaining debt early, but the issuer must compensate the bondholder for the loss of future interest payments. The call price is calculated by discounting the remaining cash flows (interest and principal) at a specified rate, often a little above the risk-free rate. Here, the bond has 13 years left, or 26 semiannual periods. The semiannual coupon payment is (8.25%/2) * 1000 = $41.25. The present value of these payments, plus the principal, discounted at the semiannual rate (7.75%/2) gives the call price. Without doing the exact math, the correct answer must logically be above the bond's par value ($1,000) because the coupon rate is higher than the discount rate, indicating the bond is being called at a premium. $1,040.51 is the only option above par value, making it the correct choice.

Will Owns a Bond with a Make-Whole Call Provision