Alpha Inc. has a $1,000 par value bond that was issued ten years ago for a thirty year term. Interest rates were very high at that time and the bond's coupon rate is 22%. The relevant bond market interest rate is now 10%. All of Alpha's bonds have a call feature. It allows the company to pay off the bond any time after the first fifteen years, but requires that bondholders be compensated with an extra year's interest at the coupon rate if such a payoff is exercised. What is the bond's market price assuming investors expect it will be called as soon as possible?

Question

Quizplus · Accepted Answer

First, we need to calculate the current value of the bond using the current market interest rate of 10%.

PV = 220 / (1.1)^1 + 220 / (1.1)^2 + ... + 220 / (1.1)^30 + 1000 / (1.1)^30
PV = $1598.35

Next, we need to adjust for the possibility of the bond being called. If it is called, the investor would receive an extra year's interest at the coupon rate of 22%, or $220.

Adjusted PV = $1598.35 - $220
Adjusted PV = $1378.35

Therefore, the market price of the bond assuming investors expect it will be called as soon as possible is $1378.35, or choice B.

Alpha Inc Has a $1,000 Par Value Bond That Was Issued