Spiess Corporation's 12%, $1,000 bonds mature in 10 years. The company can call the bonds in five years if it pays bondholders a call premium of 12 percent. What should Spiess's bonds sell for if investors expect them to be called in five years and the interest rate is 9%?

Question

Quizplus · Accepted Answer

To calculate the price of the bond we need to find the Present Value (PV) of the bond. Given the parameters, the bond will pay a coupon of $120 every year for the first five years, and $1200 plus the call premium of $1200*12%=$144 at year 5 if it is not called. If it is called, the bond will pay $1200+$144=$1344. We can calculate the PV of these cash flows using the following formula:

PV = (coupon payment / (1 + r)^t) + (coupon payment / (1 + r)^t) + ... + (coupon payment + call price / (1 + r)^t)

Where:
r = the interest rate
t = the year of the cash flow

PV = (120 / (1 + 0.09)^1) + (120 / (1 + 0.09)^2) + (120 / (1 + 0.09)^3) + (120 / (1 + 0.09)^4) + (120 / (1 + 0.09)^5) + (1344 / (1 + 0.09)^5)

PV = $1,195.96

Therefore, the bond should sell for $1,195.96. The best choice is A.

Spiess Corporation's 12%, $1,000 Bonds Mature in 10 Years