29 Bond Refunding Heineken NV has decided to borrow money by issuing perpetual bonds with a coupon rate of 6 per cent, payable annually. The one-year interest rate is 6 per cent. Next year, there is a 35 per cent probability that interest rates will increase to 7 per cent, and there is a 65 per cent probability that they will fall to 5 per cent.

(a) What will the market value of these bonds be if they are non-callable?

(b) If the company instead decides to make the bonds callable in one year, what coupon will be demanded by the bondholders for the bonds to sell at par? Assume that the bonds will be called if interest rates fall and that the call premium is equal to the annual coupon.

(c) What will be the value of the call provision to the company?

CHALLENGE