20.8 Illinois Industries has decided to borrow money by issuing perpetual bonds. The face value of the bonds will be $1,000. The coupon will be 8 percent, payable annually. The one-year interest rate is 8 percent. It is known that next year there is a 65-percent chance that interest rates will decline to 6 percent, and that there is a 35-percent chance that they will rise to 9 percent.

a. What will the market value of these bonds be if they are noncallable?

b. If the company instead decides to make the bonds callable, what coupon will be demanded by the bondholders for the bonds to sell at par? Assume that the bonds can be called in one year (i.e., the call date is one year from now) and that the call premium is equal to the annual coupon.

c. What will be the value of the call provision to Illinois Industries?