Bay Nuclear Power Plant (BNP) is considering raising funds $120 million over a short period. In its last management meeting, the finance director, Mani Lau (Mani), suggested that BNP issues perpetual bonds with a face value of $1,000 each with a coupon rate of 8.1% paid annually. The current market interest rate is 8%. Mani estimates a 0.3 probability that next years interest rate will increase to 10%, and a 0.7 probability that it will fall to 6%.

(a) If NBP issue a perpetual bond based on Manis suggestion, please evaluate the current market value of the perpetual bond given the probabilities of the interest rate change. (Show your calculations).

(7 marks)

(b) The chairperson, Philips Chuang (Philips), decides to add a call provision into the bond contract and make the bonds callable in one year. Determine what the new coupon rate of the callable bonds should be if the bonds are issued at par. Assume that the bonds will be called if the interest rates fall and the call premium is set at $150 over par value. (Show your calculations).

(7 marks)

(c) Suppose that after evaluating market conditions, BNP finally issued a callable bond with a coupon rate of 8.2% paid annually, and the call premium is equal to 16% of the principal amount of bonds. The total principal value of the bonds issued is $100 million. The company is subject to a tax rate of 35%.

Assume it is now one year after the callable bonds were issued and the current market interest rate is 7.35%. BNP is considering refunding the callable bond issue. Refunding means that the company would issue new bonds and use the proceeds from the new bond issuance to repurchase the outstanding bonds. Given transaction cost of refunding is equal to $1 million should BNP refund and call the bonds? (Show your calculations).

(6 marks)