A hospital has outstanding $100 million of bonds that mature in 20 years (40 periods). The debt was issued at par and pays interest at a rate of 6 percent (3 percent per period). Prevailing rates on comparable bonds are now 4 percent (2 percent per period).
1. What would you expect to be the market price of the bonds, assuming that they are freely traded? Would there be an economic benefit for the hospital to refund the existing debt by acquiring it at the market price and replacing it with new, ‘‘low-cost’’ debt?
2. Assume that the bonds contain a provision permitting the hospital to call the bonds in another five years (ten periods) at a price of $105 and that any invested funds could earn a return equal to the prevailing interest rate of 4 percent (2 percent per period). What would be the economic savings that the hospital could achieve by defeasing the bonds ‘‘in substance’’?