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Bay Nuclear Power Plant (BNP) is looking to raise $120 million in a short amount of time. Mani Lau (Mani), the finance director, advised that BNP issue perpetual bonds with a $1,000 face value and an annual coupon rate of 8.1 percent. The market interest rate is currently at 8%. Mani believes there is a 0.3 probability that the interest rate will rise to 10% next year, and a 0.7 chance that it will decline to 6%.

Question:

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?