Question 1 (20 marks)

Question 1, Part A (10 marks):

A firm wishes to issue a perpetual callable bond.The one-year interest rate is 7%. The bond makes annual coupon payments. There is 60% probability that long-term interest rates one year from today will be 8.25%, and a 40% probability that they will be 6.5%. The call price is $1075 (i.e. a call premium at $75 over par value), and it will be called if the interest rate drops to 6.5%.

a) What is the correct coupon amount if the bond is priced to sell at par? (5 marks)

b) Given calculations in a), what is the value of the call provision to the company? (5 marks)

Question 1, Part B (10 marks):

To finance the construction of a new plant, Bluestar Inc. must raise an additional $8,000,000 of equity capital through rights offering. The firm currently has an EPS of $5.40 and a P/E ratio of 10, with 1,200,000 shares outstanding. If the firm wants its ex-rights price (Px) to be $50,

a)what subscription price must it set on the new shares? (7 marks)

b) What are the advantages of a rights offer? (3 marks)