First Inc. is facing a liquidity problem and needs to issue a perpetual bond that is callable only at the end of year 2. The call price is $1,000 (face value) plus an additional coupon payment. The current interest rate is 8% per year. At the end of each year, interest rate will either increase or decrease by 1% with equal probability. a. What is the bond's value today if the coupon rate is set at 7%? b. What is the value of the call provision?

Question

First Inc. is facing a liquidity problem and needs to issue a perpetual bond that is callable only at the end of year 2. The call price is $1,000 (face value) plus an additional coupon payment. The current interest rate is 8% per year. At the end of each year, interest rate will either increase or decrease by 1% with equal probability.  a. What is the bond's value today if the coupon rate is set at 7%? b. What is the value of the call provision?