19. KLY Inc. existing bonds have the following terms: 8% coupon, $1,000 face value and
they mature in 12 years. The discount rate reflective of the default risk and maturity is
14%. KLY Inc. is offering the bondholders the option to swap their existing bonds into 3-
year zero-coupon bonds with a face value of $1,000. Assuming KLY Inc. will not default
during the next 12 years, should existing bondholders accept the option?
A) Yes, because the zero coupon bonds have a shorter 3 year maturity.
B) Yes, because, the zero coupon bonds are worth more.
C) Yes, because the zero coupon bonds are less sensitive to interest rate risk.
D) No, because the existing bonds are worth more.
E) No, because zero coupon bonds do not pay interest.
Answer B
Current price of existing bonds:
PV = $40 x PVIFA(7%,24) + $1,000 / (1 + 7%)
24 = $655.92
Current value of zero-coupon bonds:
PV = $1,000 / (1.14)
3 = $674.97.
The bondholders should accept the offer since the zero-coupon bond is worth
more.
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