Final answer:
If the interest rates drop to 5.5% in 2030, Rocky Mountain Brewers is likely to exercise the call on the bond Reagan invested in, as it allows them to lower their cost of borrowing. For a bond with lower interest rates than the market, like the local water company bond at 6% when market rates are 9%, the buying price would be less than the face value, reflecting its relative unattractiveness.
The correct option is D.
Step-by-step explanation:
The question relates to the scenario where Reagan invested in a 15-year bond that pays 8 percent interest annually, callable in 2030, with a maturity date of 2035. If in 2030 the interest rates drop to 5.5 percent, it is likely that the brewery will exercise the call.
This is because callable bonds allow the issuer to repurchase the bond at a specified call price before maturity. If the market interest rates have fallen, it becomes advantageous for the issuer to call the bonds and reissue new bonds at a lower interest rate, which reduces their cost of borrowing. Conversely, if interest rates rise, the issuer will generally not call the bonds, as it would not be economical to issue new bonds at higher rates.
If we consider buying a bond from a local water company issued at 6% interest rate but the current interest rates are now at 9%, we would expect to pay less than the face value of the bond ($10,000) since the bond offers a less attractive rate compared to prevailing interest rates. To calculate the price you would be willing to pay for the bond, you would discount the final year's payments (interest plus principal) by the prevailing market rate (9%).
The correct option is D.