Question

9. You are considering buying the bonds of a very risky company. $A$ bond with a $$\$ 100$$ face value, a 1-year maturity, and a coupon rate of $22 \%$ is selling for $$\$ 95$$. You consider the probability that the company will actually survive to pay off the bond $80 \%$. With $20 \%$ probability, you think that the company will default, in which case you think that you will be able to recover $$\$ 40$$. a. What is the expected return on the bond? b. If the company has cost of equity $r_E=25 \%$, tax rate $T_C=35 \%$, and $40 \%$ of its capital structure is equity, what is its weighted average cost of capital (WACC)?

   9. You are considering buying the bonds of a very risky company. $A$ bond with a $$\$ 100$$ face value, a 1-year maturity, and a coupon rate of $22 \%$ is selling for $$\$ 95$$. You consider the probability that the company will actually survive to pay off the bond $80 \%$. With $20 \%$ probability, you think that the company will default, in which case you think that you will be able to recover $$\$ 40$$.
a. What is the expected return on the bond?
b. If the company has cost of equity $r_E=25 \%$, tax rate $T_C=35 \%$, and $40 \%$ of its capital structure is equity, what is its weighted average cost of capital (WACC)?

Financial Modeling

imon Benninga 4th Edition

Chapter 3, Problem 9

Instant Answer

Step 1

- If the company survives (80% probability), the bond will pay the face value of $100 plus the coupon payment of 22% of $100, which is $22. So, the total payment if the company survives is $100 + $22 = $122. - If the company defaults (20% probability), you expect Show more…

Show all steps

Thanks for your feedback!

9. You are considering buying the bonds of a very risky company. $A$ bond with a $$\$ 100$$ face value, a 1-year maturity, and a coupon rate of $22 \%$ is selling for $$\$ 95$$. You consider the probability that the company will actually survive to pay off the bond $80 \%$. With $20 \%$ probability, you think that the company will default, in which case you think that you will be able to recover $$\$ 40$$. a. What is the expected return on the bond? b. If the company has cost of equity $r_E=25 \%$, tax rate $T_C=35 \%$, and $40 \%$ of its capital structure is equity, what is its weighted average cost of capital (WACC)?

Play audio

Feedback

Ace is your personal tutor. It breaks down any question with clear steps so you can learn.

Start Using Ace

Continue solving this problem

Create a free account to:

View full step-by-step solution
Ask follow-up questions with Ace AI
Save progress and study later

Please give Ace some feedback