Question

Please answer using Excel.

RISKY BOND PROBLEM
Face value of bond	100
Coupon rate	22%
Non-default probability	80%
Default probability	20%
Payoff in default (% of face value)	40%
Market price today	95
Expected payoff in one year
Expected return, rD
Part b
Percentage equity	40%
Percentage debt	60%
Corporate tax rate, TC	35%
Cost of equity, rE	25%
WACC

Answer 1

RISKY BOND PROBLEM
Face value of bond	100
Coupon rate	22%
Non-default probability	80%
Default probability	20%
Payoff in default (% of face value)	40%
Market price today	95
Expected payoff in one year	25.6	`=(40*0.2)+(22*0.8)
Expected return, rD	5.26%	`=(100-95)/95
Part b
Percentage equity	40%
Percentage debt	60%
Corporate tax rate, TC	35%
Cost of equity, rE	25%
Cost of Debt	14%	Calculated below
WACC	18.58%	`=(0.25*0.4)+(0.143*0.6)

If it the company defaults we will get 40 and chances of its default is 20%

If it does not default we will get coupon payment 22 and chances of no default is 80%

So using probability we get the expected payoff in one year

The expected return on a bond can be expressed with this formula:

Expected return = (F-P)/P

F = the bond's face value, and

P = the bond's purchase price.

To get WACC we need to find Cost of debt which can be calculated as

Cost of Debt = Interest Expense (1 – Tax Rate)

In our case interest exp is coupon payment

= 0.22(1-0.35)

=14.3%