Suppose the risk-free rate is 3.5%; on average, an AAA-rated corporate bond carries a credit spread...

Suppose the risk-free rate is 3.5%; on average, an AAA-rated corporate bond carries a credit spread of 0.3%, an A-rated corporate bond carries a credit spread of 1.1%, and a B-rated corporate bond carries a credit spread of 3.9%. Company XYZ’s outstanding debt is rated BBB by rating agencies. What would be the cost of debt for XYZ based on prevailing market rates?

Expert Solution

This has to be a multiple choice question. And the final answer can be arrived by method of elimination.

We are not in a position to directly observe the credit spread for BBB based on the information in the question. However we know that credit spread of BBB should be lower than that of B rated bond and higher than that of A rated bonds.

A_spread < BBB_spread < B_spread

Cost of Debt, I = Risk free rate + Credit spread

Hence, I_A = Cost of debt of A rated bond < I_BBB = Cost of debt of BBB rated bond < I_B = Cost of debt for B rated bond

Hence, 3.5% + 1.1% < I_BBB < 3.5% + 3.9%

Hence, 4.6% < I_BBB < 7.4%

So, please select that multiple choice option, that meets the above crietrion.

jeff jeffy answered 2 years ago

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