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?

Solutions

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 1 year ago

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