suppose the risk free rate is 1.50%; on average, an AAA rated corporate bond carries a...

suppose the risk free rate is 1.50%; on average, an AAA rated corporate bond carries a credit spread of 0.5%, an BB-rated corporate bond carries a credit spread of 2.5% and a B rated corporate bond carries a credit spread of 3.5%. company BTS's outstanding debt is rated A by rating agencies. What could be the cost of debt for BTS based on prevailing market rates?

a. 1.25%

b. 5.25%

c. 3.25%

d. 4.25%

Expert Solution

The solution require additional information about Probability of Default and Recovery Rate of different Ratings. But this question can be answered by eliminating the options.

Risk Free Rate is 1.5% and any corporate bond would carry a cost of Debt of respective Credit Spread + Risk Free rate.

So the cost of debt of specified rated bonds are as follows,

AAA : 1.5% + 0.5% = 2%

BB : 1.5% + 2.5% = 4%

B : 1.5% + 3.5% = 5%

Since BTS is rated AA which falls between AAA and BB, Option C 3.25% would be the correct answer.

jeff jeffy answered 2 years ago

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