In mid-2009, Rite Aid had CCC-rated, 12-year bonds outstanding with a yield to m

Question

In mid-2009, Rite Aid had CCC-rated, 12-year bonds outstanding with a yield to maturity of 17.3%. At the time, similar maturity Treasuries had a yield of 5%. Suppose the market risk premium is 6% and you believe Rite Aid's bonds have a beta of 0.39. The expected loss rate of these bonds in the event of default is 50%.

a. What annual probability of default would be consistent with the yield to maturity of these bonds in mid-2009?

b. In mid-2015, Rite-Aid's bonds had a yield of 6.6%, while similar maturity Treasuries had a yield of 1.4%. What probability of default would you estimate now?

The required return for this investment is ____ %?

Explanation / Answer

(a)

Rd = Rf + (Rm - Rf) x B

Rd = 5 + 6 x 0.39 = 7.34%

Rd = Yield - P(L)

7.34 = 17.3 - P(0.5)

P = (17.3 - 7.34 )/0.5 = 19.92%

(b)

Rd = 1.4 + 6 x 0.39 = 3.74%

3.74 = 6.6 - P(0.5)

P = (6.6 - 3.74)/0.5 = 5.72%

Required rate of return = P(Non default) x Yield Non default + P(Default) x Yield Non default

(For part a)

ROR = (1-0.1992) x 17.3 + 0.1992 X (-50)

= 3.8938%

Please provide feedback.... Thanks in advance.. :-)

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