During the recession in mid-2009, homebuilder KB Home had outstanding 7-year bon

Question

During the recession in mid-2009, homebuilder KB Home had outstanding 7-year bonds with a yield to maturity of 8.5% and a BB rating. If corresponding risk-free rates were 2.7%, and the market risk premium was 5.3%, estimate the expected return of KB Home's debt using two different methods. How do your results compare? (Note: the average loss rate for unsecured debt is about 60%. See annual default rates by debt rating hereand average debt betas by rating and maturity here Considering the probability of default, the expected return of the bond is | %. (Round to two decimal places.) Considering CAPM and given the beta for a 7-year bond, the expected return of the bond is%(Round to two decimal places.) How do your results compare? (Select from the drop-down menu.) While both estimates are rough approximations, they both confirm that the expected return of KB Home's debt is well V its promised yield i Data Table 15 TABLE 12.3 Average Debt Betas by Rating and Maturity By Rating Avg. Beta By Maturity Avg. Beta Source: S. Schaefer and I. Strebulaev, "Risk in Capital Structure Arbitrage," Stanford GSB working A and above 0.05 (BBB and above) 0.10 1-5 Year 0.01 0.17 5-10 Year 0.06 0.26 10-15 Year 0.07 0.31 >15 Year 0.14 paper, 2009 Print Done

Explanation / Answer

1) Rd = Yield to Maturity Prob(default) × Expected Loss Rate Rd = 8.5% 8% × 60% 3.70% Probability of default for BB-rated bonds in recession– it is 8%. The average loss for the unsecured debt is 60% 2) Rd = Rf + Beta x MRP Rd = 2.7% + .17 x 5.3% 3.60% 3) First Approach cost of debt is less than the second approach due to low rating of debt, as well as the recessionary economic conditions at the time. 4) While both estimates are rough approximations, they both confirm that the expected return of KB Home’s debt is well below its promised yield

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