In mid-2009, Rite Aid had CCC-rated, 9-year bonds outstanding with a yield to ma

Question

In mid-2009, Rite Aid had CCC-rated, 9-year bonds outstanding with a yield to maturity of 17.3%. At the time, similar maturity Treasuries had a yield of 3%. Suppose the market risk premium is 5%and you believe Rite Aid's bonds have a beta of 0.34. The expected loss rate of these bonds in the event of default is 60%.

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 7.2%, while similar maturity Treasuries had a yield of 1.4%. What probability of default would you estimate now?

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

The required return for this investment is nothing %. (Round to two decimal places.)

Explanation / Answer

Ans a) Rd= 3% + 0.34(5%) = 4.70%

4.7% = y–pL

4.7% = 17.3% –p(0.60)

p= (17.3% –4.7%)/0.60 = 21%

Ans b) p= (7.2% –1% –0.34(5%))/0.60

= 7.5%

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