Question

You are considering buying the bonds of a very risky company. A bond with a $100 face value, a 1-year maturity, and a coupon rate of 22% is selling for $95. You consider the probability that the company will actually survive to pay off the bond 80%. With 20% probability, you think that the company will default, in which case you think that you will be able to recover $40.

a. What is the expected return on the bond?

b. If the company has cost of equity re=25%, tax rate Tc=35%, and 40% of its capital structure is equity, what is its weighted average cost of capital (WACC)?

(do it by excel, please show the formula)

Answer 1

Answer ) In case of survival of company to pay ; return from bond in one year with face value $100 and coupon of 22%

Return = Coupon recieved + Change in price = 22 + (100-95) = 27 .

Return(yield) % = 27 /95 = 28.42%

In case of default , recovery of $ 40 , return = $40- $95 = -$ 55.

Return(yield) % = -55 /95 = -57.9%

Return with probability ,

Return = Probability * return

Return	Probability	Expected return
28.42%	0.8	22.74%
-57.89%	0.2	-11.58%
		11.16%

Answer b)

WACC = Weight of equity * cost of equity +  Weight of Debt * cost of Cost of debt

Cost of debt = Rate of debt ( 1- tax rate ) = 11.16%( 1-0.35) = 7.25%

Here, Weight of equity = 40% = 0.40 ,   Weight of Debt = 1-Weight of equity = 1-0.40 = 0.60

cost of equity (re) =25%

WACC = 0.40 * 25% + 0.60 *7.25% =14.35%.