Question

ClearOne Elec Co. has a bond issue with a face value of $1,000 that is due in one year. The value of ClearOne Elec’s assets is currently $1,200. The CEO believes that the assets in the firm will be worth either $920 or $1,400 in a year. The going rate on one-year T-Bill is 2.8%. What is the interest rate of the current value of the debt?

Group of answer choices 3.05% 5.73% 7.05% 8.32% None of above is correct.

Answer 1

Given about ClearOne Elec Co.

Bond's face value = $1000

years to maturity = 1 year

current assets = $1200

The CEO believes that the assets in the firm will be worth either $920 or $1,400 in a year

risk free rate Rf = 2.8%

We know that

Value of Assets = [E0 * {(Higher level of Asset in a year - Lower level of Asset in a year) / (Higher level of Asset in a year - Face Value)}] + [Lower level of Asset in a year / (1 + rF)]

where E0 is value of equity

=> 1200 = E0*[(1400-920)/(1400-1000)] + [920/1.028]

=> 1200 - 894.94 = 1.2E0

=> E0 = $254.22

So, D0 = assets - E0 = 1200 - 254.22 = $945.78

So, current value of bond = $945.78

So, interest rate on the bond = FV/D0 - 1 = (1000/945.78) - 1 = 5.73%

Option B is correct.