Question

If there is a significant risk that the firm will default on its​ obligation, ________ of...

If there is a significant risk that the firm will default on its​ obligation, ________ of the​ firm's debt, which is promised​ return, will​ ________ investors' expected return.

A.

the risk​ level; understate

B.

the yield to​ maturity; overstate

C.

the yield to​ maturity; understate

D.

the risk​ level; overstate

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Answer #1

If there is a significant risk that the firm will default on its​ obligation, the yield to​ maturity of the​ firm's debt, which is promised​ return, will​ overstate investors' expected return.

Hence, the correct option is Option B​​​​​. Whenever there is risk of default on the company's obligations, it tends to provide a higher rate of interest to compensate the risk of the company. Also, when the risk increases, the bond price decreases due to lower demand of the bond, which in turn increase the yield to maturity of the bond.

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