In mid-2009, Rite Aid had CCC-rated, 19-year bonds outstanding with a yield to m

Question

In mid-2009, Rite Aid had CCC-rated, 19-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 4% and you believe Rite Aid's bonds have a beta of 0.38. The expected loss rate of these bonds in the event of default is 56%. What annual probability of default would be consistent with the yield to maturity of these bonds in mid-2009? In mid-2012, Rite-Aid's bonds had a yield of 8%, while similar maturity Treasuries had a yield of 1.1%. What probability of default would you estimate now? 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 %. (Round to two decimal places.) The annual probability of default is %. (Round to two decimal places.) In mid-2012, Rite-Aid's bonds had a yield of 8%, while similar maturity Treasuries had a yield of 1.1%. What probability of default w ould you estimate now ? The probability of default will be %. (Round to two decimal places.)

Explanation / Answer

Answer:a Required return (Rd)=Risk free rate+Beta *Market risk premium

Rd = 3% + 0.38(4%) = 4.52%

Required return (Rd)=Yield to maturity-probability (p)*expected loss (l)

Rd= y – pL

4.52%= 17.3% – p(0.56)

p = (17.3% – 4.52%)/0.56

= 22.82%

Answer: b.   

p = (8% – 1.1% – 0.38(4%))/0.56 = 9.61%

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