Corporate Finance A company has two bonds outstanding: Bond A has a maturity of
ID: 2725669 • Letter: C
Question
Corporate Finance
A company has two bonds outstanding: Bond A has a maturity of 1 year and a face value of 3,000, bond B has the same maturity and a face value of 1,500. Bond A, though, has a higher seniority than Bond B. One year from now the company can be in a good state or in a bad state. If it is in a good state, its assets' value will be 4,250, while if it is in a bad state its assets' value will be 2,500. Both states are equally likely to happen. The risk-free interest rate is 4.50%, the market risk premium is 7%, and the two bonds bear no systematic risk. The value of the 2 bonds is Bond A: 2631.58; Bond B: 598.09
(a) Consider the information given above, assume now that the two bonds bear some systematic risk and that the value of Bond A is 2,300 while the value of Bond B is 500. What is the overall beta of debt? Answer: 2.29
Explanation / Answer
Expected value of bond in one year = sum of probability x cash flows
= (0.50 x 4250 + 0.50 x 2500)
= 3375
Current value of bonds = 2300 +500
= 2800
Expected return = (V1/ Vo) -1
= (3375 / 2820.5400) -1
= 20.54%
Expected return using CAPM:
Er = Rf + MRP x beta
20.54% = 4.5% + 7% x beta
Beta = 16.04%/7
Beta = 2.29