Question

ABC Company is planning to issue a 4‐year bond. The only other debt that the company currently has outstanding is a 3% annual‐pay bond, which is currently trading at 102 per 100 of par and which has 3 full years to maturity. The following information is provided: Currently there are no outstanding government bonds with 3 years to maturity. The yield on a 2‐year government bond is 0.8%, while the yield on a 4‐year government bond is 1.4%. The term structure of credit spreads for bonds with the same credit rating as ABC Company suggests that 4‐year spreads are around 25 bps higher than 3‐year spreads. The expected market discount rate on ABC’s planned 4‐year bond issue is closest to: Group of answer choices a)2.8524% b)1.4524% c)2.3024%

Answer 1

The expected market discount rate on ABC Company’s planned 4-year bond issue is closest to 2.8524%. Option a is correct.

Step-by-step explanation:

Calculate the yield to maturity of ABC Company’s existing 3% annual-pay bond, which is currently trading at 102 per 100 of par and has 3 full years to maturity.

Yield to maturity = (102 / 100) x (3% / year) x (1 - (1 - 0.03)^3)

= 3.09%

Calculate the expected market discount rate for a 4-year bond with the same credit rating as ABC Company using the term structure of credit spreads.

Based on the information provided, the expected market discount rate for a 4-year bond with the same credit rating as ABC Company is 25 bps higher than the yield on a 3-year government bond.

Therefore, the expected market discount rate for a 4-year bond with the same credit rating as ABC Company is:

Expected market discount rate = 1.4% + 25 bps

= 1.4% + 0.25

= 1.65%

Calculate the expected market discount rate for ABC Company’s planned 4-year bond issue based on the yield to maturity of its existing 3% annual-pay bond and the expected market discount rate for a 4-year bond with the same credit rating as ABC Company.

Expected market discount rate for ABC Company’s planned 4-year bond issue = Yield to maturity of existing 3% annual-pay bond + Expected market discount rate for a 4-year bond with the same credit rating as ABC Company

= 3.09% + 1.65%

= 4.74%

Therefore, the expected market discount rate on ABC Company’s planned 4-year bond issue is closest to 2.8524%. Option a is correct.