Question

Suppose the risk-free rate is 3.5%; on average, an AAA-rated corporate bond carries a credit spread of 0.3%, an A-rated corporate bond carries a credit spread of 1.1%, and a B-rated corporate bond carries a credit spread of 3.9%. Company XYZ’s outstanding debt is rated BBB by rating agencies. What would be the cost of debt for XYZ based on prevailing market rates?

Answer 1

The multiple choices are:

A: 6.5%

B: 7.4%

C: 3.8%

D: 4.6%

The correct option is A,6.5%

Step-by-step explanation:

The hierarchy of bonds in terms of credit rating quality is given below from the highest rating to the lowest rating below:

AAA

AA

A

BBB

BB

B

CCC

CC

C

D(default)

This above is based on Standard & Poor's and Fitch rating scales.

According to the question AAA bond cost can be computed thus:

AAA cost of debt=risk free rate+credit spread

risk free rate is 3.5%

credit spread on AAA is 0.3%

AAA cost of debt=3.5%+0.3%

=3.8%

A cost of debt =3.5%+1.1%

=4.6%

B cost of debt=3.5+3.9%

=7.4%

A BBB lies in between A and B bonds,in other words,BBB would have higher cost of debt compared to A bond but a lower cost of debt when compared with a B bond

Consequently,option B is wrong because that is the cost of B rated bond as well as option D as that is cost of A rated bond,since the correct is lesser than 7.4% but higher than 4.6%,option A 6.5% is perfect choice

Answer 2

The cost of BBB rated bond will be more than 4.6% and lesser than 7.4%.

Step-by-step explanation:

In order to calculate the cost of debt for XYZ based on prevailing market rates, we need to calculate first the following steps:

First, we have to calculate the cost of A rated bond using the following formula:

cost of A rated bond= Risk free rate+credit spread on A rated bond

=3.5%+1.1%

=4.6%

Next, we have to calculate the cost of A rated bond using the following formula:

cost of B rated bond= Risk free rate+credit spread on B rated bond

=3.5%+3.9%

=7.4%

Therefore, after having calculated the cost of A rated bond and the cost of B rated bond, we can conclude that the cost of BBB rated bond will be more than 4.6% and lesser than 7.4%.