The 1-year bonds of Casino, Inc., have a 12 percent coupon rate and trade in the market at a yield of 14 percent. There is a 5 percent chance that Casino will default and pay nothing. What cost of debt should be used in Casino's WACC?

Question

Quizplus · Accepted Answer

The cost of debt should reflect both the coupon rate and the yield, as well as the probability of default. Since there is a 5 percent chance of default, the expected cost of debt can be calculated as: 
Expected Cost of Debt = (Probability of No Default x Yield) + (Probability of Default x 0)
Expected Cost of Debt = (95% x 14%) + (5% x 0) = 13.3%
Therefore, the cost of debt used in Casino's WACC should be 13.3%, which is closest to option B (8.3%).

The 1-Year Bonds of Casino, Inc