Suppose a ﬁrm has a total market value of $900 and outstanding debt with a face value of $850. The risk-free rate of interest is 6%. If the ﬁrm will have a value of either $650 or $900 next period,
What is the rate of return on the ﬁrm's debt? (Assume the bond makes no coupon payments during
This time period.)
A) 0.9%
B) 6.7%
C) 7.2%
D) 7.8%
E) 8.1%

Question

Quizplus · Accepted Answer

The rate of return on the firm's debt is calculated as (Face Value - Market Value) / Market Value. Here, the market value of debt is $850, and the face value is $850. If the firm value is $650, the debt is worth $650. The return is ($650 - $850) / $850 = -0.2353 or -23.53%. If the firm value is $900, the debt is worth $850. The return is ($850 - $850) / $850 = 0%. The expected return is a weighted average of these, but since the debt is risk-free, the return is close to the risk-free rate, 0.9%.

Suppose a ﬁRm Has a Total Market Value of $900