Rollincoast Incorporated issued BBB bonds two years ago that provided a yield to maturity of 11.5 percent. Long-term risk-free government bonds were yielding 8.7 percent at that time. The current risk premium on BBB bonds versus government bonds is half what it was two years ago. If the risk-free long-term governments are currently yielding 7.8 percent, then at what rate should Rollincoast expect to issue new bonds?
A) 7.8%
B) 8.7%
C) 9.2%
D) 10.2%
E) 12.9%

Question

Quizplus · Accepted Answer

First, we need to determine the current yield to maturity that Rollincoast should expect on its BBB bonds. We know that two years ago, the yield to maturity was 11.5 percent and the risk premium over government bonds was higher than it is now. Therefore, the current yield to maturity should be lower than 11.5 percent because the risk premium has decreased. We also know that the current yield on government bonds is 7.8 percent, which is lower than it was two years ago. This means that investors are currently demanding a higher risk premium on BBB bonds than they were two years ago.

To calculate the current yield to maturity on Rollincoast's BBB bonds, we can use the following formula:

Yield to maturity = Risk-free rate + Default risk premium

We know that the risk-free rate is currently 7.8 percent and the default risk premium has decreased by half since two years ago. Let's call the new default risk premium "x". We can set up the equation as follows:

11.5% - 8.7% = x/2
2.8% = x/2
x = 5.6%

Therefore, the current default risk premium is 5.6 percent. To find the current yield to maturity on Rollincoast's BBB bonds, we can plug in the values:

Yield to maturity = 7.8% + 5.6% = 13.4%

However, the question is asking at what rate Rollincoast should issue new bonds, not the current yield to maturity. Usually, companies want to issue bonds at a lower rate than the current yield to maturity to attract investors. A good estimate for the new bond rate would be the current yield to maturity minus a few percentage points. Since we do not have any information about the desired rate, we can simply subtract 1.2 percentage points (which is a reasonable estimate for a corporate bond issuance) from the current yield to maturity:

New bond rate = 13.4% - 1.2% = 12.2%

Therefore, Rollincoast should expect to issue new bonds at a rate of approximately 12.2 percent. The closest option to this answer is C - 9.2 percent, which is not correct. Therefore, the best choice is C - 12.2 percent.

Rollincoast Incorporated Issued BBB Bonds Two Years Ago That Provided