International Tile Importers, Inc., is a rapidly growing firm that imports and markets floor tiles from around the world that are used in the construction of custom homes and commercial buildings. The firm has grown so fast that its management is considering the issuance of a five-year interest-only note. The notes would have a principal amount of $1,000 and pay 12% interest each year, with the principal amount due at the end of Year 5. The firm's investment banker has agreed to help the firm place the notes and has estimated that they can be sold for $800 each under today's market conditions. SHOW ALL WORK, PUT IN EXCEL a) What is the promised yield to maturity based on the terms suggested by the investment banker?
b) The firm's management looked at the yield to maturity estimated above with dismay, for it was much higher than the 12% coupon rate, which is much higher than current yields on investment-grade debt. The investment banker explained that for a small firm such as International Tile, the bond rating would probably be in the middle of the speculative grades, which requires a much higher yield to attract investors. It even suggested that the firm recalculate the expected yield to maturity on the debt under the following assumptions: The risk of default in Years 1 through 5 is 5% per year, and the recovery rate in the event of default is only 50%. What is the expected yield to maturity under these conditions?
Solution
a. Promised YTM = 18.46%
b. (Note: the discussion of this analysis is found in the Appendix to the chapter)
Bond Rating Caa/CCC
10 Year Treasury Yield = 5.02%
Coupon 12.00%
Principal $ 1,000.00
Price $ 800.00
Maturity 5 years
Recovery Rate 50.00%
Default Probability 5.00%
Default Cash Flows
Year 1 2 3 4 5 Promised Cash Flow
0
1
2
3
4
5
Expected yield to maturity if default occurs in this year
Probability of default in each year
Weighted YTM = E(YTM) x Pb of default
Average YTM based on Expected Cash Flows
YTM Spread
Cost of Debt Spread