International Tile Importers Inc. is a rapidly growing firm that imports and markets floor tiles from around the world. The tiles 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 annually, 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.
a. What is the promised YTM based on the terms suggested by the investment banker?
b. Refer to the appendix to this chapter for this analysis. The firm’s management looked with dismay at the YTM estimated in Problem 4- 9( a) because it was much higher than the 12% coupon rate, which is much higher than the yield to maturity currently paid 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. The banker even suggested that the firm recalculate the expected YTM 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 YTM under these conditions?