Based on the following example. A company has estimated that issuing a senior, unsecured bond in the market will require the company to pay a 7% interest rate to investors to compensate for the risk of default. The company is rated BB-. The company is also considering borrowing from a bank instead of issuing a bond.

A. Suppose that the probability of default on this company's debt is 3.5% a year. The recovery rate for unsecured bondholders is 40%. What is the expected annual return that bond investors will face when investing in this bond?

4%

Approximately 3.5%

We cannot calculate the expected return with these data.

4.65%.

Now, suppose that the recovery rate on the bank loan increases to 80% (as opposed to 40% with the unsecured bond). In addition, suppose that the bank demands the same expected return that bondholders demand. The interest rate on the bank loan will be __________.

7%

8%

6.26%

5.55%