Southland, Inc. is a shipping company that specializes in moving cargo by sea on barges. Southland has recently issued bonds with a face value of $1000. The bonds also promise 1 annual coupon payment of 3%, which is due, along with the face value, in exactly one year. Information from the credit rating agencies indicates that the bonds have a 10% chance of defaulting. In the event of default, investors are expected to recover 85% of the amount due to them (i.e. 85% of the coupon payment and face value due to them). Assume that other bonds of similar risk and maturity have an expected rate of return of 6%. Considerable more risky bonds have yields as high as 12%. Other bonds have coupon rates as high as 5%. 20 year Treasury bonds have yields of 3%. Suppose that inflation is expected to be 2% next year. What is the opportunity cost of debt for these bonds? Please explain (briefly) why you chose this particular opportunity cost from among the other potential choices. What Price should Southland bonds sell for in the equity market? What should the yield-to-maturity be on Southland bonds in a capital market? A colleague at work with an MBA from a different business school claims that the Southland bonds are a 'suckers' game (i.e. they are NPV < 0) because there are other bonds with yields as high as 12% in the market. Is he correct? Why or Why not? Your neighbor says that Southland bonds are NPV < 0 investment. Her reasoning is that since inflation is expected to be 2% next year, the 3% coupon on the Southland bonds will be 'almost completely wiped out' by inflation. Thus, she says, the bonds will provide investors with an 'inadequate' 1% rate of return. Is she correct? Why or why not?

Answer rating: 100% (QA)

1 The opportunity cost of debt for these bonds is the expected rate of return on similar bonds minus ... View the full answer