(a) Suppose that you are able to perfectly estimate that the true default probability for Hou's...

  

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(a) Suppose that you are able to perfectly estimate that the true default probability for Hou's Luxury Cars and Birru's Bicycles are both 5% for a 5-year horizon. You also perfectly estimate that the recovery rate of both companies (if a default occurs) will be exactly 40%. However, the yield spread on a 5-year zero coupon Hou bond is 1.5% while the yield spread on a 5-year zero coupon Birru bond is 1.4%. The two bonds have identical terms with only the issuer being different. Does this mean that at least one of the two bonds is mispriced? Why or why not? (b) What do the shaded areas in the graph below represent? Why are recovery rates low in these periods? % of Par 90 80 70 30 20 1985 1990 B. Recovery rates 1995 2000 Moodys Recovery Rates Altman Recovery Rates Long-Term Mean 2005 (c) Suppose that you are given the following data Total Liabilities Stock Volatility EBIT/Interest Expense $100mm 0.3 $75mm 0.4 Company Wellman Sporting Goods Chabi-Yo Gambling Parlors Which company would you expect to have a better credit rating. Explain why. 10 8 (d) Holding all else constant (including firm value and the face value of debt), does a higher asset volatility increase or decrease equity value? What about the likeli- hood of default? Explain how these two effects can be reconciled. (a) Suppose that you are able to perfectly estimate that the true default probability for Hou's Luxury Cars and Birru's Bicycles are both 5% for a 5-year horizon. You also perfectly estimate that the recovery rate of both companies (if a default occurs) will be exactly 40%. However, the yield spread on a 5-year zero coupon Hou bond is 1.5% while the yield spread on a 5-year zero coupon Birru bond is 1.4%. The two bonds have identical terms with only the issuer being different. Does this mean that at least one of the two bonds is mispriced? Why or why not? (b) What do the shaded areas in the graph below represent? Why are recovery rates low in these periods? % of Par 90 80 70 30 20 1985 1990 B. Recovery rates 1995 2000 Moodys Recovery Rates Altman Recovery Rates Long-Term Mean 2005 (c) Suppose that you are given the following data Total Liabilities Stock Volatility EBIT/Interest Expense $100mm 0.3 $75mm 0.4 Company Wellman Sporting Goods Chabi-Yo Gambling Parlors Which company would you expect to have a better credit rating. Explain why. 10 8 (d) Holding all else constant (including firm value and the face value of debt), does a higher asset volatility increase or decrease equity value? What about the likeli- hood of default? Explain how these two effects can be reconciled.

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Students name institution instructors name course title due date Suppose that you are able to perfectly estimate that the true default probability for Hous Luxury Cars and Birrus Bicycles are both 5 f... View the full answer