Chartered Financial Analyst Level 2
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59 An analyst is estimating the cost of debt for a company's 10-year non-traded bonds. She relies on an internally developed matrix of synthetic credit ratings, a portion of which is presented in the following table:
| Credit Rating | Debt-to-Equity Ratio | Credit Spread (%) |
|---|---|---|
| AAA | Less than 0.15 | 0.80 |
| AA | 0.15 to 0.20 | 1.10 |
| A | 0.20 to 0.25 | 1.45 |
| BBB | 0.25 to 0.30 | 2.10 |
| BB | 0.30 to 0.40 | 2.50 |
The yield to maturity (YTM) on the US Treasury 10-year benchmark government bond is 5.41%. In its most recent financial statements, the company reported equity of 34.5 million. The implied YTM of the company's 10-year bond is closest to:
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A
1.45%
B
6.51%
C
6.86%
Explanation:
Calculation Steps
-
Calculate Debt-to-Equity Ratio:
- Total Debt = $34.5 million
- Equity = $150.0 million
- Debt-to-Equity Ratio = 150.0 = 0.23
-
Determine Credit Rating and Spread:
- Based on the matrix:
- AAA: < 0.15
- AA: 0.15 to 0.20
- A: 0.20 to 0.25
- BBB: 0.25 to 0.30
- BB: 0.30 to 0.40
- With D/E = 0.23, the company falls into the "A" rating category (0.20 to 0.25)
- Credit Spread for A rating = 1.45%
- Based on the matrix:
-
Calculate Implied YTM:
- Risk-free rate (10-year Treasury) = 5.41%
- Credit Spread = 1.45%
- Implied YTM = Risk-free rate + Credit Spread = 5.41% + 1.45% = 6.86%
Therefore, the implied YTM of the company's 10-year bond is closest to 6.86%.
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