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A year ago
Nielson Motors plans to issue 10-year bonds that it believes will have an BBB rating.  Suppose AAA bonds with the same maturity have a 3.5% yield.  Assume that the market risk premium is 5% and the expected loss rate in the event of default on the bonds is 60%.  The yield that these bonds will have to pay during average economic times is closest to:
A) 3.50%
B) 3.75%
C) 4.00%
D) 5.50%
Textbook 

Corporate Finance: The Core


Edition: 4th
Authors:
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A year ago
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C
Explanation:  C) For AAA   rd = rrf + β(rm - rrf) = rrf + 0.05(5%) = 3.5% → rrf = 3.25%
For BBB   rd = rrf + β(rm - rrf) = 3.25% + 0.10(5%) = 3.75%
rd = ytm - prob(default) × loss rate → 3.75% = ytm - 0.4%(60%) → ytm = 3.99%
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