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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

DEFAULT RISK PREMIUM A company’s 5-year bonds are yielding 7.75% per year. Treasury bonds with the same maturity arc yielding 5.2% per year, and the real risk-free rate (r*) is 2.3%. The average inflation premium is 2.5%; and the maturity risk premium is estimated to be 0.1 × (t − 1)%, where t = number of years to maturity. If the liquidity premium is 1%, what is the default risk premium on the corporate bonds?

Summary Introduction

To identify:

The default risk premium.

Default Risk Premium:

A premium, which is paid by the borrower to its lender in the form of compensation of lender’s money in the regards of default risk is known as default risk premium.

Explanation

Solution:

The items required for the calculation of default risk are corporate yield, Treasury bond yield and liquidity premium.

Given,

The corporate yield is 7.75%.

The Treasury bond yield is 5.2%.

The liquidity premium is 1%.

Formula to calculate the default risk premium derives from the formula of corporate bond yield,

CorporateBondYield=TreasuryBondYield+LP+DRPDRP=CorporateBondYield(TreasuryBondYield+LP)

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