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A corporation is considering whether to borrow money from a bank or in the bond market. The bank offered an interest rate of 5% to the firm. The bank debt will be collateralized and subject to covenants, and thus, the bank expects a recovery rate of 80% on the debt if the company defaults. The bank demands an expected return of 4.25% on bank debt. If the company issues bonds, the recovery rate on bonds upon default is expected to be 40%. The probability of default is the same for both bank and bond debt. Using these data, estimate the interest rate that the company will pay on its bonds. Assume that bondholders demand the same expected return as the bank.

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Financial Management, Finance

Category:- Financial Management
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