Computation of promised yield to maturity for Cardiotronic's zero coupon bonds.
1) Due to Cardiotronics Corporation's recent failure to obtain FDA approval for their new Impeller heart assist device, security analysts believe that there is a significant probability that Cardiotronics will default on its outstanding debt, a single issue of zero-coupon bonds that mature in exactly three years. Cardiotronics' zero-coupon bonds promise to pay $1000 when the bonds mature at the end of three years. The bonds are currently trading at a price of $691.07 (69.1 percent of par value). By comparison, risk-free zero-coupon bonds having two years to maturity are currently trading at a price of $915.73 per $1000 of face value, while risk-free zero-coupon bonds having three years to maturity are currently trading at a price of $863.84 per $1000 of face value. Assuming that investors value risky bonds by discounting the expected payoff at the risk-free rate of interest, determine
a. the promised yield to maturity for Cardiotronic's zero coupon bonds
b. the probability of default that is implicit in the price of Cardiotronics outstanding zero-coupon bonds.
2) The Levitation Wind Turbine Company (LWT) expects to have earnings of $3.00 per share during the fiscal year ending in one year at date 1. LWT has just developed an exciting new turbine design that uses an anti-gravity device to reduce rotational friction and increase efficiency. LWT plans to retain 90 percent of earnings at the end of each of the next three years to build the production capacity required to satisfy demand for the government subsidized production of 'green energy'. LWT expects that the ROA for the new investment in production capacity will be 30 percent. At the end of year four at date 4, LWT expects that the high cost of producing 'wind power' will reduce the firm's retention rate to only 25 percent of earnings, since the ROA for new investment is expected to fall to 16 percent. LWT expects that this level of reinvestment (25 percent of earnings) can be sustained for an indefinitely long (infinite) period of time. Assuming that LWT has an opportunity cost of capital of 12 percent, determine the share price for LWT.