The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 4% per year for each of the next four years and 3% thereafter. The maturity risk premium (MRP) is determined from the formula: 0.1(t – 1)%, where t is the security’s maturity. The liquidity premium (LP) on all Rink Machine Co.’s bonds is 1.05%. The following table shows the current relationship between bond ratings and default risk premiums (DRP): Rating Default Risk Premium U.S. Treasury — AAA 0.60% AA 0.80% A 1.05% BBB 1.45%   Rink Machine Co. issues fourteen-year, AA-rated bonds. What is the yield on one of these bonds? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average. 7.94%   9.24%   8.19%   5.95%     Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true? An AAA-rated bond has less default risk than a BB-rated bond.   A BBB-rated bond has a lower default risk premium as compared to an AAA-rated bond.

FINANCIAL ACCOUNTING
10th Edition
ISBN:9781259964947
Author:Libby
Publisher:Libby
Chapter1: Financial Statements And Business Decisions
Section: Chapter Questions
Problem 1Q
icon
Related questions
Question
The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 4% per year for each of the next four years and 3% thereafter.
The maturity risk premium (MRP) is determined from the formula: 0.1(t – 1)%, where t is the security’s maturity. The liquidity premium (LP) on all Rink Machine Co.’s bonds is 1.05%. The following table shows the current relationship between bond ratings and default risk premiums (DRP):
Rating
Default Risk Premium
U.S. Treasury
AAA 0.60%
AA 0.80%
A 1.05%
BBB 1.45%
 
Rink Machine Co. issues fourteen-year, AA-rated bonds. What is the yield on one of these bonds? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average.
7.94%
 
9.24%
 
8.19%
 
5.95%
 
 
Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true?
An AAA-rated bond has less default risk than a BB-rated bond.
 
A BBB-rated bond has a lower default risk premium as compared to an AAA-rated bond.
Expert Solution
trending now

Trending now

This is a popular solution!

steps

Step by step

Solved in 3 steps

Blurred answer
Knowledge Booster
Bond Valuation
Learn more about
Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, accounting and related others by exploring similar questions and additional content below.
Similar questions
  • SEE MORE QUESTIONS
Recommended textbooks for you
FINANCIAL ACCOUNTING
FINANCIAL ACCOUNTING
Accounting
ISBN:
9781259964947
Author:
Libby
Publisher:
MCG
Accounting
Accounting
Accounting
ISBN:
9781337272094
Author:
WARREN, Carl S., Reeve, James M., Duchac, Jonathan E.
Publisher:
Cengage Learning,
Accounting Information Systems
Accounting Information Systems
Accounting
ISBN:
9781337619202
Author:
Hall, James A.
Publisher:
Cengage Learning,
Horngren's Cost Accounting: A Managerial Emphasis…
Horngren's Cost Accounting: A Managerial Emphasis…
Accounting
ISBN:
9780134475585
Author:
Srikant M. Datar, Madhav V. Rajan
Publisher:
PEARSON
Intermediate Accounting
Intermediate Accounting
Accounting
ISBN:
9781259722660
Author:
J. David Spiceland, Mark W. Nelson, Wayne M Thomas
Publisher:
McGraw-Hill Education
Financial and Managerial Accounting
Financial and Managerial Accounting
Accounting
ISBN:
9781259726705
Author:
John J Wild, Ken W. Shaw, Barbara Chiappetta Fundamental Accounting Principles
Publisher:
McGraw-Hill Education