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
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