Suppose the risk-free rate is 3.5%; on average, an AAA-rated corporate bond carries a credit spread of 0.3%, an A-rated corporate bond carries a credit spread of 1.1%, and a B-rated corporate bond carries a credit spread of 3.9%. Company XYZ’s outstanding debt is rated BBB by rating agencies. What would be the cost of debt for XYZ based on prevailing market rates?

The cost of BBB rated bond will be more than 4.6% and lesser than 7.4%.

Explanation:

In order to calculate the cost of debt for XYZ based on prevailing market rates, we need to calculate first the following steps:

First, we have to calculate the cost of A rated bond using the following formula:

cost of A rated bond= Risk free rate+credit spread on A rated bond

                                 =3.5%+1.1%

                                =4.6%

Next, we have to calculate the cost of A rated bond using the following formula:

cost of B rated bond= Risk free rate+credit spread on B rated bond

                                 =3.5%+3.9%

                                 =7.4%

Therefore, after having calculated the cost of A rated bond and the cost of B rated bond, we can conclude that the cost of BBB rated bond will be more than 4.6% and lesser than 7.4%.

The multiple choices are:

A: 6.5%

B: 7.4%

C: 3.8%

D: 4.6%

The correct option is A,6.5%

Explanation:

The hierarchy of bonds in terms of credit rating quality is given below from the highest rating to the lowest rating below:

AAA

AA

A

BBB

BB

B

CCC

CC

C

D(default)

This above is based on  Standard & Poor's and Fitch rating scales.

According to the question AAA bond cost can be computed thus:

AAA cost of debt=risk free rate+credit spread

risk free rate is 3.5%

credit spread on AAA is 0.3%

AAA cost of debt=3.5%+0.3%

                            =3.8%

A cost of debt =3.5%+1.1%

                       =4.6%

B cost of debt=3.5+3.9%

                      =7.4%

A BBB lies in between A and B bonds,in other words,BBB would have higher cost of debt compared to A bond but a lower cost of debt when compared with a B bond

Consequently,option  B is wrong because that is the cost of B rated bond as well as option D as that is cost of A rated bond,since the correct is lesser than 7.4% but higher than 4.6%,option A 6.5% is perfect choice

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