Problem: Int'l Tiles is a rapidly growing firm. The firm has grown so fast that its management is considering the issuance of a five-year interest only note. The notes would have a principal amount of $1000 and pay 12% interest each year, with the principal amount due at the end of year 5. The firm's investment banker has agreed to help the firm place the notes and has estimated that they can be sold for $800 each under today's market conditions.
1) What is the promised YTM based on the terms suggested by the investment banker
2) The firm's management looked at the YTM estimated above with dismay, it was much higher thatn the 12% coupon rate, which is much higher than current yields on investment grade debt. The investment banker explained that for a small firm the bond rating would probably be in the middle of the specualtive grades, which requires a much higher yield to maturity on the debt under the following assumptions: This risk of default in Years 1 through 5 is 5% per year and the recovery rate in the event of default is only 50%. What is the expected YTM under these conditions.