Orange, Inc. is a technology company that designs cell phones, computers and operating systems among other products. Orange has recently undergone a large bond issue. This bond issue includes a number of $1000 face value bonds that are due in 1 year and promise a 5% coupon. These bonds will pay 1 annual coupon payment, which is due, along with the face value, in exactly one year. The bonds have a beta of 0.30. The market risk premium is 5% and the risk free rate is 4%. Information from the credit rating agencies indicates that the bonds have a 7% chance of defaulting. In the event of default, investors are expected to recover 95% of the amount due to them (i.e. 95% of the coupon payment and face value due to them).
a.) What is the opportunity cost of debt (i.e. expected return) for these bonds?
b.) What price should these bonds sell for in the market?
c.) What should the YTM be on these bonds?
d.) Is the expected return on these bonds equal to their YTM? Why or why not?
e.) Your colleague at work notes that these bonds have a ‘low yield' and are therefore a ‘bad' investment. He says that there are other bonds in the market with much higher yields and these, he says, are clearly better investments. Is he correct?