1. You are analyzing a distressed bond with one year to maturity. The bond has a face value of $100 and pays a coupon rate of 5 percent per year, with annual coupons. The bond is currently trading at $80.
What is the yield to maturity on the bond? If the probability of default is 35 percent, what is the cost of debt? Assume that upon default, only 50 percent of face value will be recovered and that remaining coupons will not be paid. If the probability of default rises to 40 percent but the expected payout in default remains at 50 percent, what do you think will happen to the yield to maturity and the cost of debt? Why?
2. What challenges did the financial crisis of 2008 and its aftermath pose for estimating a firm's cost of capital? How should one handle these challenges?