Hodge Sports bonds are selling on the open market at par value. The bonds have a stated interest rate of 9 percent and mature in five years. You have determined that the risk-free rate is 7 percent. REQUIRED:
a. What is the maximum risk premium you could attach to these bonds and still be willing to purchase them?
b. Assume that Standard & Poor's lowers the credit rating of Hodge Sports bonds, and this action causes you to increase your risk premium to 5 percent. The bonds have a face value of $1,000 and pay interest semiannually. What price would you be willing to pay for the bonds?
c. Independent of (b), assume that you read in the Wall Street Journal that the prime rate has been cut by 1 percent. All other factors being equal, would this news tend to increase or decrease the market price of Hodge Sports bonds? Why? Assume that reducing the prime rate by 1 percent reflects a reduction in the risk-free rate of 1 percent, and estimate the magnitude of this effect on the price of Hodge Sports bonds.