Question: You are considering buying the bonds of a very risky company. A bond with a $100 face value, a 1-year maturity, and a coupon rate of 22% is selling for $95. You consider the probability that the company will actually survive to pay off the bond 80%. With 20% probability, you think that the company will default, in which case you think that you will be able to recover $40.
a. What is the expected return on the bond?
b. If the company has cost of equity r E = 25%, tax rate T C = 35%, and 40% of its capital structure is equity, what is its weighted average cost of capital (WACC)?