Risky Business’s outstanding debt are 6% bonds, paying interest annually and maturing 1 year from today. The bonds currently sell for $569 per $1,000 par value. The company is experiencing severe financial difficulties and analysts predict that there is a 60% probability that the company will go bankrupt within the year. If bankruptcy occurs, bondholders are predicted to receive only 30% of the promised cash flow (principal plus coupon).
a. What is the current promised yield to maturity (assuming that bondholders receive all promised)?
b. What is the current yield to maturity assuming that default occurs?
c. What is the current expected yield to maturity? Explain why the promised yield to maturity is not a good measure of a bond’s expected return when the probability of default is not low.