Synchron Corporation borrowed long-term capital
at an interest rate of 8.5 percent under the expectation that the annual
inflation rate over the life of this borrowing was likely to be 5 percent.
However, shortly after the loan contract was signed, the actual inflation rate climbed
to 5.5 percent, where it is expected to remain until Synchron’s loan reaches maturity.
What is likely to happen to the market value per share of Synchron’s common stock?
Would its stock price be more affected or less affected than the price of the
bonds? Explain your reasoning.
2. The market yield to maturity on a risky bond is currently listed at 10.50 percent. The riskfree
interest rate is estimated to be 5.25 percent. What is the default-risk premium, all
other factors removed? The promised yield on this bond is 11 percent. A certain investor,
looking at this bond, estimates there is a 25 percent probability the bond will pay 11
percent at maturity, a 50 percent probability it will pay a 6 percent return, and a 25
percent probability it will yield only 2 percent. What is the bond’s expected yield? What is
this investor’s anticipated default loss? Will the investor buy this bond?