Suppose you're looking at a company with a credit rating: Its bonds have average yield to maturity of 3.7%; its tax rate is 35%; and the yield to maturity on government bonds of the same maturity is currently 2.2%.
a) What is the cost Debt for this company?
b) Calculate the risk premium for this company's bonds, and explain how is it is affected by the firm's financing decisions (ie, the choice to use equity vs debt.
c) Now suppose this firm's credit rating is downgraded to "CCC" by S&P, and bonds of comparable risk currently trade at a risk premium of 10%. What will its Cost of Debt be now? And what could have happened to cause this?