International Tile Importers Inc. is a rapidly growing ?rm that imports and markets ?oor tiles from around the world that are used in the construction of custom homes and commercial buildings. The ?rm has grown so fast that its management is considering the issuance of a seven-year interest-only note. The notes would have a principal amount of $1,000 and pay 10.5% interest each year, with the principal amount due at the end of Year 7.The ?rm's investment banker has agreed to help the ?rm place the notes and has estimated that they can be sold for $900 each under today's market conditions.
a. What is the promised yield to maturity based on the terms suggested by the investment banker?
b. (Hint: Refer to the textbook Appendix for this analysis.) The ?rm's management looked with dismay at the yield to maturity estimated above, for it was much higher than the 12% coupon rate, which is much higher than current yields on investment-grade debt. The investment banker explained that for a small ?rm such as International Tile, the bond rating would probably be in the middle of the speculative grades, which requires a much higher yield to attract investors. The banker even suggested that the ?rm recalculate the expected yield to maturity on the debt under the following assumptions: The risk of default in Years 1 through 7 is 6% per year, and the recovery rate in the event of default is only 50%. What is the expected yield to maturity under these conditions?