Description
A. Preliminary Remarks:
The purpose of this minicase is to demonstrate how the required rate of return on a fixedincome security can be determined, using the risk premium perspective. The minicase brings together, in a simple model, several of the various risks associated with fixedincome securities. From a corporation perspective, the nominal interest rate to be determined in this minicase can serve as a basis for estimating the firm’s beforetax cost of debt. At the issue of the security, if the nominal interest rate is set as the coupon rate that is equal to the yield to maturity (so that the price equals the par value), then one could interpret the obtained rate as a discount rate. From the perspective of investors (buyers of the security), the rate could be interpreted as the investor’s nominal required rate of return.
B. The MiniCase Assignment:
• Your company, Binghamton Truck, Inc., is about to offer a new issue of corporate bonds to the investing marketplace. You have been asked by your CFO to provide a reasonable estimate of the nominal interest rate (nominal yield), Rd, for a new issue of Aaarated bonds to be offered by Binghamton Truck.
• Some agreedupon procedures related to generating estimates for key variables in the relevant equation, Rd = R*rf + IRP + DRP + MP + LP, are as follows:
(1) The current (mid2008) financial market environment is considered representative of the prospective tone of the market near the time of offering the new bonds to the investing public. This means that current interest rates will be used as benchmarks for some of the variable estimates. All estimates will be rounded off to hundredths of a percent; thus, 6.288 becomes 6.29 percent.
(2) The real riskfree rate of interest, R*rf, is the difference between the calculated average yield on 3month Treasury bills and the inflation rate.
(3) The inflationrisk premium, IRP, is the rate of inflation expected to occur over the life of the bond under consideration.
(4) The defaultrisk premium, DRP, is estimated by the difference between the average yield on Aaarated bonds and 30year Treasury bonds.
(5) The maturity premium, MP, is estimated by the difference between the calculated average yield on 30year Treasury bonds and 3month Treasury bills.
(6) Binghamton Truck’ bonds will be traded on the New York Exchange for Bonds, so the liquidity premium, LP, will be slight. It will be greater than zero; however, because the secondary market for the firm’s bonds is more uncertain than that of some other truck producers, it is estimated at 3 basis points.
Note: A basis point is one onehundredth of 1 percent.(E.g., 1 basis point = 0.01%; 25 basis points = 0.25%)
• Based on your research, the mid2008 estimates of the representative interest and inflation rates are as follows: (1) 3Month TBills = 4.89%, (2) 30Year TBonds = 5.38% (use this as proxy for 20year TBonds), (3) AaaRated Corporate Bonds = 6.24%, and (4) Inflation Rate = 3.60%. Visit online Federal Reserve Bank of St. Louis (Google “Federal Reserve Bank of St. Louis FRED”) and update the above data with the most recently available rates for each of the above fixed income securities and for the inflation rate.
• Required Task: Complete the Solution Table below, which is presented in form of a formula required to determine Rd. Place your answers (values) in the cells below the variables in the second row, and show your calculations below the Table, where applicable, of how you obtained the value for each of the variables. Similarly, use your most recent collected rates(May 2019; see source below) to complete the third row of the worksheet below. Briefly comment on the differences between the two results (i.e. results obtained from above old data versus results obtained from recent data you collected).
Solution to MiniCase 1 (show your work below the table, as appropriate):
R*rf 
+ IRP 
+ DRP 
+ MRP 
+ LRP 
= 
Rd 

Using “old” datain the case above 

Using “newer” data* 
Show in this space (add page as necessary) any calculations you performed to find any of the terms in the above table.