Question
The following table shows the prices and yields on one and two-year zero coupon bonds issued by Firm A and Firm B. Firm A Firm
The following table shows the prices and yields on one and two-year zero coupon bonds issued by Firm A and Firm B.
| Firm A | Firm B | ||
Years to Maturity | Price | YTM | Price | YTM |
1 | $92.857 | 7.692% | $90.476 | 10.526% |
2 | $85.986 | 7.842% | $85.986 | 7.842% |
The one-year bonds either default or pay in full at maturity. The two-year bonds can default at the end of one year and the end of two years. Bond holders receive a recovery rate of 50% when the firms default. The one and two-year Treasury yields are 4%.
One of the firms gets 90% of its revenues from an established product and 10% of its revenues from a new unproven but potentially innovative product. The other firm gets 70% of its revenues from an established product and 30% of its revenues form a new but potentially innovative product. Which firm, Firm A or Firm B, is the firm with 90% of its revenues from the established product, and which firm, Firm A or Firm B, is the firm 70% of its revenues from the established product?
Fill in the following table by marking an X in the columns labelled Firm A and Firm B that match the firms bond yields with the established/unproven product mix.
Established Product | Unproven Product | Firm A | Firm B |
90% | 10% |
|
|
70% | 30% |
|
|
Explain your answer.
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