Promised yield to maturity for illinois outstanding issue

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Reference no: EM131985727

The state of Illinois is facing a budget crisis due to the combined effects of the failure of the state legislature to cut spending and the migration of high-income taxpayers to nearby Indiana. Security analysts agree there is a 15 percent probability that Illinois will default on its outstanding debt during the next year, in which case bondholders will lose 80 percent of the $1000 principal value of their investment. The state’s outstanding debt consists of a single bond issue having one year to maturity, a 6 percent annual coupon rate, and a face value of $1000. The coupon payments on the bonds, which are exempt from Federal taxes, are paid annually (once per year), with the final coupon payment occurring at the end of the year. The annualized yield to maturity for risk-free US Government bonds having one year to maturity is 4.0 percent. The tax rate for the marginal investors who earn the same after-tax return from Illinois municipal bonds and US government bonds is 40 percent. Assuming that investors determine the prices of municipal bonds by discounting their expected payoffs using the discount rate for risk-free municipal bonds, determine the promised yield to maturity for Illinois’ outstanding issue of 6 percent coupon bonds.

Reference no: EM131985727

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