Reference no: EM13380815

The city of Rio Linda is currently in a difficult budgetary position due to the failure of the city council to either raise property taxes or reduce expenditures. Bond market analysts agree that there is a 20 percent probability that the city will default on its outstanding debt during the next year, causing the bondholders to lose 100 percent of their original investment. The city's outstanding debt consists of a single bond issue having one year to maturity, a 4.5 percent coupon rate and a face value of $1000. The coupon payments on the bonds, which are exempt from State and 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 investors who earn the same after-tax return from tax-exempt municipal bonds and US government bonds is 25 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 Rio Linda's outstanding issue of 4.5 percent coupon bonds. (15 points)