Question [25 points]
In mid–2009, Rite Aid had CCC–rated, 10–year bonds outstanding with a yield to maturity of
18.5%. At the time, similar maturity risk–free treasury bonds had a yield of 3.5%. Suppose the
market risk premium is 6% and you believe Rite Aid’s bonds have a beta of 0.39. The expected
loss rate of these bonds in the event of default is 55%.
a) What annual probability of default would be consistent with the yield to maturity of these
bonds in mid–2009?
b) In mid–2019, Rite–Aid’s bonds had a yield of 6.1%, while similar maturity Treasuries had
a yield of 2.1%. What probability of default would you estimate now?
(Hint: assume that the market risk premium, and the beta and loss given default of RiteAid’s bonds
have not changed from Question (a).)
c) From 2015 to 2019, the annual market returns were 8%, –3%, 15%, 6%, and 4%. During the
same years Rite Aid’s annual stock returns were 16%, –9%, 20%, 11%, and 1%. What is the
equity beta and expected equity return of Rite Aid using these five years of data?
(Hint: consider the covariance and average returns of RiteAid and the market to determine the beta
and expected return of RiteAid’s equity. Assume that the risk–free rate is unchanged from part (b).)
d) In mid–2019 WholeFoods decides to expand their operations into the pharmacy sector. As
a comparable company, the CEO of WholeFoods has identified Rite Aid, which currently
has a Debt–to–Equity Ratio of 2. WholeFoods stock price is $40 per share, with 12 million
shares outstanding. It also has $120 million in outstanding corporate debt, with an average
credit rating of A– and a debt–beta of 0.05.
First, find the asset–beta of RiteAid. Then, determine the appropriate after–tax WACC for
WholeFood’s expansion project if the company will be subject to a 25% corporate tax rate.
(Hint: use the information from Question b to determine the debt–beta of Rite Aid. Use your answer
from Question c for the equity–beta of Rite Aid.
