Question

Sludge Corporation has two bonds outstanding, each with a face value of $3.00 million. Bond A is a senior bond; bond B is subordinated. Sludge has suffered a severe downturn in demand, and its assets are now worth only $5.00 million. If the company defaults, what payoff can the holders of bond B expect

Answer 1

Answer:

The payoff for holders of Bond B is $2,000,000

Explanation:

The senior bond takes priority over the subordinated bond when it comes redeeming bondholders investment in the business.

The senior bond has a lower risk as it is paid first in the event of liquidation,though attracts a lower rate of return since return and risk are positive related.

The subordinated is ranked lower than the senior debt but may command a higher rate of return because of its high risk.

Assets worth                                            $5,000,000

repayment of senior debt                        ($3,000,000)

Balance left for subordinated debt          $2,000,000