You are considering investing in the long-term debt of a pharmaceutical company, Blackmores. You require a credit risk premium of 2.5% and a maturity risk premium of 2%. In addition, the long-term inflation rate is 2.5% p.a, the risk-free rate of return is 3.8% and the liquidity-risk premium is 5 basis points. Blackmores' shareholders also require a 2% premium above what creditors earn. Given such information, what would be an appropriate total rate of return suitable for Blackmores' long-term debt?

Question

BlackTom AI · Accepted Answer

Nominal required return on long-term corporate debt is the risk-free return plus compensation for expected inflation and the specific risk premiums investors demand (credit, maturity, liquidity). The shareholders’ 2% premium over creditors is irrelevant for setting a debt yield (it describes equity costing more than debt).

1) Relevant knowledge points and concepts
- Risk-free rate (provided): 3.8% (base return).
- Long-term inflation: 2.5% (adds to nominal yield).
- Credit risk premium (default/credit spread): 2.5%.
- Maturity risk premium (term premium): 2.0%.
- Liquidity-risk premium: 5 basis points = 0.05%.
- Equity premium above debt (2%) is NOT added to debt yields.

2) Step-by-step reasoning
- Start with the risk-free rate (3.8%).
- Add expected inflation (2.5%) to move to a nominal baseline if the 3.8% is interpreted as a real or baseline return to which inflation should be added per the problem’s structure.
- Add the firm-specific premiums: credit (2.5%), maturity (2.0%), and liquidity (0.05%).

3) Intermediate calculations
- Risk-free rate: 3.80%
- Inflation: +2.50% → subtotal = 3.80 + 2.50 = 6.30%
- Credit premium: +2.50% → subtotal = 6.30 + 2.50 = 8.80%
- Maturity premium: +2.00% → subtotal = 8.80 + 2.00 = 10.80%
- Liquidity premium: +0.05% → total = 10.80 + 0.05 = 10.85%

4) Why this answer is correct
Adding all required components (risk-free + inflation + credit + maturity + liquidity) gives 10.85%, which is the appropriate total rate of return for Blackmores’ long-term debt given the stated investor requirements.

5) Why other multiple-choice options are incorrect
- 8.80% (option b) equals 3.8 + 2.5 + 2.5 but omits the maturity (2.0%) and liquidity (0.05%) premiums.
- 8.85% (option a) appears to include liquidity but omits the maturity premium (3.8 + 2.5 + 2.5 + 0.05 = 8.85).
- 8.35% (option c) likely omits the credit premium (3.8 + 2.5 + 2.0 ≈ 8.3) and is therefore too low.

6) Conclusion
The correct total required return for Blackmores’ long-term debt is 10.85%, matching the provided answer (d).

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