Holly Berry Incorporated will earn $40 in one year if it does well. The debtholders are promised payments of $25 in one year if the firm does well. If the firm does poorly,expected earnings in one year will be $20 and the repayment will be $15 because of the dead weight cost of bankruptcy. The probability of the firm performing poorly or well is 50%. If bondholders are fully aware of these costs what will they pay for the debt? The interest rate on the bonds is 8%.
A) $18.52
B) $30.00
C) $32.55
D) $35.75
E) $37.04

Question

Quizplus · Accepted Answer

The expected repayment to bondholders is (0.5 * $25) + (0.5 * $15) = $20. The present value of this expected repayment, discounted at an 8% interest rate, is $20 / 1.08 = $18.52.

Holly Berry Incorporated Will Earn $40 in One Year If