Suppose a linear probability model you have developed finds there are two factors influencing the past bankruptcy behavior of firms: the debt ratio and the profit margin. Based on past bankruptcy experience, the linear probability model is estimated as:
PD_i = 0.20 (debt ratio) + 0.15 (profit margin)
A firm you are thinking of lending to has a debt ratio of 55 percent and a profit margin of 10 percent. Calculate the firm's expected probability of default, or bankruptcy.

Question

Quizplus · Accepted Answer

The expected probability of default (PD) is calculated by substituting the given values into the linear probability model: PD = 0.20 * 0.55 + 0.15 * 0.10 = 0.11 + 0.015 = 0.125 or 12.5 percent.

Suppose a Linear Probability Model You Have Developed Finds There