A linear probability model you have developed finds there are two factors influencing the past bankruptcy behavior of firms: the debt-to-equity ratio and the sales-to-total assets ratio. Based on past bankruptcy experience, the linear probability model is estimated as:
PD_i = 0.60 (debt/equity) + 0.02 (sales/total assets)
A firm you are thinking of lending to has a sales-to-assets ratio of 1.75 and its expected probability of default, or bankruptcy, is estimated to be 8.1 percent. Calculate the firm's debt-to-assets ratio.

Question

Quizplus · Accepted Answer

To find the firm's debt-to-equity ratio, use the linear probability model: 0.081 = 0.60(debt/equity) + 0.02(1.75). Solving for debt/equity gives approximately 0.0712 or 7.12 percent.

A Linear Probability Model You Have Developed Finds There Are