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 profit margin. Based on past bankruptcy experience, the linear probability model is estimated as:
PD_i = 0.02 (debt/equity) + 0.80 (profit margin)
A firm you are thinking of lending to has a debt-to-equity ratio of 110 percent and its expected probability of default, or bankruptcy, is estimated to be 8 percent. If sales are $2 million, calculate the firm's net income.

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The correct answer is A. The firm's net income is $145,000.The firm's debt-to-equity ratio is 110 percent, and its expected probability of default, or bankruptcy, is estimated to be 8 percent. The linear probability model is estimated as:PD_i = 0.02 (debt/equity) + 0.80 (profit margin)Substituting the firm's debt-to-equity ratio and expected probability of default into the linear probability model, we get:0.08 = 0.02 (110) + 0.80 (profit margin)Solving for the profit margin, we get:profit margin = (0.08 - 0.02 (110)) / 0.80 = 0.075The firm's net income is equal to its profit margin multiplied by its sales. The firm's sales are $2 million, so its net income is:net income = profit margin * sales = 0.075 * $2 million = $145,000

A Linear Probability Model You Have Developed Finds There Are