Buckeye Industries has a bond issue with a face value of $20,000 that is coming due in one year. The current value of the firm's assets is $22,200 but these assets are expected to be worth either $18,000 or $26,000 one year from now. The going rate on one-year T-bills is 3.6 percent. What is the current value of the firm's debt?

Question

Quizplus · Accepted Answer

To calculate the current value of the firm's debt, we need to find the expected value of the assets at maturity and then discount the face value of the bond by the risk-adjusted interest rate.

Expected value of assets = ($18,000 + $26,000) / 2 = $22,000

Default risk premium = (Expected asset value - Current asset value) / Current asset value
= ($22,000 - $22,200) / $22,200
= -0.009

Risk-adjusted interest rate = One-year T-bill rate + Default risk premium
= 3.6% - 0.9%
= 2.7%

Current value of debt = Face value of bond / (1 + Risk-adjusted interest rate)
= $20,000 / (1 + 0.027)
= $18,581

Therefore, the best choice is B.

Buckeye Industries Has a Bond Issue with a Face Value