Calculating the Probability of Bankruptcy 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 = .45 (debt/equity) + .01 (sales/total assets)
A firm you are thinking of lending to has a sales-to-assets ratio of 1.9 and its expected probability of default, or bankruptcy, is estimated to be 7 percent. Calculate the firm's debt ratio.

Question

Quizplus · Accepted Answer

To find the firm's debt-to-equity ratio, use the linear probability model: 0.07 = 0.45(debt/equity) + 0.01(1.9). Solving for the debt/equity ratio gives approximately 0.1018 or 10.18%.

Calculating the Probability of Bankruptcy a Linear Probability Model You