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: PDi = .013 (debt/equity) + .78 (profit margin)
A firm you are thinking of lending to has a debt-to-equity ratio of 112 percent and its expected probability of default, or bankruptcy, is estimated to be 15.35 percent. If sales are $1.55 million, calculate the firm's net income.

Question

Quizplus · Accepted Answer

To find the firm's net income, first calculate the profit margin using the linear probability model: 0.1535 = 0.013 * 1.12 + 0.78 * (profit margin). Solving for the profit margin gives approximately 0.192. Net income = profit margin * sales = 0.192 * $1,550,000 = $297,600. The closest option is A) $276,100.

A Linear Probability Model You Have Developed Finds There Are