Loveland Enterprises will earn $70 in one year if it does well.The debtholders are promised payments of $40 in one year if the firm does well.If the firm does poorly,expected earnings in one year will be $35 and the repayment will be $25 because of the dead weight cost of bankruptcy.The probability of the firm performing poorly or well is 50%.If bondholders are fully aware of these costs what will they pay for the debt? The interest rate on the bonds is 9%.
A)$23.50
B)$25.00
C)$27.50
D)$29.82
E)$35.00

Question

Quizplus · Accepted Answer

The correct answer is D because the present value of the debt is $29.82. The present value of the debt is calculated as follows:PV = (0.5 * $40) / (1 + 0.09) + (0.5 * $25) / (1 + 0.09) = $29.82

Loveland Enterprises Will Earn $70 in One Year If It