Suppose a linear probability model you have developed finds there are two factors influencing the past bankruptcy behavior of firms: the debt ratio and the profit margin. Based on past bankruptcy experience, the linear probability model is estimated as:
PD_i = 0.20 (debt ratio) + 0.50 (profit margin)
You know a particular firm has a debt ratio of 60 percent and a probability of default of 15 percent. Calculate the firm's profit margin.

Question

Quizplus · Accepted Answer

The correct answer is A.The firm's profit margin can be calculated by rearranging the linear probability model as follows:Profit margin = (PD_i - 0.20 (debt ratio)) / 0.50Plugging in the given values, we get:Profit margin = (0.15 - 0.20 (0.60)) / 0.50 = 0.06 = 6.00 percent

Suppose a Linear Probability Model You Have Developed Finds There