TL Company has expected earnings of $75 in one year if it does well and $25 if it does poorly. The firm has outstanding debt of $50 that is due in one year. However, given the financial distress costs, the debtholders will only receive $40 in one year if the firm does well and $15 if it does poorly. There is a 60 percent chance the firm will do well and a 40 percent chance that it will do poorly. What is the current value of the debt if the interest rate on bonds is 8 percent?
A) $27.78
B) $27.50
C) $30.00
D) $26.67
E) $28.40

Question

Quizplus · Accepted Answer

The expected payoff to debtholders is (0.6 * $40) + (0.4 * $15) = $24 + $6 = $30. The present value of this expected payoff is $30 / (1 + 0.08) = $27.78.

TL Company Has Expected Earnings of $75 in One Year