Question

However, the debt issues also raises the probability of bankruptcy. You company has a 30% chance of going bankrupt after 3 years. If it does go bankrupt, it will incur bankrupt costs of $200,000. Again, the discount rate is 10%. What is the expected cost of bankruptcy at the end of the third year? And what is the present value of this cost as of today? (Hint: if there is a 30%t chance of costing shareholders $200,000, what is the expected cost? And, it could only happen at the end of the third year.)

Answer 1

Answer:

Expected Cost = $60,000

Present Value of Expected Cost = $45,079

Explanation:

The chance that the bankruptcy will happen is 30% and the cost it will incur if it happens is $200,000. The expected cost is the probability of the event happening multiplied by the cost of the event happening.

Expected Cost = 200,000 * 0.3

= $60,000

The present value of this cost assuming a discount rate of 10% is;

= $\frac{60,000}{(1 + 0.10)^{3} }$

= $45,078.89

= $45,079