Question

Assume a firm’s debtholders are promised payments in one year of $35 if the firm does well and $20 if the firm does poorly. There is a 50/50 chance of the firm doing well or poorly. If bondholders are willing to pay $25.50, what is the promised return to those bondholders?

Answer 1

Answer:

$2 or 7.84%

Explanation:

we need to determine the expected value of the firm's payments:

• $35 x 50% chance of doing well = $17.50
• $20 x 50% chance of doing poorly = $10
• total expected value = $27.50

Since investors are willing to pay $25.50 and the expected value in one year is $27.50, the promised return = $27.50 - $25.50 = $2 or 7.84% (= $2 / $25.50)