2) Brad\'s Robotics Incorporated will earn $60 in one year if it does well. The

Question

2) Brad's Robotics Incorporated will earn $60 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 $10 and the repayment will be $5 because of the dead weight cost of bankruptcy. The probability of the firm performing poorly or well is 40%. If bondholders are fully aware of these costs what will they pay for the debt? The interest rate on the bonds is 7%.

$16.82

$39.04

**Please show work.

$16.82

$39.04

**Please show work.

Explanation / Answer

Expected earning of the bondholders = ($40x0.4) + ($5x0.4) = $18

Since the will earn $40 if the firm performs well and $5 if the firm performs poorly. And the probability of both the cases is 40%

The cost of debt is 7%

The amount bondholders willing to pay = $18/1.07 = $16.82

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