Question

C Company’s risk-free interest rate is 6 percent. The standard deviation in the rate of change in the underlying asset's value is percent, and the leverage ratio of C Company is 0.9. C Company has a $350,000 loan that will mature in one year. The value for N(h1) is 0.028, and the value for N(h2) is 0.94. I don't need anything with the numbers, I just need answers to b. and c. below. b. Briefly discuss what this loan value represents? c. What is the importance of default risk to loan, give an example.

Answer 1

Answer (b)

This Loan Value represents Debt. As leverage ratio(Debt/Equity) is given, you can find out Equity using it.

Answer(c)

Default risk to loan is the probability that the company will not repay the loan in particular time.( 1 year in this question). It generally happens with the companies that have high leverage ratio. It has good leverage ratio of 0.9. So, there are less chances that this company will default.

for eg.

1-The chance that a financial institution like a bank may collapse if it is unable to return interest payment and principle is the default risk the investors take. although this default risk is low.

2- Companies extend credit to individual consumers such as car loans, mortgage, credit card face far higher default risk.

3- US Government bonds are considered as immune to default risk.