Question

Concord Company has a $10,000 pure discount bond that comes due in one year. The risk-free rate of return is 4 percent. The firm's assets are expected to be worth either $8,000 or $13,000 in one year. Currently, these assets are worth $11,000. What is the current value of the firm's debt?

Answer 1

Formula sheet

A	B	C	D	E	F	G	H	I	J
2
3		The firms debt value will be the minimum of the debt value and the value of assets of the company.
4		Assuming the increase and decrease in value have same probability.
5
6		Bond Face Value	10000
7		Risk free return	0.04
8
9		Year	0			1
10			Asset Value		Probability	Asset Value	Bond Value
11
12					0.5	=13000	=MIN($D$6,G12)	=MIN($D$6,G12)
13			10000
14					0.5	8000	=MIN($D$6,G14)
15
16		Expected Value of debt after 1 year	=F12*H12+F14*H14	=F12*H12+F14*H14
17
18		Present value of expected value	=D16/(1+D7)^1	=D16/(1+D7)^1
19
20		Hence the current value of firms debt is	=D18
21