Doubts

Mock Exam 3b

Mock Exam 3b

by Salvador Valverde R. Azevedo Almeida -
Number of replies: 1

Hello Professor, I don't understand why we multiply each probability by 100. I understand we're testing if in scenario D the firm goes bankrupt or not, but nor in A nor in B the payoff is 100, so it doesn't make sense to me to compute the PV of the loan repayment with 3 100s instead of only 1 and 130 and 140. Thanks in advance


In reply to Salvador Valverde R. Azevedo Almeida

Re: Mock Exam 3b

by Julio Crego -
We want to know if scenario D is bankrupt. It will go bankrupt if the debt payment exceeds 100. Therefore, we start checking whether 100 is enough for the debt payment. Enough means that the discounted expected payoff exceeds the value today (90).

If we promise 100 to the bank, we pay 100 in every scenario that we are not bankrupt, even if we have a higher cashflow. Debt contracts cannot be conditioned on the scenario (by definition).

We observe that the bank does not lend us 90 if we promise 100, so we need to promise more than 100; hence going bankrupt in scenario D.