TL Company has outstanding debt of $50 that is due in one year. However, given the financial distress costs, the debtholders will only receive $40 if the firm does well and $15 if it does poorly. The probability the firm will do well is 60 percent with the 40 percent probability assigned to poor conditions. What is the current value of the debt if the discount rate is 8 percent?

A. $27.78

B. $30.00

C. $26.67

D. $27.50

E. $28.40

The correct option is A,$27.78

Explanation:

The expected value of the debt is = probability of distress * value at distress+probability of firm doing well*value when is doing well

probability of doing well is 60% = 0.6

probability of distress=40%=0.4

value when doing well is $40

value at distress = $15

expected value=$40*0.6+$15*0.4

=$30

the present value of expected value=$30 / (1+8%) ^1

=$30/1.08

=$27.78

the current value of the debt is present value of the expected as calculated above where discounting factor is (1+r) ^N where r the rate of return is 8% and N is the period of debt is 1 year