A Linear Probability Model You Have Developed Finds There Are

question 32

Multiple Choice

A linear probability model you have developed finds there are two factors influencing the past bankruptcy behavior of firms: the debt-to-equity ratio and the sales-to-total assets ratio. Based on past bankruptcy experience, the linear probability model is estimated as:
PD_i = 0.65 (debt/equity) + 0.10 (sales/total assets)
A firm you are thinking of lending to has a sales-to-assets ratio of 0.9 and its expected probability of default, or bankruptcy, is estimated to be 11 percent. Calculate the firm's debt ratio.

• A) 1.03 percent
• B) 2.99 percent
• C) 3.08 percent
• D) 9.70 percent

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Definitions:

Security Market Line

A line that represents the relationship between the expected return of a security and its systematic risk, illustrating the risk-return trade-off in the capital asset pricing model (CAPM).

Portfolio Weight

The proportion of a specific asset within an investment portfolio relative to the total asset value of the portfolio.

Beta

A measure of a stock's volatility in comparison to the overall market, indicating its relative risk.