The TrunkLine Company will earn $60 in one year if it does well. The debtholders are promised payments of $35 in one year if the firm does well. If the firm does poorly, expected earnings in one year will be $30 and the repayment will be $20 because of the dead weight cost of bankruptcy. The probability of the firm performing poorly or well is 50%.

If bondholders are fully aware of these costs what will they pay for the debt?

The interest rate on the bonds is 10%.

a. $25.00

b. $27.50

c. $29.55

d. $32.50

e. $35.00

The answer is a. $25.00

Explanation:

The bondholder's cash flow in one-year time from holding a TrunkLine's bond is calculated as:

(The possibility of TrunkLine doing well x Repayment receipt in case TrunkLine doing well) + (The possibility of TrunkLine doing poorly x Repayment receipt in case TrunkLine doing poorly) = (0.5 x 35) + (0.5 x 20) = $27.50.

The current price bondholders are willing to pay for a bond is equal to the present value of a bond's cash flow in one-year time, discounted at the interest rate on the bond 10% which is calculated as below:

27.50 / (1+10%) ^1 = $25

Thus, the correct choice is a. $25.00