Question

Assume Forrest Corporation debtholders are promised payments in one year of $42 if the firm does well and $18 if the firm does poorly. There is a 50/50 chance of the firm doing well or poorly. If debtholders are willing to pay $28.65 today to purchase this debt, what is the promised return to those debtholders? Multiple Choice

a) 4.7 percent
b) 4.5 percent
c) -4.7 percent
d) 3.8 percent
e) -3.8 percent

Answer 1

The promised return to debtholders of Forrest Corporation, given a 50/50 chance of different payoff outcomes and a purchase price of $28.65, is approximately 4.7 percent, which is option (a).

Step-by-step explanation:

To calculate the promised return to debtholders, we need to take the expected payoff and compare it with the price they pay today. As debtholders are promised $42 with a 50% chance and $18 with another 50% chance, the expected payoff is (0.5 * $42) + (0.5 * $18) = $21 + $9 = $30. To find the return, we use the following formula:

Return = (Expected Payoff - Price Paid) / Price Paid

Substituting the given values:

Return = ($30 - $28.65) / $28.65 = $1.35 / $28.65 ≈ 0.0471 or 4.71%

Therefore, the closest choice to the calculated return is 4.7 percent, which corresponds to option (a).