A company has an outstanding bond that will mature in two years. After two years the company will terminate all activity. The company unlevered equity value in two years can be $25 million with a 50% probability, or $12 million with probability 50%. The bond is a zero-coupon bond with face value $15 million. Everyone is risk-neutral, and the risk-free rate is 5%. The market price of the bond is 75% of the face value. Assume perfect capital markets and no taxation.
What is the value of bankruptcy costs at year two?
The correct answer is 2.19 million.
I have absolutely no clue how they would come up with that answer. I just don't see any logic with the expected values of the equity and the loss of debtors. Can someone please lead me through this calculation?
