Mr. O'Kay, a risk -neutral investor, is contemp lating a one-year, 8 percent loan of $750 to Firm J. Mr. O'Kay demands at least a 5 percent expected return per annum on loans like this. O'Kay is concerned that the firm may not be able to pay the interest and/or principal at the end of the year. A further concern is that if he makes the loan, Firm J may engage in additional borrowing. If so, O'Kay's security would be diluted and the firm would become more risky. Since Firm J is growing rapidly, O'Kay is sure that the firm would engage in additional borrowing if he makes the loan.

O'Kay examines Firm J's most recent annual report and calculates an interest coverage ratio (the ratio of net income before interest and taxes to interest expense) of 4, including his contemplated $750 loan.

Upon considering all of these matters, O'Kay assesses the following probabilities:

PAYOFF                                                                                       PROBABILITY

91: Interest and principal repaid..........................................................0.83
92: Reorganization, principal repaid but not interest........................0.15
93: Bankruptcy, nothing repaid............................................................0.02
..................................................................................................................1.00

Required

a. Should Mr. O'Kay make the loan? Show calculations.

b. Firm J offers to add a covenant to its lending agreement with Mr. O'Kay, undertaking not to engage in any additional borrowing if its interest coverage ratio falls below 4 before the next year-end. Mr. O'Kay estimates that there is a 60 percent probability that the interest coverage ratio will fall below 4. If it does, there would be no dilution of his security by additional borrowing under the Firm J offer, and he feels the lower coverage ratio would still be adequate. He assesses that his payoff probabilities would then be

Payoff                 Probability

θ₁..................................0.96

θ₂..................................0.03

θ₃..................................0.01

......................................1.00

If the coverage ratio does not fall below 4, the resulting additional borrowing and dilution of security would cause him to assess payoff probabilities as

Payoff                 Probability

θ₁................................0.87

θ₂................................0.12

θ₃.................................0.01

....................................1.00

Should Mr. O'Kay now make the loan? Show calculations.