The value of a company’s equity is $4 million and the volatility of its equity is 60%. The debt that will have to be repaid in two years is $15 million. The risk-free interest rate is 6% per annum. Use Merton’s model to estimate the expected loss from default, the probability of default, and the recovery rate

(as a percentage of the no-default value) in the event of default. Explain why Merton’s model gives a high recovery rate.

AppendixLO1