Question 2

You are currently doing research on Annex Corporation (symbol: ANX), a levered firm that appears to be financially distressed. Your goal is to use bond prices for ANX to infer both the probability that the firm goes into default and the estimated bond repayment in the event of default.

a) Bond ANX.B currently has a price $850, one year until maturity, a promised cash flow of $1,050 next year, and an expected return of 6 percent. If ANX defaults, then Bond ANX.B pays nothing. What is the probability of default implied by this information?

b) Bond ANX.A is senior to Bond ANX.B, and thus has first priority on any available cash flows in the default state. Bond ANX.A has a current price of $950, one year until maturity, a promised cash flow of $1,025 next year, and an expected return of 5 percent. The probability of default is given by your answer in part (a). Based on this information, what is the cash flow that Bond ANX.A will pay in the default state? (The cash flow in the default state is also known as the bankruptcy cash flow or the recovery cash flow.)