The following table shows asset, debt, and equity time 1 cash flows (first two columns of numbers), expected time 1 cash flows (third column of numbers), and present values (last column of numbers) for a firm. The amount of money loaned to the firm is $60 and it has a 50% chance of bankruptcy (i.e., in the bad state), but bankruptcy costs = $0.

Now assume that bankruptcy costs = $11. (Of course, you will only have to pay the bankruptcy costs in the bad state.) Including bankruptcy costs in the analysis, what promised interested rate will you need to pay the lender so that the lender still makes an expected return of 5% on the $60 loan to the firm?

Bad state (50%) Good state (50%) Expected PV Assets $50 $170 $110 $110/1.1 = $100 Debt $50 $76 $63 $63 / 1.05 = $60 Equity $0 $94 $47 $47 / 1.175 = $40