You are currently doing research on Kensington Corporation, a levered firm that appears to be financially distressed. Your goal is to infer the probability that this firm goes into default and the estimated bond repayment in the default state using available market data. The firm has two bonds outstanding: Bond A and Bond B. Bond A is senior to Bond B, meaning that it has the first claim on the cash flows generated by the firm. 

 

a) Bond B has a current price of $800, one year until maturity, a promised cash flow of $1,100 next year, and an expected return of 5 percent. If Kensington defaults, then Bond B pays a cash flow of zero because Bond A claims all available cash flows first. What is the probability of default implied by this information?

b) Bond A has a current price of $900, one year until maturity, a promised cash flow of $1,075 next year, and an expected return of 4 percent. The probability of default is given by your answer in part (a). Based on this information, what is the cash flow to Bond A in the default state?