Question

Q2.Calculate the distance to default if the current market value of asset is 300 Million, growth is 3%, asset volatility is 15%, current liabilities are 200 Million, and non-current liabilities are 140 Million, interpret your answer.

If there are 500 firms with this distance to default, and 30 of these have defaulted, calculate the expected default probability, explain in detail the implications this number has for the future default rate?

Distance to default = ((Market Value of Assets) – (Current Liabilities + 0.5 X Non Current Liabilities))/(Market Value of Assets X Asset Volatility)

Answer 1

Answer to the question:

Calculation of the Distance to default (DTD)

DTD = ((Market Value of Assets) – (Current Liabilities + 0.5 X Non Current Liabilities))/(Market Value of Assets X Asset Volatility)
DTD = ((300 million) – (200 million + 0.5 X 140 millions))/($300 million X 0.15)
= 300 - 270 / 45
= 0.66667

If there are 500 firms with this distance to default, and 30 of these have defaulted, then the expected default probability
= 30/500*100
= 6%

The distance to default (DD) and the probability of default (PD) are the essential credit risks in the finance world. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations. It is necessary to know which parameter impacts more on PD and DD so that the firm will deal with that parameter

In the given case DTD is 0.66667 hence DTD is low and there is only 6% of the probability that the firm is expected to default on the basis of the given data.