Following the Detroit bankruptcy filing in mid-2013, yields on Detroit bonds increased to approximately 16 percent. Lenders ultimately received about 25 percent of the cash flows they were promised by Detroit.
Suppose that Detroit wants to issue $10M worth of one-year bonds in late-2013. Also suppose that potential lenders still demand a promised yield of 16 percent (that is, a promised cash flow of $11.6M), and believe that they will receive 25 percent of the cash they are promised if Detroit defaults again. Assume that the expected return on risky debt is 6 percent. What is the probability of default implied by this information?
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