Which of the following would increase the probability of a firm defaulting on its debt when using the Merton model for predicting the probability of default?
An increase in firm value.
An increase in firm value volatility.
An increase in the expected return on the firm.
A. I only. B. II only. C. I and III. D. I, II and III.
Statement II is correct because the firm value volatility is directly related to the probability of default; therefore, an increase in volatility will increase the probability of default.
