Structural Model and Default Risk Evaluation

Very Hard Credit Analysis And Valuation Structural Models

Consider a firm that has a structural model of credit risk that includes the use of a default barrier approach. In this model, the firm is valued by estimating the likelihood of default based on the firm’s asset value relative to its liabilities. The barrier is set at the level of total liabilities. Given a scenario where economic conditions are deteriorating, the firm’s asset value has fallen significantly, yet it still has substantial cash reserves and untapped credit lines that could be drawn upon to maintain operations.

Which of the following statements best describes the implications of the structural model in this context?

Despite the asset value falling below the default barrier, the availability of cash reserves means the firm is not at immediate risk of default.

The model suggests that default risk increases as the asset value approaches the level of liabilities, regardless of cash reserves.

The structural model is not applicable in this scenario since it only considers market value fluctuations, ignoring liquidity factors.

Hint

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