The correct answer is C. Using the Merton model, the probability of default (PD) is calculated using the formula:

$PD = N\left(\frac{\ln(\frac{F}{V}) + \mu(T - t)}{\sigma\sqrt{T - t}}\right)$

where:

• $V$ is the value of the company's assets (CAD 400 million)
• $F$ is the face value of the company's debt (CAD 300 million)
• $\mu$ is the expected rate of return of the value of the company's assets (15% or 0.15)
• $\sigma$ is the instantaneous volatility of the value of the company's assets (25% or 0.25)
• $T - t$ is the remaining time to maturity for the company's debt (1 year)

Plugging in the values:

$PD = N\left(\frac{\ln(\frac{300}{400}) + 0.15 \times 1}{0.25 \times \sqrt{1}}\right)$ $PD = N(-1.626)$ $PD = 5.20\%$

(Using Excel: PD = NORMSDIST(-1.626) = 0.051975)

The Merton model has several limitations. It is applicable to liquid, publicly traded names only, and there is a continuous need for calibration of the PD on historical series of actual defaults as an analytical requirement, a maintenance requirement, which is costly for smaller organizations. The Merton model also relies on the continually changing movements in market prices, volatility, and interest rates.

Option A is incorrect because the calculation error led to a PD of 3.03%, and the Merton model can indeed be applied to debt holdings maturing in more than 1 year.

Option B is incorrect because the PD is not 4.04%, and the limitation mentioned is not accurate.

Option D is incorrect because the PD is not 12.49%, and while the Merton model does rely on changing market conditions, the limitation mentioned is not a direct limitation of the model itself.