Monsters Incorporated (MI) in ready to launch a new product. Depending upon the success of this product, MI will have a value of
either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect. 1. Suppose that MI has zero-coupon debt with a $125 million face value due next year. The total value of MI with leverage is closest to:
(1) $133 million
(2) $140 million
(3) $147 million
(4) $125 million
2. Assuming that in the event of default, 20% of the value of MI’s assets will be lost in bankruptcy costs, the initial value of MI’s equity without leverage is closest to:
(1) $150 million
(2) $147 million
(3) $140 million
(4) $133 million
3. Assume that in the event of default, 20% of the value of MI’s assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The total value of MI with leverage is closest to:
(1) $140 million
(2) $100 million
(3) $125 million
(4) $134 million
A situation known as a "market failure" occurs when the market itself is unable to efficiently distribute resources in a way that balances social costs and benefits.
Market failure refers to a situation where there is an inefficient allocation of products and services on the open market. The individual incentives for rational behavior do not result in rational outcomes for the collective in a market failure.
In other words, each person chooses what is best for themselves, but those choices end up being bad for the collective. This can occasionally be demonstrated in conventional microeconomics as a steady-state disequilibrium condition.
