Question

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. 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 initial value of MI's debt is closest to:

Answer 1

The Initial value of debt is $111.11 million.

Value of unlevered equity = ($100 million+ $150 million + $191 million)/3 / 1.05

Value of unlevered equity = $147 miliion / 1.05

Value of unlevered equity = $140 million.

Since the corporation have has zero-coupon debt with a $125 million face value, this means If the firm has a value of $100 million, all of it is from the debt value,

Initial value of debt = ($100 million + $125 million + $125 million)/3 / 1.05

Initial value of debt = $111.11 million.

The Initial value of equity = Value of unlevered equity - Initial value of debt

The Initial value of equity = $140 million - $111.11 million

The Initial value of equity = $29 million

Hence, the Initial value of debt is $111.11 million.

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