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The firm Kappa has just decided to undertake a major new project. As a result, the...

The firm Kappa has just decided to undertake a major new project. As a result, the value of the firm in one year’s time will be either $120 million (probability 0.25), $250 million (probability 0.5) or $360 million (probability 0.25). The firm is financed entirely by equity and has 10 million shares. All investors are risk-neutral, the risk-free rate is 4% and there are no taxes or other market imperfections

Kappa decides to issue debt with face value $146 million due in one year and use the proceeds to repurchase shares now. Assume now that bankruptcy costs will be 15% of the value of the firm’s assets in the event of default on debt repayment.

What is the value of the debt now? What is its yield?

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Answer #1

According to the given data

The value of the debt ==>$146 million

(where as the value of debt will be the FV of the debt which is $146Million due in one year)

now lets calculate its yield

Therefore, Yield==>value of debt * rate of interest

==>$146million x 4%

==>$5.84million

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