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Predictions of Distress Currently the value of Commodus Ltd’s assets are $16 million while the face...

Predictions of Distress

Currently the value of Commodus Ltd’s assets are $16 million while the face value of the firm’s debt (as zero-coupon bonds) is $14.5 million. The risk-free rate is 4 percent and the time horizon is ten years. The variance of Commodus Ltd cash flows is 16 percent.

Required:

  1. If N(d1) = 0.847673669                                                                                    
    and N(d2) = 0.405783861                                                                                 
    Please calculate the call value of Commodus Ltd’s equity              
  2. What is the cost of debt of Commodus Ltd and its default risk premium    
  3. The CEO of Commodus wants the firm to take on a large new project with a projected NPV of $6 million which would be funded by raising $4m new debt and the remainder being funded from retained earnings. The danger of this project is that it adds 16% more variance to the company’s projected cash flows. If this new project causes the call value of the equity to rise to $16,780,899, calculate the dollar wealth gains to winners and dollar wealth losses to losers with the taking on of the new project.                                     
    [Note the solution to the Black-Scholes calculation is provided for you!]      

  1. Calculate the effective cost of debt AFTER the project is taken on AND calculate the percentage change in the default risk premium.                         

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Homework Answers

Answer #2

a) According Scholes Formula,

Call Value= Present value * Nd1 - Ke^Rf * t * Nd2

Rf = 0.04, K - Strike Price= Face Value = $ 14.5 mn, t = time to expiration = 10 years, Present Value = $ 16 mn

Call Value = 16 * 0.8476 - 14.5 * e ^ (0.04 * 10) * 0.4057

= $ 9.60 mn.

Call Value = Buy priceof Debt = $ 9.60 mn.

therefore according to zero coupon bond formula, Price = Face value * 1/ (1 + r) ^n, n = 10 years

(1 + r) ^ 10 = 1 / ( 9.60/14.5), = 31.39 % .

The cost odf debt is 31.39%

the default risk premium for debt is ( Cost of debt- Risk free rate) = ( 31.39- 4) = 27.39%.

answered by: anonymous
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