Question

Buckeye Industries has a bond issue with a face value of $1,000 that is coming due in one year. The value of Buckeye’s assets is currently $1,090. Jim Tressell, the CEO, believes that the assets in the firm will be worth either $920 or $1,380 in a year. The going rate on one-year T-bills is 4.8 percent.

  

a-1	What is the value of Buckeye’s equity (Do not round intermediate calculations. Round the final answer to 2 decimal places.)

  

Value of equity

$

  

a-2	What is the value of the debt? (Do not round intermediate calculations. Round the final answer to 2 decimal places)

  

Value of debt

$

  

Suppose Buckeye can reconfigure its existing assets in such a way that the value in a year will be $800 or $1,600.

   

b.	If the current value of the assets is unchanged, what is the new value of the company's equity? (Do not round intermediate calculations. Round the final answer to 2 decimal places.)

   

Value of equity

$

Answer 1

a.

Using the no arbitrage valuation model, we can use the current market value of the firm as the stock price,

and the par value of the bond as the strike price to value the equity. Doing so, we get:

$1,090 = [($1,380 – 920)/($1,380 – 1,000)]E0 + [$920/1.048]

E0 = $175.24

The current value of the debt is the value of the firm’s assets minus the value of the equity, so:

D0 = $1,090 – 175.24

D0 = $914.76

b.

Using the no arbitrage model as in part a, we get:

$1,090 = [($1,600 – 800)/($1,600 – 1,000)]E0 + [$800/1.048]

E0 = $244.98

The stockholders will prefer the new asset structure because their potential gain increases while their

maximum potential loss remains unchanged.

Hence,

a-1) Value of equity = $175.24

a-2) Value of debt = $914.76

b) Value of equity = $244.98