Question

ABS Limited, an automobile company financed by both debt and equity, is undertaking a new project. If the project is successful, the value of the firm in one year will be $150,000, but if the project is a failure, the firm will be worth only $50,000. The current value of ABS is $100,000, a figure that includes the prospects for the new project. ABS has outstanding zero coupon bonds due in one year with a face value of $85,000. Treasury bills that mature in one year yield a 5 percent Effective Annual Rate (EAR). ABS pays no dividends. (Please note that no marks will be awarded if there are no workings provided in your answer.)

Required:

1. Use risk-neutral valuation approach to find the current value of ABS Limited's debt and equity: what is the risk-neutral probability of the up state (i.e., the risk-neutral probability of an increase in the asset value)? What is the value of ABS Limited’s equity? What is the value of ABS Limited’s debt?
2. What is the current value of riskless debt with the same face value and maturity as ABS Limited’s debt? (1 mark)
3. If ABS Limited seeks a loan guarantee from its parent firm (ABS Group holding), how much does this loan guarantee cost the parent firm? (1 mark)

Answer 1