Question

Buckeye Industries has a bond issue with a face value of $1000. The value of Buckeye’s asset is $1200. In one year they will be worth either $800 or $1400. The going rate on T-bill is 4 percent. What is the value of debt, equity, and interest rate on debt?

Answer 1

Answer :

Total Value of Assets =  {Equity value * [(Higher level of Asset - Lower level of Asset ) / (Higher level of Asset - Face Value)]} + {Lower level of Asset in a year / (1 + Risk free rate)}

Given

Higher level of Asset = 1400

Lower level of Asset = 800

Risk free rate = 4% or 0.04

Total Value of Assets = 1200

Face value = 1000

1200 = {Equity value * [(1400 - 800) / (1400 - 1000)]} + {800 / (1 + 0.04)}

1200 = {Equity Value * [600 / 400]} + {796.23076923}

1200 - 796.23076923 = 1.5 Equity value

==> Equity Value = 430.76923077 / 1.5

= 287.17948718 or 287.18

Value of Debt = Total Value of Asset - Value of Equity

= 1200 - 287.18

= 912.82

Interest rate on Debt = (Face Value - Value of Debt) / Value of Debt

= (1000 - 912.82) / 912.82

= 9.55%