Question

1. Suppose firm A and firm B are planning on merging. There are no costs or benefits from the merger. Before the merger firm A has an issue of bonds outstanding and Firm B has an issue of bonds outstanding. The Firm A bonds entitle the holder to a payment of $20 million when the bonds mature next year, and the Firm B bonds entitle the holder to a payment of $25 million when the bonds mature next year. The risk free interest rate is 0. (hint- that means you do not need to discount any cash flows)

With probability 1/3 there will be a “boom” in the economy next year, with probability 1/3 there will be a “normal” economy next year, and with probability 1/3 there will be a “recession” next year. The value of firm A’s assets and firm B’s assets in “boom”, “normal”, and “recession” years are as follows.

	“boom” (probability 1/3)	“normal” (probability 1/3)	“recession” (probability 1/3)
Firm A asset value	90	70	10
Firm B asset value	60	20	15

1. What will be the change in the total value of all outstanding bonds if the firms merge?
2. What will be the change in the total value of all outstanding equity if the firms merge?

Please show the work! Thank you

Answer 1

Ans. Total value of all outstanding bonds if the firms is merge

if firms are merge than bond value will be not effecting it will same as individually firm is holding

Total value of outstanding bonds if the firms is merge

Firm A = $20million

Firm B = $25million

Total = $45million

Total value of outstanding = $45million

Ans 2. Calculation of value of outstanding equity if firm is merge

Total value of Firm A = 90X1/3+ 70X1/3 + 10X1/3 = 30+23.33+3.33 = 56.67

Total value of Firm B = 60X1/3 + 20X1/3+15X1/3 = 20+6.67+5 = 31.67

Total value after merged = $88.34 Million

Value of total bond outstanding = $45million

Total value of equity = total value of firm-total value of bond

= 88.34-45 = $43.34 Million

Total value of equity after merged = $43.34 Million