SpinTheWheel Co. has assets currently worth $10 million in the form of one-year risk-free bonds that will

Question:

SpinTheWheel Co. has assets currently worth $10 million in the form of one-year risk-free bonds that will return 10 percent. The company has debt with a face value of $5.5 million due in one year. (No interest payments will be made.) The stockholders decided to sell $8 million of the risk-free bonds and to invest the money in a very risky venture. This venture consists of giving Mr. William Kid the money now and, in one year, flipping a coin. If it comes up heads, Mr. Kid will pay SpinTheWheel $17.6 million. If it is tails, SpinTheWheel gets nothing. This investment has an NPV of zero.

a. What is the value of the debt and equity before the stockholders make this” investment”?

b. Using the binomial pricing model, with the payoff to the equity holders representing the option and the assets of the company representing the underlying asset, estimate the value of the equity after the stockholders make the investment.

c. What is the new value of the debt after the investment?

Face Value
Face value is a financial term used to describe the nominal or dollar value of a security, as stated by its issuer. For stocks, the face value is the original cost of the stock, as listed on the certificate. For bonds, it is the amount paid to the...