1. Bankruptcy in an MM world: Suppose you have a company, which, starting next year, will either generate 200 every year forever, or 100 every year forever (equal probability). Assume no systematic risk; rf is 10%. All uncertainty will be resolved at date 1. a) What is the value of the equity of the company?

b) Suppose now this company issues perpetual debt with face value 1500 and coupon 10%. That means that the company promises to pay $150 in interest payments every year; if it fails to pay this debt service, the bond holders get to seize the company. If the bondholders seize the company, they get all cash flows forever. Definition: Face value of the debt is what you promise to repay (or base interest payments on). It is not the same thing as market value. What would the stock price reaction be if the company is initially allequity financed, and then announces (at date 0) that it will issue this level of debt and use the proceeds to repurchase shares?

c) What will the promised yield between date 0 and date 1 on the debt have to be? What will the expected rate of return on the debt be? Definition: Promised yield is the regular yieldtomaturity that is usually quoted in the newspaper, = promised payment next year / market value now.

How do I calculate C??