1) When securities are fairly priced, the original shareholders of a firm pay ________ of the costs associated with bankruptcy and financial distress.

A) the present value

B) the book value

C) the current value

D) the market value

Use the information for the question(s) below.

Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect.

2) Assuming that in the event of default, 20% of the value of MI's assets will be lost in bankruptcy costs, the initial value of MI's equity without leverage is:

Answer: Explanation:

3) Assume that in the event of default, 20% of the value of MI's assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MI's debt is closest to:

A) $110 million

B) $105 million

C) $125 million

D) $111 million

Answer: Explanation:

4) Assume that in the event of default, 20% of the value of MI's assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The yield to maturity of MI's debt is closest to:

A) 13.75%

B) 5.00%

C) 19.25%

D) 12.50%

Answer: Explanation:

5) Assume that in the event of default, 20% of the value of MI's assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MI's equity is closest to:

A) $30 million

B) $29 million

C) $15 million

D) $24 million

Answer: Explanation:

6) Assume that in the event of default, 20% of the value of MI's assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The total value of MI with leverage is closest to:

A) $140 million

B) $100 million

C) $125 million

D) $134 million

Answer: Explanation:

7) Assume that in the event of default, 20% of the value of MI's assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The present value of MI's financial distress costs is closest to:

A) $20.0 million

B) $6.6 million

C) $6.3 million

D) $19.0 million

Answer:

Explanation:

8) Assume that in the event of default, 20% of the value of MI's assets will be lost in bankruptcy costs. Suppose that at the start of the year, MI has no debt outstanding, but has 5.6 million shares of stock outstanding. If MI does not issue debt, its share price is closest to:

A) $5.15

B) $23.75

C) $23.90

D) $25.00

Answer: Explanation:

9) Assume that in the event of default, 20% of the value of MI's assets will be lost in bankruptcy costs. Suppose that at the start of the year, MI has no debt outstanding, but has 5.6 million shares of stock outstanding. If MI issues debt of $125 million due next year and uses the proceeds to repurchase shares, the share price following the announcement of the repurchase will be closest to:

A) $23.90

B) $23.75

C) $25.00

D) $5.15

Answer: Explanation:

10) Assume that in the event of default, 20% of the value of MI's assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $140 million face value due next year. Calculate the value of levered equity, the value of debt, and the total value of MI with leverage.

Answer: