3) (Asymmetric effect mentioned in class) At the end of one year, a firms assets have a liquidating payoff of either 100 or 32 with equal probabilities. The riskfree rate is 5% per year, and the riskpremium on the firms assets is 5% per year. The firm has existing debt with market value $40 and promised yield equal to 32% per year. Assume all ModiglianiMiller conditions hold.

a. What is market value of equity?

b. What is the expected return on debt?

c. In case of bankruptcy, what fraction of face value do debtholders get? That is, for each dollar they are promised, how many dollars do they get? (this is also called the recovery rate on defaulted debt) The firm decides to raise $5 by issuing additional shares (at fair market prices!) and uses proceeds to buy back debt. Assume debt is repurchased at a promised yield equal to 32% per year, and that the expected return of debt remains the same as before the deal.

d. What fraction of the face value of debt can be repurchased?

e. What is the new market value debt? f. What is the new recovery rate on defaulted debt?

g. What is the new market value of equity? (Note the cost of equity does not remain the same!)

h. New shareholders get a fair deal by assumption: the fair market value of the shares they bought is $5. What fraction of the corporation they own?

i. Are old shareholders better off or worse off or the same? How much value they lose or gain?

j. Does the cost of equity capital increase or decrease? By how much?