5. A firm currently has the following balance sheet. Assets Debt Equity Bad state (50%) $50 $42 $8 Good state (50%) $170 $42 $128 Expected $110 $42 $68 PV $110 / 1.1 = $100 $42 / 1.05 = $40 $68 / 1.1333 = $60 The dollar amounts in the first three columns are time one cash flows. The last column shows the present values of these cash flows. Assume the firm is planning to switch to higher-risk / lower-valued assets in order to help its stockholders. The higher-risk / lower-valued assets pay $24 in the bad state and $174 in the good state. In the class example, I pointed out that the lender will charge a higher promised interest rate to protect themselves against the possibility that the firm will risk-shift. What promised interest rate will the lender need to charge in this problem so that they still receive an expected return of 5% on their $40 loan? Hint: filling in the blanks in the following table will help you answer the question. As in class, ignore taxes. Bad state (50%) $24 Good state (50%) $174 Expected $99 Assets Debt Equity PV $99 / 1.1 = $90 $42 / 1.05 = $40 $57 / 1.14 = $50 5. A firm currently has the following balance sheet. Assets Debt Equity Bad state (50%) $50 $42 $8 Good state (50%) $170 $42 $128 Expected $110 $42 $68 PV $110 / 1.1 = $100 $42 / 1.05 = $40 $68 / 1.1333 = $60 The dollar amounts in the first three columns are time one cash flows. The last column shows the present values of these cash flows. Assume the firm is planning to switch to higher-risk / lower-valued assets in order to help its stockholders. The higher-risk / lower-valued assets pay $24 in the bad state and $174 in the good state. In the class example, I pointed out that the lender will charge a higher promised interest rate to protect themselves against the possibility that the firm will risk-shift. What promised interest rate will the lender need to charge in this problem so that they still receive an expected return of 5% on their $40 loan? Hint: filling in the blanks in the following table will help you answer the question. As in class, ignore taxes. Bad state (50%) $24 Good state (50%) $174 Expected $99 Assets Debt Equity PV $99 / 1.1 = $90 $42 / 1.05 = $40 $57 / 1.14 = $50