a) FIN222 Ltd owns assets that will be worth only $2,000 in one year. The current risk-free rate is 5%, and the cost of capital is 10%.

i) If FIN222 Ltd is unlevered, what is the current market value of its equity today?

ii) Instead, assume that FIN222 is levered. FIN222 Ltd has debt with a face value of $500 due in one year. According to Modigliani and Miller, what is the value of the equity today in this case?

iii) What is the expected return on the equity without leverage?

iv) What is the expected return on the equity with leverage?

v) Discuss your answers in iii) and iv) with reference to Modigliani and Millers Proposition 2 (MM2).

b) Discuss the agency costs arising from equityholder-debtholder conflicts when firms are financially distressed.