Company ZZZs future is uncertain. Depending on the strength of demand for its products, the market value of its assets next year will be either $130 million or $70 million. The two outcomes are equally likely. The risk-free interest rate is 5%. Moreover, the risk in ZZZs assets is completely diversifiableit contains no market risk or aggregate risk, and thus its cost of capital is also 5%. If not for potential costs associated with financial distress, the Modigliani-Miller theorem would otherwise apply.

a. What is the value of ZZZs equity if there is no leverage?

b. Suppose now that ZZZ has substantial debt. Specifically, it has zero coupon bonds with a total face value of $100 million that mature next year. What price should this debt sell at currently?

c. Given the $100 million in debt in part (b), but assuming for the moment that there are no direct or indirect costs of financial distress, what is the value of the firms equity?

d. Now suppose that in the event of default, 10% of the ZZZs assets will be lost to bankruptcy costs. Now what should the debt be valued at?

e. Continuing to assume the 10% bankruptcy costs, what is the value of the firms equity?

f. What is the total value of the firm with bankruptcy costs? How does it compare to the value without bankruptcy costs?