Gidget International is domiciled in the Land of Make Believe. The local currency is called the Goodwill (abbreviated G). Gidget will own assets worth either G6,000 or G16,000 this year (with equal probability), depending on the value of the local currency on world currency markets. Gidget has a promised payment to debt of G10,000 due in one year. Although there are no taxes in the Land of Make Believe, there are lawyers (this isn't a perfect world, after all). If Gidget cannot meet if debt obligations, legal fees will impose direct bankruptcy costs of G2,000 as the firm is divided amongst its creditors.

(a) How much will debt and equity owners receive at asset values of G16,000 and of G6,000? Calculate the expected value of equity, debt, and the firm.

(b) How can hedging increase the value of Gidget International in the presence of direct costs? Who wins debt, equity, or both? Find a combination of market values of equity and debt when the company hedges that are better for both, debtholders and equityholders.