Horus is an all-equity firm that raises debt for the first time. It decides to issue 35,000 senior bonds and 20,000 junior bonds. Both types of bonds are zero-coupon, have a maturity of 1 year and a face value of 1,000. The table below describes the return of the market portfolio rM and Horus asset value as a function of the state of the economy. The risk-free rate is 3%. State of the economy Probability rM Horus Assets (Market Value) Boom 0.3 +20.00% 100,000,000 Normal 0.5 +7.50% 85,000,000 Depression 0.2 -10.00% 46,000,000 In case of default, that is, if the value of Horus assets in one year is too low to cover payments to bondholders, Horus assets are liquidated at their market value.

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1. Suppose that both categories of bonds carry no systematic risk. How much can Horus raise with this bond issue? (i.e., what price would investors be willing to pay for these bonds?) 2. Is it correct to assume that both categories of bonds have no systematic risk? Explain (qualitative answer) 3. Taking into account systematic risk, how much can Horus raise with this bond issue? Hint: let V denote the value of one bond (for one of the two categories). Compute the of this bond as a function of V . Then use the CAPM equation. This is a tougher question...