PROBLEM 3: JUNIOR AND SENIOR DEBT

Jay Corp. owns a single machine that will produce cash flows of 1,400,000 if the economy is good and 800,000 if the economy is bad. The good and the bad states occur with equal probability. Jay Corp. also has an outstanding debt with a face value (the amount to be paid) of 600,000 due at the end of the period. There are no taxes or other market imperfections and the risk-free rate of interest, as well as the premium for systematic risk are zero (i.e. this is an economy with risk-neutral investors). a) What are the market values of equity and debt of the firm based on these cash flow expectations?

b) Suppose that there is a twin firm---Kay Corp.---that owns the same machine, but is financed differently. Compared to Jay Corp., it has additional debt with a face value of 400,000 that is junior with respect to the remaining debt with a face value of 600,000, i.e., the additional debt will be paid only after the first one is fully paid. What are the market values of senior debt, junior debt, and equity for Kay Corp.?

c) Does MM proposition I hold?

d) Now suppose, that there is a third firm with the same machine, Bowling Corp., which is financed like Kay Corp. (senior debt with face value 600,000 and junior debt with face value 400,000). However, Bowling Corp. is located in a neighboring county with a more complicated insolvency law, where a firm incurs legal costs of 100,000 in case of default. What are the market values of equity, junior and senior debt of Bowling Corp.? What's the firm value?

e) Now suppose, that Bowling Corp. were financed like Jay Corp. (senior debt with face value 600,000, no junior debt) instead. The legal costs of 100,000 in case of default still apply. What are the market values of equity and debt of Bowling Corp. in this scenario? What's the firm value? Does MM proposition I hold in this county?

f) Why is MMs proposition 2 meaningless in this example?