Question 1 You announce that you will issue $SOM worth of one-year bonds today. You would like to determine the appropriate promised cash flow to offer on these bonds. Assume that your investors expect a return of 7 percent on this debt investment. a) There is an 8 percent chance you will only be able to pay bondholders $15M next year (state B). There is a 92 percent chance you will be able to fully repay your bondholders the promised cash flow (state G). For now, assume no bankruptcy costs. What promised cash flow must you provide to bondholders in state G so that they receive a 7 percent expected return? b) Now assume that there is a $12M bankruptcy cost in the default state. What promised cash flow must you provide to bondholders in state G so that they receive a 7 percent expected return? c) Prior to the debt issuance, the share price for your firm was $20. The expected bankruptcy cost from part (b) due to the new debt issuance will negatively affect the share price. What will be the new share price following the announcement of the debt issuance? Assume that there are SM shares outstanding in the firm, and that the discount rate for the expected bankruptcy cost is the expected return on debt. (Hint: the value of equity will decrease by the present value of the expected bankruptcy cost.) Question 1 You announce that you will issue $SOM worth of one-year bonds today. You would like to determine the appropriate promised cash flow to offer on these bonds. Assume that your investors expect a return of 7 percent on this debt investment. a) There is an 8 percent chance you will only be able to pay bondholders $15M next year (state B). There is a 92 percent chance you will be able to fully repay your bondholders the promised cash flow (state G). For now, assume no bankruptcy costs. What promised cash flow must you provide to bondholders in state G so that they receive a 7 percent expected return? b) Now assume that there is a $12M bankruptcy cost in the default state. What promised cash flow must you provide to bondholders in state G so that they receive a 7 percent expected return? c) Prior to the debt issuance, the share price for your firm was $20. The expected bankruptcy cost from part (b) due to the new debt issuance will negatively affect the share price. What will be the new share price following the announcement of the debt issuance? Assume that there are SM shares outstanding in the firm, and that the discount rate for the expected bankruptcy cost is the expected return on debt. (Hint: the value of equity will decrease by the present value of the expected bankruptcy cost.)
