Question 11 5 pts Santos Limited, an automobile company financed by both debt and equity, is undertaking a new project. If the project is successful, the value of the firm in one year will be $400,000, but if the project is a failure, the firm will be worth only $70,000. The current value of Santos is $150,000, a figure that includes the prospects for the new project. Santos has outstanding zero coupon bonds due in one year with a face value of $120,000. Treasury bills that mature in one year yield a 5 percent Effective Annual Rate (EAR). Santos pays no dividends. (Please note that no marks will be awarded if there are no workings provided in your answer.) Required: 1. Use risk-neutral valuation approach to find the current value of Santos Limited's debt and equity: what is the risk-neutral probability of the up state (i.e., the risk-neutral probability of an increase in the asset value)? What is the value of Santos Limited's equity? What is the value of Santos Limited's debt? (3 marks) 2. What is the current value of riskless debt with the same face value and maturity as Santos Limited's debt? (1 mark) 3. If Santos Limited seeks a loan guarantee from its parent firm (Santos Group holding), how much does this loan guarantee cost the parent firm? (1 mark) Kirk Limited, an automobile company financed by both debt and equity, is undertaking a new project. If the project is successful, the value of the firm in one year will be $100,000, but if the project is a failure, the firm will be worth only $20,000. The current value of Kirk is $50,000, a figure that includes the prospects for the new project. Kirk has outstanding zero coupon bonds due in one year with a face value of $40,000. Treasury bills that mature in one year yield a 5 percent Effective Annual Rate (EAR). Kirk pays no dividends. (Please note that no marks will be awarded if there are no workings provided in your answer.) Required: 1. Use risk-neutral valuation approach to find the current value of Kirk Limited's debt and equity: what is the risk-neutral probability of the up state (i.e., the risk-neutral probability of an increase in the asset value)? What is the value of Kirk Limited's equity? What is the value of Kirk Limited's debt? (3 marks) 2. What is the current value of riskless debt with the same face value and maturity as Kirk Limited's debt? (1 mark) 3. If Kirk Limited seeks a loan guarantee from its parent firm (Kirk Group holding), how much does this loan guarantee cost the parent firm? (1 mark) 1. If Kirks project is successful then in one year the Firm Value will be $100,000, Debt would be $40,000 and Equity will be $60,000 However, if the project fails then Firm Value will only be $20,000, Debt also $20,000 and Equity will be $0 (as Debt holders would be paid out first, hence nothing left for Equity/Shareholders of the firm) Risk-Neutral Probability of Upstate (u= $10,000/$50,000 = 2 Downstate (d=Sd/So) $20,000/$50,000 = 0.4. dy resou So, the risk neutral probability (p*u+(1-p)*d = 1 + rf)) solving for p the risk neutral probability would equal: p= (1.05-0.4)/(2-0.4)=0.40625 Value of Debt 40000 *0.40625+ 20000* (1-0.40625))/1.05 = $26785.71 And correspondingly, the Value of Equity would be (60000*0.40625+0*(1-0.40625))/1.05 = $23,214.29 (or simply $50,000 - $26,785.71 (debt value) = $23,214.29 2. Current value of riskless debt (Debt due in 1 year/ (1+r)) = $40000/1.05 = $38,095.24 3. If Kirk Limited seeks a loan guarantee from its parent firm (Kirk Group holding), the cost of this loan guarantee to the parent would be: y source was downloaded by 100000803367884 from CourseHero.com on 10-08-2021 02:06:49 GMT-05:00 ww.coursehero.com/file/69649682/CIS-Kirk-Limited-Questiondocx/ The value of Riskless Debt - Value of Debt of the firm =38095.24-26785.71 = $11,309.52