Question 6

The firm Kappa has just decided to undertake a major new project. As a result, the value of the firm in one years time will be either $120 million (probability 0.25), $250 million (probability 0.5) or $360 million (probability 0.25). The firm is financed entirely by equity and has 10 million shares. All investors are risk-neutral, the risk-free rate is 4% and there are no taxes or other market imperfections.

(a) What is the value of the company and its share price? (4 marks)

Kappa decides to issue debt with face value $146 million due in one year and use the proceeds to repurchase shares now. Assume now that bankruptcy costs will be 15% of the value of the firms assets in the event of default on debt repayment. (b) What is the value of the debt now? What is its yield? (5 marks)

(c) What is the expected value of the firm and the price per share? How many shares will be repurchased? (5 marks)

(d) Assume Kappa decides instead to issue debt with face value $100 million due in one year and repurchase shares with the proceeds. What is the firms value now? Why? What is its share price? (5 marks)

(e) Explain how the presence of corporate taxes would influence Kappas restructuring decision. (100 words) (6 marks)