Question a

GoGoAUCity Inc. plans to issue a perpetual callable bond that pays 11.39% annual coupons. The current interest rate is 8%. Two years later, there is 16% probability that the interest rate will be 4.6%, 31% probability that the interest rate will be 10.1% and 53% probability that the interest rate will be 12.1%. The bond is callable at par value of 1,000 plus 3 additional coupon payments and it will be called if the bond price is greater than the call price.

1. Calculate the price of the callable bond.
2. What is the value of the call option?
3. What is the minimum coupon rate that the bond will be certainly called in two years?

Question b

CEGM Inc. currently has 8,200 shares outstanding, selling at $16.6 per share. Its 10.4% annual coupon, perpetual debt has a par value of $65,000 and is trading to yield 8.2%. The present value of the financial distress costs is $13,200. The annual EBIT is expected to be $40,000 forever. The tax rate is 30%.

1. What is the unlevered firm value?
2. What is the unlevered cost of equity?
3. What is the cost of equity?
4. What is the weighted average cost of capital?
5. The company issues stocks to buy back half of the existing perpetual debt (assuming buying back at the market price of the debt). If the cost of equity changes to 14.6% and the cost of debt remains the same after the recapitalization, calculate the present value of financial distress costs under this new capital structure.