Question
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
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:
- 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)
- What is the current value of riskless debt with the same face value and maturity as Santos Limited's debt? (1 mark)
- 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)
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