Question
Suppose a firms assets are worth either $100 or $120 with equal probabilities in one year from now. The firm had previously issued debt with
Suppose a firms assets are worth either $100 or $120 with equal probabilities in one year from now. The firm had previously issued debt with a face value of $90, which matures in one year. Suppose investors are risk neutral, and the risk-free rate is 10% p.a. 1. What is the value of the outstanding debt and equity given the above information? 2. Suppose the debt were convertible into 75% of the firms equity. (a) What would be the value of the outstanding (convertible) debt and equity? (b) Does the convertibility feature have any value? 3. Suppose the firms management has the possibility to invest in a new project, which pays of either +$50 or -$60 with equal probabilities (independent of the firms other assets) in one year. (a) What is the value of the outstanding debt and equity given the above information? (b) What is the value of the outstanding debt and equity if the debt were convertible into 75of the firms equity? (c) Does the convertibility feature have any value? 4. What are the benefits for a firm to issue convertible debt rather than straight debt?
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