Suppose you have a company, which, starting next year, will either generate 200 every year forever, or 100 every year forever (with equal probability). Assume no systematic risk; rf is 10%. All uncertainty will be resolved at date 1. There are 1000 shares outstanding. All of the MM assumptions hold. Suppose the company is 100% equity financed. And suppose now this company issues perpetual debt with a face value of 1500 and a 10% coupon. If it fails to pay this debt service, the bondholders get to seize the company. If the bondholders seize the company, they get all cash flows forever.

1) Suppose that there is a one-time bankruptcy cost of 121. That means that if the firm fails to meet its first coupon payment in one years time, it will have to pay a fee of 121, which will represent lost value (hint: this is the lost value in time t=1, if you want to know the lost value in time 0 you need to discount the expected loss). After that it will continue as a company owned by the former creditors, who become shareholders. Suppose the company starts off as an all-equity company in date 0, and the market thinks it will never issue debt. Then the company announces it will issue debt with face value of 1500 and coupon of 10%, and will repurchase stock with the proceeds. How does the stock price change and why? How much will the debt and the equity be worth after the debt is issued?