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.

a) Suppose the company is 100% equity financed. What is the value of the equity of the company? What is the share price?

b) 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. What is the new value of debt and equity? What is the new value of the firm? What would the stock price reaction be if the company is initially all-equity, and then announces (at date 0) that it will issue this level of debt and use the proceeds to repurchase shares?

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