The assets of a firm are worth $100m, and has a volatility of 20%. The firm is an all equity firm. It is considering altering its capital structure by issuing a 2 year zero coupon bond with face value $60m, and a 2 year zero coupon subordinated debt issue with face value $20m. The riskless yield is 8% continuously compounded.

1. Set up a two period binomial lattice over two years that shows the asset value of the firm at each node. Explain each step of the process. Also compute the risk neutral probability of an up jump.

b.Use backward recursion to establish the value at each node of both the senior debt and the junior debt.

c.Compute the continuously compounded yield to maturity, and the credit spread of the senior debt and the junior debt.