Question
The firm Kappa has just decided to undertake a major new project. As a result, the value of the firm in one years time will
The firm Kappa has just decided to undertake a major new project. As a result, the value of the firm in one years time will be either $120 million (probability 0.25), $250 million (probability 0.5) or $360 million (probability 0.25). The firm is financed entirely by equity and has 10 million shares. All investors are risk-neutral, the risk-free rate is 4% and there are no taxes or other market imperfections.
(a) What is the value of the company and its share price?
Kappa decides to issue debt with face value $146 million due in one year and use the proceeds to repurchase shares now. Assume now that bankruptcy costs will be 15% of the value of the firms assets in the event of default on debt repayment.
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(b) What is the value of the debt now? What is its yield?
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(c) What is the expected value of the firm and the price per share? How many
shares will be repurchased?
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(d) Assume Kappa decides instead to issue debt with face value $100 million due in one year and repurchase shares with the proceeds. What is the firms value now? Why? What is its share price?
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(e) Explain how the presence of corporate taxes would influence Kappas restructuring decision.
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