A firm is equally likely to be worth $50 million, $80 million, $120 million, or

Question

A firm is equally likely to be worth $50 million, $80 million, $120 million, or $150 million. There is one bond outstanding that promises to pay $100 million at an interest rate of 6%. The appropriate cost of capital for the firms projects is 12%. 1) What is the expected payoff to the bondholders? 2) What is the current value of the bonds? 3) What is the promised return on the firms debt? 4) What is the expected payoff to the levered equity holders? 5) What is the value of the levered equity? 6) What is the expected return on the levered equity? 7) What proportions of debt and equity financing is the firm currently using?

Explanation / Answer

1) Expected payoffs to the bond holders = $100M * 6% = $6M

2) Current value of the bond = $6M/12% = $50M

3) Pomised return on the firms debt = $6M/$50M = 12%

4) Cost of equity = 12%-6% = 6%

Expected payoffs to the levered equity holders = [($50+$80+$120+$150)/4]*6%

= $6M

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