A firm is currently partially financed with zero-coupon debt that promises to repay bondholders $100 at maturity. These bonds mature one year from today at t=1. The firm is in a very risk industry, so its assets will be worth $200 next year with probability 1/3, $100 next year with probability 1/3, and $50 next year with probability 1/3. The existing debt holders were very trustful of management, so they did not insist on any clauses governing issuance of additional debt. It turns out that this was a mistake. The firm is planning to issue new debt that is senior to the old debt (i.e., in bankruptcy the new debt holders are first in line to get their cash back). This new debt promises to pay these new debt holders $50 at maturity. Assume for simplicity that interest rates are zero and thus that the value of a claim today at t=0 is equal to the expected payoff to the claimholder at t=1. a) What will the new debt sell for? b) Assuming that the proceeds from the new debt issue are used to pay a special dividend to shareholders, after the debt is issued what will be the value of (i) the old debt, (ii) the new debt, and (iii) equity? Has total firm value changed? Who is made better off or worse off from the transaction?
A firm is currently partially financed with zero-coupon debt that promises to repay bondholders $100 at maturity. These bonds mature one year from today at t=1. The firm is in a very risk industry, so its assets will be worth $200 next year with probability 1/3, $100 next year with probability 1/3, and $50 next year with probability 1/3. The existing debt holders were very trustful of management, so they did not insist on any clauses governing issuance of additional debt. It turns out that this was a mistake. The firm is planning to issue new debt that is senior to the old debt (i.e., in bankruptcy the new debt holders are first in line to get their cash back). This new debt promises to pay these new debt holders $50 at maturity. Assume for simplicity that interest rates are zero and thus that the value of a claim today at t=0 is equal to the expected payoff to the claimholder at t=1. a) What will the new debt sell for? b) Assuming that the proceeds from the new debt issue are used to pay a special dividend to shareholders, after the debt is issued what will be the value of (i) the old debt, (ii) the new debt, and (iii) equity? Has total firm value changed? Who is made better off or worse off from the transaction?
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Question
A firm is currently partially financed with zero-coupon debt that promises to repay bondholders $100 at maturity.
These bonds mature one year from today at t=1. The firm is in a very risk industry, so its assets will be worth $200
next year with probability 1/3, $100 next year with probability 1/3, and $50 next year with probability 1/3. The existing
debt holders were very trustful of management, so they did not insist on any clauses governing issuance of additional
debt. It turns out that this was a mistake. The firm is planning to issue new debt that is senior to the old debt (i.e., in
bankruptcy the new debt holders are first in line to get their cash back). This new debt promises to pay these new debt
holders $50 at maturity. Assume for simplicity that interest rates are zero and thus that the value of a claim today at t=0
is equal to the expected payoff to the claimholder at t=1.
a) What will the new debt sell for?
b) Assuming that the proceeds from the new debt issue are used to pay a special dividend to shareholders, after the
debt is issued what will be the value of (i) the old debt, (ii) the new debt, and (iii) equity? Has total firm value
changed? Who is made better off or worse off from the transaction?
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