Hema Corp. is an all-equity firm with a current market value of $1,230 million (i.e., $1.23 billion), and will be worth $1,107 million or $1,722 million in one year. The risk-free interest rate is 5%. Suppose Hema Corp. issues zero-coupon, one-year debt with a face value of $1,292 million, and uses the proceeds to pay a special dividend to shareholders. Suppose that in the event Hema Corp. defaults, $90 million of its value will be lost to bankruptcy costs. Assume there are no other market imperfections. a. What is the present value of these bankruptcy costs, and what is their delta with respect to the firm's assets? b. In this case, what is the value and yield of Hema's debt? c. In this case, what is the value of Hema's equity before the dividend is paid?
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Hema Corp. is an all-equity firm with a current market value of $1,230 million (i.e., $1.23 billion), and will be worth $1,107 million or $1,722 million in one year. The risk-free interest rate is 5%. Suppose Hema Corp. issues zero-coupon, one-year debt with a face value of $1,292 million, and uses the proceeds to pay a special dividend to shareholders. Suppose that in the event Hema Corp. defaults, $90 million of its value will be lost to bankruptcy costs. Assume there are no other market imperfections. a. What is the
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