Monsters Incorporated (MI) is ready to launch a new product. Depending upon the
ID: 2669549 • Letter: M
Question
Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy and the cost of capital is equal to the risk-free rate, which is currently 5%. Assume that capital markets are perfect.(g) Assume that in the event of default, 20% of the value of MI’s assets will be lost
in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The present value of MI’s financial distress cost is closest to:
(1) $20 million
(2) $6.6 million
(3) $6.3 million
(4) $19 million
Explanation / Answer
(g) Assume that in the event of default, 20% of the value of MI’s assets will be lost
in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The present value of MI’s financial distress cost is closest to:
(1) $20 million
(2) $6.6 million
(3) $6.3 million
(4) $19 million