Monsters Incorporated (MI) is ready to launch a new product. Depending upon the
ID: 2712697 • 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.
(a) The initial value of MI’s equity without leverage is closest to:
(1) $133 million
(2) $147 million
(3) $140 million
(4) $150 million
(b) Suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MI’s debt is closest to:
(1) $125 million
(2) $111 million
(3) $100 million
(4) $116 million
(c) Suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MI’s equity is closest to:
(1) $30 million
(2) $15 million
(3) $29 million
(4) $24 million
(d) Suppose that MI has zero-coupon debt with a $125 million face value due next year. The total value of MI with leverage is closest to:
(1) $133 million
(2) $140 million
(3) $147 million
(4) $125 million
(e) Assuming that in the event of default, 20% of the value of MI’s assets will be lost in bankruptcy costs, the initial value of MI’s equity without leverage is closest to:
(1) $150 million
(2) $147 million
(3) $140 million
(4) $133 million
(f) 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 total value of MI with leverage is closest to:
(1) $140 million
(2) $100 million
(3) $125 million
(4) $134 million
(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
a. Value of unlevered equity = (100+150+191)/3/1.05 = 147/1.05 = $140 million ie choice 3.
b. MI has zero-coupon debt with a $125 million face value:
That means if MI has a value of $100 mils, all of it is from debt, otherwise if MI's value is 150 or 191, debt is of $125 mils.
Thus, initial value = (100+125+125)/3/1.05 = $111.11 million ie choice 2.
c. Initial value of equity = 140 - 111.11 = $29 million ie choice 3.
d. AS per Modigiliani and Miller theorem, Unlevered firm value equals levered firm value.
Thus, choice 2. $140 million
e. since there is no debt, there will be no default. Value of unlevered equity = (100+150+191)/3/1.05 = 147/1.05 = $140 million ie choice 3.
f. In the event of default:
Value of debt = 1/3((100-20)+125+125)/1.05 = 104.76 million
Value of equity = 1/3(0+25+66)/1.05 = 28.89 million
Total value = 104.76 + 28.89 = $133.65 million ie choice 4.
g. The distress costs will apply only when the value of the firm is less than the debt. i.e when MI has a value of $100.
Thus distress costs = (20+0+0)/3/1.05 = $6.35 million ie choice 3