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Question - Assume the assets of a firm will be worth either $100 million or $200 million in 1 year with equal (50%) probability. The firm owes debt holders a payment of $100 million in 1 year. (For convenience assume a discount rate of 0% throughout for all valuations. Absolute priority rules hold, i.e., the debt gets paid first. Hint: Think DCF!)
a. What is the value of the firm today?
b. What are the values of the debt and equity today?
c. Imagine the firm pays stockholders a dividend of $10 million in 1 year (in both states of the world), just before the debt comes due. This dividend payment reduces the value of the assets in 1 year to $90 million and $190 million in the two states. What are the values of the debt and equity today, where the dividend should be included in the equity value?
d. Instead of paying a dividend the firm decides to increase risk, without changing expected asset value. Specifically, the assets will be worth either $80 million or $220 million in the two states. What are the values of the debt and equity?
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