Reference no: EM132715459

You announce that you will issue $20M worth of one-year bonds tomorrow. You would like to determine the proper yield to offer on these bonds. Because your asset cash flows are independent of market conditions, investors expect a return of 5 percent (the risk-free rate) on this debt investment. Your firm has 5M shares outstanding priced at $15 per share prior to this announcement.

a) There is an 8 percent chance you will only be able to pay bondholders $9M next year (state B). There is a 92 percent chance you will be able to fully repay your bondholders the promised cash flow (state G). For now, assume no bankruptcy costs. What promised cash flow must you provide to bondholders in state G so that they receive a 5 percent expected return?

b) What is the promised yield on this debt issuance?

c) Now assume that there is a $3M bankruptcy cost in the default state. What promised cash flow must you provide to bondholders in state G so that they receive a 5 percent expected return?

d) The expected bankruptcy cost will negatively affect the share price. What will be the new share price following the announcement of the debt issuance? (Hint: the value of equity will decrease by the present value of the expected bankruptcy cost.)