What is the value of debt and equity

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Spartan Corporation estimates that there is 25% chance of a recession economy next year, a 50% chance of a normal economy next year, and a 25% chance of a boom economy next year. The corporation will exist until the end of next year and then it will cease to exist. Spartan has $80 of debt that must be repaid next year. Assume a 0% discount rate for all cash flows (in other words, there is no discounting). (a) Spartan has a low risk project that yields a cash flow of $70 in a recession, $100 in a normal economy, and $130 in a boom. If Spartan chooses this low risk project: (i) what is the value of Spartan’s debt? (ii) what is the value of Spartan’s equity? (b) Spartan has a high risk project that yields a cash flow of $30 in a recession, $100 in a normal economy, and $160 in a boom. If Spartan chooses this high risk project: (i) what is the value of Spartan’s debt? (ii) what is the value of Spartan’s equity? (c) Which project will Spartan choose? Given your answers to (a) and (b), when Spartan sells the bonds would it like to include a covenant that would prohibit it from taking the high-risk project? Explain your answer.

Reference no: EM131054780

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