Strudler Real Estate, Inc., a construction firm financed by both debt and equity, is undertaking a new project. If the project is successful, the value of the firm in one year will be $280 million, but if the project is a failure, the firm will be worth only $190 million. The current value of Strudler is $230 million, a figure that includes the prospects for the new project. Strudler has outstanding zero coupon bonds due in one year with a face value of $260 million. Treasury bills that mature in one year yield a 7 percent EAR. Strudler pays no dividends.
a. Use the two-state option pricing model to find the current value of Strudler’s debt and equity.
b. Suppose Strudler has 500,000 shares of common stock outstanding. What is the price per share of the firm’s equity?
c. Compare the market value of Strudler’s debt to the present value of an equal amount of debt that is riskless with one year until maturity. Is the firm’s debt worth more than, less than, or the same as the riskless debt? Does this make sense? What factors might cause these two values to be different?
d. Suppose that in place of the preceding project, Strudler’s management decides to undertake a project that is even more risky. The value of the firm will either increase to $315 million or decrease to $175 million by the end of the year. Surprisingly, management concludes that the value of the firm today will remain at exactly $230 million if this risky project is substituted for the less risky one. Use the two-state option pricing model to determine the values of the firm’s debt and equity if the firm plans on undertaking this new project. Which project do bondholders prefer?