# Question

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 $170 million, but if the project is a failure, the firm will only be worth $105 million. The current value of Strudler is $130 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 $120 million. Treasury bills that mature in one year yield 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 project described above, Strudler’s management decides to undertake a project that is even more risky. The value of the firm will either increase to $193 million or decrease to $85 million by the end of the year. Use the two-state option pricing model to determine the value of the firm’s debt and equity if the firm plans on undertaking this new project. What is the stock price if the firm undertakes this project? Which project do bondholders prefer?

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 project described above, Strudler’s management decides to undertake a project that is even more risky. The value of the firm will either increase to $193 million or decrease to $85 million by the end of the year. Use the two-state option pricing model to determine the value of the firm’s debt and equity if the firm plans on undertaking this new project. What is the stock price if the firm undertakes this project? Which project do bondholders prefer?

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