Hema Corp. is an all equity firm with a current market value of $1000 million (i.e., $1 billion), and will be worth $900 million or $1400 million in one year. The risk-free interest rate is 5%. Suppose Hema Corp. issues zero-coupon, one-year debt with a face value of $1050 million, and uses the proceeds to pay a special dividend to shareholders. Assuming perfect capital markets, use the binomial model to answer the following:
a. What are the payoffs of the firm’s debt in one year?
b. What is the value today of the debt today?
c. What is the yield on the debt?
d. Using Modigliani-Miller, what is the value of Hema’s equity before the dividend is paid? What is the value of equity just after the dividend is paid?
e. Show that the ex-dividend value of Hema’s equity is consistent with the binomial model. What is the Δ of the equity, when viewed as a call option on the firm’s assets?