Masters Real Estate, Inc., a construction firm financed by both debt and equity, is undertaking a new

Question:

Masters 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 $125 million, but if the project is a failure, the firm will only be worth $85 million. The company’s current value is $103 million, a figure that includes the prospects for the new project. The company has outstanding zero coupon bonds due in one year with a face value of $95 million. Treasury bills that mature in one year yield 7 percent EAR. The company pays no dividends.
a. Use the two-state option pricing model to find the current value of the company’s debt and equity.
b. Suppose the company has 300,000 shares of common stock outstanding. What is the price per share of the firm’s equity?
c. Compare the market value of the company’s debt to the present value of an equal amount of debt that is risk less 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, the company’s management decides to undertake a project that is even more risky. The value of the firm will either increase to $135 million or decrease to $70 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?

Common Stock
Common stock is an equity component that represents the worth of stock owned by the shareholders of the company. The common stock represents the par value of the shares outstanding at a balance sheet date. Public companies can trade their stocks on... Coupon
A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity. Coupons are usually referred to in terms of the coupon rate (the sum of coupons paid in a... Face Value
Face value is a financial term used to describe the nominal or dollar value of a security, as stated by its issuer. For stocks, the face value is the original cost of the stock, as listed on the certificate. For bonds, it is the amount paid to the...