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

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 $198 million, but if the project is a failure, the firm will be worth only $120 million. The current value of the company is $163 million, a figure that includes the prospects for the new project. The company has zero coupon bonds due in one year with a face value of $150 million. Treasury bills that mature in one year have an EAR of 7 percent. 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 500,000 shares of common stock outstanding. What is the price per share of the company’s equity?

c. Compare the market value of the company’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, the company’s management decides to undertake a project that is even more risky. The value of the company will either increase to $217 million or decrease to $105 million by the end of the year. Surprisingly, management concludes that the value of the company today will remain at exactly $163 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 company plans on undertaking this new 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...

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