1. Consider a single period binomial setting where the risk-free interest rate is 0, and there are no taxes. A firm consists of a machine that will produce cash flows of $210M if the economy is good and $80M if the economy is bad. The good and bad states occur with equal probability. Initially, the firm has 10.000 shares. Assume that outstanding debt with a face value of $50M is due at the end of the period.

a. Which are the market values of the equity and the debt of this firm?

Suppose the firm unexpectedly announces that it will issue additional debt. This debt will be junior with respect to existing debt and will have a face value of $50M. The firm will use the entire proceeds to repurchase some of the outstanding shares.

b.What is the market price of the new debt?

c.Which will be the value of each of the firms securities after the completion of this

financial operation?

d.Show how this change affects the wealth of a shareholder with 20 percent of the

shares outstanding

Scenario 1 the shareholder sells but still remains 20% of all shares after the operation.

Scenario 2 the shareholder sells all. Scenario 3 the shareholder chooses not to sell. Does the Modigliani Miller Theorem hold?

e. How would your previous answers change if the new debt were to be issued with the same seniority as existing debt?