Consider a firm whose assets might be valued 30 or 10 in one year. Currently, the firm assets are worth 15. The firm has committed to a debt payment of 5 in one year. The risk-free rate is 5%. 

a) Compute the value of the equity and the debt of the firm. Explain in detail your procedure (There is no need for formulas but you can use them).

b) Consider the firm changed the project such that the asset value today is 15 and it can go up to 35 or down to 1. Nonetheless, the committed debt payment is the same.

c) Explain why the value of equity and debt are higher or lower.

Answer rating: 100% (QA)

a To compute the value of the equity and debt of the firm we need to consider the expected values of the assets in one year We are given that the firms assets might be valued at either 30 or 10 in one year with equal probabilities of 05 for each outcome Value of Equity The value of equity represents the residual value after deducting the debt payment from the total asset value In this case the debt payment is 5 Since the asset values are equally likely we can calculate the expected value of the assets by taking the average of the possible outcomes 30 10 2 20 The value of equity is then calculated as the expected asset value minus the debt payment 20 5 15 Value of Debt The value of debt represents the contractual obligation that the firm ... View the full answer