Exercise 3 (7 points). (Debt overhang) BioNewCorp (BNC) is a startup specialized in biomedical technology. It has assets in place that yield a single cash flow X at t=2. Three states are equiprobable: good (X=$100m), medium (X=$30m) or bad (X=$5m). The firm has debt with face value K=$35m due at t=2. a. Suppose all agents are risk neutral and discount all cash flows at the same (riskfree) 10% discount rate. What is the value of BNC's debt? What is the value of BNC's equity? b. At t=1, BNC has a project: investing $15m yields a safe cahflow $22m at t=2. However, BNC does not have any liquidity to fund the investment. Show that although the project is valuable, shareholders will not fund it if they have to inject the $15m themselves into the firm. Explain c. For this question only, assume that the good, medium and bad states' probabilities are 1/4, 1/4, and 1/2. Show that shareholders are even less prone to inject the $15m. Explain. Since the existing shareholders will not add money onto BNC to fund the project, they are considering funding the $15m with different sources of outside finance. d. Equity: how much new equity would BNC need to issue? Would shareholders agree? e. Junior debt: the new debt would be junior to the existing debt, i.e. the new debt gets paid only after the existing debt has been paid in full. How much new debt would BNC need to issue? Would shareholders agree? Exercise 4 (5 points). In class we argued that a share of stock is a option on a company's assets. Consider the case of Yipee.com, an Internet service provider. Yipee has 80M ( of zero-coupon debt maturing in 2 years' time. The company's assets are currently worth 100M ( and can go up each period by a factor of 1.25 or down by a factor of 0.8. Yipee has 1 million shares outstanding and the risk-free interest rate is 10% per year. Please use risk-neutral option pricing to answer the following questions. a. What is the current share price of Yipee? b. Recently, the Chicago Options Exchange started trading options on Yipee's stock. You are interested in a call option on their stock that matures in two years time, and has an exercise price equal to (40. Calculate a fair price for this call option. c. What is the value of Yipee's existing bonds? d. Is Yipee's debt risky? If yes, what is the credit spread on Yipee