Knowee
Questions
Features
Study Tools

Bright Future Corporation (BFC) is ready to launch a new product. Depending upon the success of this product, BFC will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely.  The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%.  Assume that the capital markets are perfect. Assume that in the event of default, 20% of the value of BFC's assets will be lost in bankruptcy costs and suppose that BFC has zero-coupon debt with a $125 million face value due next year.2.  The initial value of BFC’s equity is closest to

Question

Bright Future Corporation (BFC) is ready to launch a new product. Depending upon the success of this product, BFC will have a value of either 100million,100 million, 150 million, or 191million,witheachoutcomebeingequallylikely. Thecashflowsareunrelatedtothestateoftheeconomy(i.e.riskfromtheprojectisdiversifiable)sothattheprojecthasabetaof0andacostofcapitalequaltotherisk−freerate,whichiscurrently5191 million, with each outcome being equally likely.  The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%.  Assume that the capital markets are perfect. Assume that in the event of default, 20% of the value of BFC's assets will be lost in bankruptcy costs and suppose that BFC has zero-coupon debt with a 125 million face value due next year.2.  The initial value of BFC’s equity is closest to

...expand
🧐 Not the exact question you are looking for?Go ask a question

Solution

To calculate the initial value of BFC's equity, we first need to calculate the expected value of the firm and then subtract the present value of the debt.

  1. Calculate the expected value of the firm: Since each outcome (100million,100 million, 150 million, or $191 million) is equally likely, we can simply take the average.

    Expected value = (100 + 150 + 191) / 3 = $147 million

  2. Calculate the present value of the debt: The debt has a face value of $125 million due next year. Since the cost of capital is equal to the risk-free rate (5%), we can discount the debt by this rate.

    Present value of debt = 125 / (1 + 0.05) = $119.05 million

  3. Calculate the initial value of the equity: This is simply the expected value of the firm minus the present value of the debt.

    Initial value of equity = 147 - 119.05 = $27.95 million

However, we also need to consider the bankruptcy costs. If BFC defaults on its debt, 20% of the value of its assets will be lost. This means that the equity value will be zero in the states of the world where the firm value is less than the face value of the debt (i.e., $125 million).

Given the three possible outcomes for the firm value, there is a 1/3 chance that the firm value will be $100 million and BFC will default on its debt. In this case, the equity value will be zero.

So, the expected equity value considering the possibility of default is:

Expected equity value = (1/3 * 0) + (1/3 * (150 - 119.05)) + (1/3 * (191 - 119.05)) = $20.65 million

So, the initial value of BFC's equity is closest to $20.65 million.

This problem has been solved

Similar Questions

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%.The NPV for this project is closest to:Group of answer choices$14,100.$6250.$10,000.$18,600.

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%.Suppose that to raise the funds for the initial investment the firm borrows $80,000 at the risk-free rate, then the cost of capital for the firm's levered equity is closest to:Group of answer choices15%.25%.95%.45%.

Disregard your answers to the previous question. Now, assume that the cosmetic business has a valuation of $1,427 million and a beta of 0.7 with a perpetual growth rate of 4%, and the coal mining business has a valuation of $997 million and a beta of 1.2 with a perpetual growth rate of 1%. Suppose the risk-free rate is 2% and the market risk premium is 5%. Eastern Inc. is an all-equity firm. What is Eastern Inc’s current cost of capital? (Hint: first, need to calculate the current equity beta for Eastern Inc.) Note: Enter your final answers in percentage points in X.X format. e.g. if your answer is 10.654%, enter 10.7 Your answer is:

Given: risk-free rate of return = 5 % market return = 10%, cost of equity = 15% value of beta (β) is:a.1.9b.1.8c.2.0d.2.2

Based on the information given, if the risk-free rate of interest is 3% and the market risk premium is 5%.DivisionAsset BetaFree Cash Flows ($m)Expected Growth RateOil Exploration1.44504.0%Oil Refining1.15252.5%Gas & Convenience Stores0.86003.0% The total value of the firm is closest to:A.$15,000B.$37,000C.$21,500D.$31,250

1/3

Upgrade your grade with Knowee

Get personalized homework help. Review tough concepts in more detail, or go deeper into your topic by exploring other relevant questions.