Q: Which formula correctly calculates the present value of MI's debt, given the probabilities and bankruptcy costs?

$$\frac{1}{3} \times 80 + \frac{2}{3} \times 125$$

Q: Which formula correctly calculates the expected value of MI's equity?

$$\frac{1}{3} \times 0 + \frac{1}{3} \times 25 + \frac{1}{3} \times 66$$

Question 1

Monsters Incorporated (MI) is launching a new product with possible future values of $$100 million, 150 $$million, or $191 million, each equally likely. If the risk-free rate is 5% and the project has a beta of 0, what is the appropriate discount rate to use when valuing MI's future cash flows?

Accepted Answer

The risk-free rate of 5%

Question 2

Given MI's possible asset values ($$100M, 150M$$, $191M) and a risk-free rate of 5%, what is the expected value of MI's assets one year from now?

Accepted Answer

$147 million

Question 3

If MI has zero-coupon debt with a $125 million face value due next year and bankruptcy costs are 20% of asset value in default, what is the amount debtholders receive in the bankruptcy state?

Accepted Answer

$80 million

Question 4

Which formula correctly calculates the present value of MI's debt, given the probabilities and bankruptcy costs?

Accepted Answer

$$\frac{1}{3} 	imes 80 + \frac{2}{3} 	imes 125$$

Question 5

What is the present value of MI's debt, discounted at the risk-free rate of 5%?

Accepted Answer

$$104.76$$ million

Question 6

How is the yield to maturity (YTM) of MI's debt calculated, given the present value and face value?

Accepted Answer

$$\frac{125}{104.76} - 1$$

Question 7

What is the yield to maturity (YTM) of MI's debt, rounded to two decimal places?

Accepted Answer

19.25%

Question 8

In the event of default, what percentage of MI's asset value is lost to bankruptcy costs?

Accepted Answer

20%

Question 9

If MI defaults and its assets are worth $100 million, what is the value lost to bankruptcy costs?

Accepted Answer

$$20$$ million

Question 10

What is the initial value of MI's equity, given the possible asset values, debt face value, and bankruptcy costs?

Accepted Answer

$$29$$ million

Question 11

Which formula correctly calculates the expected value of MI's equity?

Accepted Answer

$$\frac{1}{3} 	imes 0 + \frac{1}{3} 	imes 25 + \frac{1}{3} 	imes 66$$

Question 12

If MI's assets are $$150 million and debt is 125 $$million, what is the value of equity in this state?

Accepted Answer

$$25$$ million

Question 13

If MI's assets are $$191 million and debt is 125 $$million, what is the value of equity in this state?

Accepted Answer

$$66$$ million

Question 14

If MI's assets are $$100 million and debt is 125 $$million, what is the value of equity in this state?

Accepted Answer

$$0$$ million

Question 15

Why is the risk from MI's project considered diversifiable?

Accepted Answer

The cash flows are unrelated to the state of the economy

Question 16

If capital markets are perfect, what does this imply about MI's ability to raise funds?

Accepted Answer

MI can raise funds without incurring transaction costs or facing restrictions

Question 17

If MI's debt is zero-coupon and due next year, what does this mean for the payment structure?

Accepted Answer

MI pays no interest during the year and repays the full face value at maturity

Question 18

If MI's project has a beta of 0, what does this indicate about its risk relative to the market?

Accepted Answer

The project's returns are uncorrelated with the market

Question 19

If MI's debt has a yield to maturity of 19.25%, what does this imply about the riskiness of the debt compared to the risk-free rate?

Accepted Answer

The debt is riskier than the risk-free asset, reflecting default risk and bankruptcy costs

Financial Accounting Guidance: Debt Yield and Equity Valuation with Bankruptcy Costs

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