SmartOptions, Inc. (SO) currently has no debt. Its assets will be worth $800 million in one year if the economy is strong, but only $300 million in one year if the economy is weak. Both events are equally likely. Assume its cost of capital is determined to be 10%. 1. Find the market value (i.e. the price today) of SO’s assets. 2. Now assume SO recapitalizes by issuing debt. First, a senior bond for $300 million dollars with a promised rate of 10%. Second, a junior bond for $100 million which promises a 20% rate of return. Find SO’s (levered) equity cost of capital under the recapitalized capital structure.
1. Find the market value (i.e. the price today) of SO’s assets.
2. Now assume SO recapitalizes by issuing debt. First, a senior bond for $300 million dollars with a promised rate of 10%. Second, a junior bond for $100 million which promises a 20% rate of return. Find SO’s (levered) equity cost of capital under the recapitalized capital structure.