Relate your answers to Modigliani and Miller propositions I and II.
Capital structure with risky debt and taxes
Now, in the Frog Island Republic debt is risky and shareholders own the
corresponding default option. The asset’s volatility of both Sun and Bright Star
Co. is 20%. The risk free interest rate is 5%. Bright Star debt can be
assimilated to a zero-coupon bond maturing in two years. Corporate tax rate
continues being 20%. The government has suppressed interest deductibility in
corporate taxation.
The expected market risk premium (RM-r) is 10%. The correlation between
the assets and the market index is 0.3125. Market volatility is 0.25. Asset’s
beta is 0.25.
Questions:
3.1) Which is the default option value for Bright Star?
3.2) Why can we interpret Bright Star shares as a call? Calculate its value
and relate it to the default option.
3.3) Calculate the cost of equity capital and the WACC.