Orange Co. has debt with a face value of 500. Its firm value next year is uncertain with a distribution shown in the following table:
Firm Value Probability
300 0.1
800 0.85
1000 0.05
Assume bankruptcy cost is 100, which will fall upon the bondholders. Further assume zero interest rate.
(1) Without risk management, what is expected debt value, equity value and firm value?
(2) Suppose Orange Co. can hedge and fix the firm value to its expected value calculated from (1) minus T=10 where T is hedging cost. Will shareholders of Orange Co. hedge if bondholders have already purchased bonds at a price of 500 (i.e. ex post analysis)? Will shareholders of Orange Co. hedge if bondholders have not purchased bonds (i.e. ex ante analysis)? Justify your answer with calculation.
(3) Propose a non-hedging strategy that can avoid expected bankruptcy costs.