Suppose a new venture promised the following payments in 5 years with the associated probabilities as listed.
Payoff Probability
80,000,000 10%
110,000,000 20%
140,000,000 40%
170,000,000 20%
200,000,000 10%
Now assume that this venture is financed with equity and a 5 year zero coupon bond with a face value of 100,000,000. Use the contingent claims approach to debt security pricing to answer questions (b) through (d).
- Create a table showing the expected payoffs to debt and equity at maturity in each of the 5 possible states of the world. Assume there are no third party costs of distress in the event of a default.
Assume that the required risk premium over the risk free rate on the debt is 3%. Calculate the current value of the debt. Based on that value, what is the yield to maturity on the debt, assuming annual compounding?
- What is the present value of the equity? What is equity risk premium that is implied by that value?