PROBLEM 3.2. Consider a company which is due to generate a single cash-flow, equal either to SEK 2500 or to SEK 1 500, in one year. The claims on the companys cash-flows consist of both debt and equity, and the companys shareholders have limited liability. The market value of the company is equal to SEK 1 750, and the assumptions of Modigliani-Miller irrelevance theorem are satisfied. The risk-free rate of interest is equal to 2%.
1. Suppose that the companys debt consists of a single bond. This bond entitles the investor(s) to a payment of SEK 1300 due in one year. Provide the current market value of the bond and the companys equity.
2. Suppose that the companys debt consists of a senior bond and a subordinate bond. The bonds entitle the investors to a payment of SEK 1 300 and a payment of SEK 500, respectively; both payments are due in one year. Provide the current market value of each bond and the companys equity.
Hint. In this Problem, we are given the market value of the company. Hence, to use the replication strategy to find the price of any given security, we must find a combination of an ideal security that includes both the firms equity and the firms debt, on one hand, and risk-free debt, on the other hand, whose value in each state is identical to that of the security to be priced. For example, using m and f to indicate the positions in the ideal security and risk-free debt, respectively, we can write the system determining the replicating portfolio for the firms equity in 3.2.1 as:
2500- 1300 = 2500x m + 1.02x( 1500- 1300= 1500x m + 1.02x f
Consider a company which is due to generate a single cash-flow, equal either to SEK 2500 or to SEK 1 500, in one year
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