A firm has a 40% chance of producing $90 in cash flows next year, and a 60% chance of producing $200 in cash flows. Assume risk neutrality and a cost of capital of 9%.
-Refer to the information above. What is the value of the firm if debt has a face value of $100, and deadweight financial distress costs are $25?

Question

Quizplus · Accepted Answer

First, we need to calculate the expected cash flows for next year:

Expected cash flows = (0.4 x $90) + (0.6 x $200) = $144

Next, we need to calculate the present value of the expected cash flows, using a discount rate equal to the cost of capital:

PV of expected cash flows = $144 / (1 + 0.09) = $132.11

We then need to subtract the expected financial distress costs from the firm's value:

Firm value = $132.11 - $25 = $107.11

Since the firm has $100 in face value debt, we need to subtract this from the firm value to get the equity value:

Equity value = $107.11 - $100 = $7.11

Therefore, the total firm value (including debt) is $100 + $7.11 = $107.11, which is closest to answer choice A ($133.95) given.

A Firm Has a 40% Chance of Producing $90 in Cash