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. Your firm has debt with a face value of $100. Deadweight financial distress costs are $25. What is your firm's cost of debt capital?

Question

Quizplus · Accepted Answer

The expected cash flow is ($90*0.4)+($200*0.6)=$150. The present value of the cash flows is ((90/(1+0.09)) * 0.4) + ((200/(1+0.09)) * 0.6) = $165.58. The market value of assets is $165.58 + $100 = $265.58. The probability of financial distress is (200-150)/200 = 0.25. The expected financial distress cost is $25 * 0.25 = $6.25. The adjusted market value of assets is $265.58 - $6.25 = $259.33. The cost of debt is ($100/$259.33) * 9% = 3.46%. Finally, the cost of debt capital is 3.46% + 6.25% = 9.71% or 21.7% depending on whether you use just the expected financial distress cost or a probability-weighted average of the possible scenarios. Choice B includes both options.

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