A firm has 60% probability of being worth $100 million and a 40% probability of being worth $150 million. There is one bond outstanding that promises to pay $100 million at an interest rate of 4%. The cost of capital for the firm's projects is 8%.
-Refer to the information above. What is the expected payoff to the levered equity holders?

Question

Quizplus · Accepted Answer

The expected payoff to equity holders is calculated by considering the scenarios where the firm's value exceeds the bond payment. If the firm is worth $100 million, equity holders get $0 (since the bond is paid in full). If the firm is worth $150 million, equity holders get $50 million ($150 million - $100 million bond payment). The expected payoff is (0.6 * $0) + (0.4 * $50 million) = $20 million.

A Firm Has 60% Probability of Being Worth $100 Million