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Gidget International is domiciled in the Land of Make Believe. The local currency is called the Goodwill (abbreviated G). Gidget will own assets worth either G6,000 or G16,000 this year (with equal probability), depending on the value of the local currency on world currency markets. Gidget has a promised payment to debt of G10,000 due in one year. Although there are no taxes in the Land of Make Believe, there are lawyers (this isn't a perfect world, after all). If Gidget cannot meet its debt obligations, legal fees will impose direct bankruptcy costs of G2,000 as the firm is divided among its creditors.
a. How much will the debt and equity owners receive at asset values of G16,000 and of G6,000?
b. Draw the value of debt and of equity as a function of the value of firm assets.
c. How can hedging increase the value of Gidget International in the presence of direct bankruptcy costs? Who wins- debt, equity, or both?
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