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Brain Drain is about to launch a new product. Depending on the success of the new product, there are three possible outcomes for value next year: $210 million, $150 million or $60 million. These outcomes are all equally likely, and this risk is diversifiable. Suppose the risk-free interest rate is 5%. (Ignore all other market imperfections, such as taxes.). Brain Drain has $120 million in debt due next year.
a. What is Brain's total value with leverage?
b. Now suppose that in the event of default, 30% of the value of Brain's assets will be lost to bankruptcy costs. What is Brain's total value with leverage and distress costs?
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