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Suppose that the assets of a firm follow a two-state binomial model and are currently market valued at 100mil.
The value of the assets in the end of one period will be either up by 10% (up-node) or down by 10% (down-node).
The one-period risk-free rate is 5%.
The company has a zero-coupon bond with one period to maturity and face value of 100mil.
What is the value of the equity and what is the value of the corporate bond today?
What will happen if the risk free rate goes from 5% to 6%?
What will be the effect of increased asset variance (value up of the assets is 120, value down is 80)?
For each proposal, calculate both the present value of the interest tax shields and the overall value of the firm, assuming that there are no personal taxes on debt or on equity income.
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