Buckeye Industries has a bond issue with a face value of $1,000 that is coming d

Question

Buckeye Industries has a bond issue with a face value of $1,000 that is coming due in one year. The value of Buckeye's assets is currently $1,300. Jim Tressell, the CEO, believes that the assets in the firm will be worth either $500 or $1,700 in a year. The going rate on one-year T-bills is 6 percent.

a. The value of Buckeye's equity is $________ and the value of the debt is $______.

b. Suppose Buckeye can reconfigure its existing assets in such a way that the value in a year will be $300 or $1,900. If the current value of the assets is unchanged, the value of Buckeye's equity will be $ and the stockholders (will not/will) favor such a move.

Buckeye Industries has a bond issue with a face value of $1,000 that is coming due in one year. The value of Buckeye's assets is currently $1,300. Jim Tressell, the CEO, believes that the assets in the firm will be worth either $500 or $1,700 in a year. The going rate on one-year T-bills is 6 percent.

a. The value of Buckeye's equity is $________ and the value of the debt is $______.

b. Suppose Buckeye can reconfigure its existing assets in such a way that the value in a year will be $300 or $1,900. If the current value of the assets is unchanged, the value of Buckeye's equity will be $ and the stockholders (will not/will) favor such a move.

Explanation / Answer

Part a)

The formula for calculating the current value of assets would be used to calculate the value of equity. The value of equit would than be used to calculate the value of debt. The formula for current value of assets would be:

Current Value of Assets = [(Expected Value 2 of Assets - Expected Value 1 of Assets)/(Expected Value 2 of Assets - Face Value of Bonds)]*Equity + (Expected Value 1 of Assets/(1+T bill rate)

Here, Current Value of Assets = $1,300, Expected Value 2 of Assets = 1,700, Expected Value 1 of Assets = 500, Face Value of Bonds = 1,000, T bill rate = 6%, Equity = ?

Using these values in the above formula, we get,

1,300 = [(1,700 - 500)/(1,700 - 1000)]*Equity + 500/(1+6%)

1.71*Equity = 1,300 - 500/(1+6%)

Value of Equity = 828.30/(1.71) = $483.18

Value of Debt = Current Value of Assets - Value of Equity = 1,300 - 483.18 = $816.82

__________________

The value of Buckeye's equity is $___483.18____ and the value of the debt is $____816.82__

__________________

Part b:

Using the same formula as above, and changing the Expected Value 1 of Assets and Expected Value 2 of Assets to $300 and $1,900 respectively, we get,

1,300 = [(1,900 - 300)/(1,900 - 1000)]*Equity + 500/(1+6%)

1.78*Equity = 828.30

Value of Equity = 828.30/1.78 = $465.92

__________________

If the current value of the assets is unchanged, the value of Buckeye's equity will be $465.92 and the stockholders (will not/will) favor such a move.

__________________

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