Suppose that today a firm”s value is $80 million and it is expected to be either $85 million or $90 million one year from now, depending on actual sales of new products that the firm has developed. Now a firm”s mangers have decided to issue a one-year debt obligation wherein the payment to the debt holders is as follows:
- If the firm”s value one year from now is $85 million (the lower expected firm value), investors would receive $84 million.
- If the firm”s value reaches the high expectation of $90 million, it would pay creditors $88 million.
- Assuming that the one-year risk-free rate is 10%, calculate the risk-neutral probability for this debt obligation.
- Create a table to illustrate the debt and equity facing the firm in time 2 (i.e., one year from now).