Mock Exam B- Q19

[vkichoi]

I don't get why value of debt= PV( 50% * $1B+ 50%* $800M)....?

Is it because of the gold selling at $1400 or $800 per oz, each with 50%,
min ($1,000M< orig debt, $1,400M) = $1,000M
min($1,000M< orig debt, $800M)= $800M

Even so I still don't understand this.

Thanks!

 

[David Harper CFA FRM]

Hi vkichoi please note the source is here (per the link at the end of the answer in the mock on page 25): http://forum.bionicturtle.com/threads/l1-t1-44-debt-overhang.3558/
... I have subsequently edited the question, and I am noticing the mock does not reflect the updated version of the question. Apologies, however I don't see that it impacts your question.

You are almost correct.

• 50% chance that future firm value will be $1,400 (equal to the price of gold, or
• 50% chance that future firm value will be $800

The future debt value is then = MIN [firm value, face value] = MIN[firm value, $1,000], which here has two possible outcomes:

• MIN[1,400, $1,000]; i.e., debt can be paid in full
• MIN[800,$1,000]; i.e., assets exhausted can only pay 800

With the PV of debt equal to the weighted average of the two. I hope that explains, thanks!

 

[vkichoi]

omg i get it now! Thanks!