Suppose that a firm has promised to pay the debt £10,000 in one period and that, depending on the value of the pound, the firm will be worth either £9,000 or £19,000 with equal probability at that time. The assets of the firm will be worth £14,000 if it hedges against currency risk.
a. Identify the value of debt and of equity under both unhedged and hedged scenarios, assuming there are no costs of financial distress.
b. Suppose the firm will incur direct costs of £1,000 in bankruptcy. Identify the value of debt and of equity under both unhedged and hedged scenarios.
c. In addition to the £1,000 direct bankruptcy cost, suppose indirect costs reduce the asset value of the firm to either £6,000 or £18,000 (before the £1,000 direct bankruptcy cost) with equal probability. Hedging can eliminate both direct and indirect bankruptcy costs, resulting in firm value of £14,000 with certainty. Identify the value of debt and of equity under both unhedged and hedged scenarios.