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"University Service Company (USC) is a local firm set up to manage student-oriented apartment complexes in several college towns. It will remain in business one more year, and its cash flows over the coming year depend upon the total level of university enrollments in the markets USC serves. This is turn depends upon the state of the national economy. If the national economy expands rapidly over the next year, university enrollments will be high and USC will have high revenues; if the national economy is in recession, university enrollments will go down and USC’s revenues will be low. The estimated probability of an expansion is 50%, while the estimated probability of a recession is also 50%. If there is an expansion, USC will have total cash flow of $400,000 while in a recession total cash flow will be $200,000. USC has zero-coupon debt outstanding that will mature in one year with a promised payment of $250,000. Assume a one-period model and that there no corporate or personal taxes. Assume further that stockholders require a return of 8.0% and bondholders require a return of 5.0%." a. If there are no bankruptcy costs, what is the total value of the stock of USC? b. If there are no bankruptcy costs, what is the total value of the firm? c. If there are no bankruptcy costs, what is the promised return on the bonds? d. Now assume that, in the event of bankruptcy, legal and other costs will reduce the cash flow available to the firm’s investors by $50,000. What is the total value of the firm under these conditions?

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Lelia Lubowitz
Lelia LubowitzLv2
28 Sep 2019

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