Question 3
SkyBus, a low-cost airline company, owns and operates 10 airplanes, each estimated to be worth
$100 million in one year. The firm has also estimated EBIT per airplane for next year as follows:
Possible Business State
Probability
EBIT
in One Year
per airplane
High travel demand
0.75
$10 million
Low travel demand
0.25
0
Assume that airplanes are the only assets that the firm owns and that the value of the firm's total
cash flows thereafter ("terminal value") equals zero.1 The marketplace for aircraft is known to be
very slow. A normal transaction, with no transaction costs, takes a year to complete. However, if an
urgent transaction is required, the transaction can be completed immediately at a cost of 50% of the
fleet value ("fire sales"). For simplicity, assume that the business state (and thus the firm's cash flow)
is uncorrelated with the market portfolio and that the effective tax rate equals zero. The risk-free
rate is 10%.
a) Suppose the firm is 100% equity-financed. Find the unlevered firm value.
b) Suppose instead that the firm has issued one-year zero-coupon bond with a face value of $100
million (i.e., due in one year). If the firm's EBIT falls below the bond face value, it will have to
invoke fire sales of its airplanes. Determine the value of the zero-coupon bond and the value of
levered equity.
