Question: The unhedged value of Make-or-Break Co. is $4,000 if the economy is in a boom and $2,000 if the economy is in a bust. Each state of the world happens with probability 0.5. M—or—B has $1,200 in senior debt and $1,200 in junior debt. If the company is in default (i.e., is unable to fully repay its debt), senior debt holders are reimbursed first. If enough is left, then junior debt holders are repaid as they have priority over equity holders. In the event of default, M-or-B faces both direct and indirect costs of distress. Each of these costs amounts (separately) to $200. Luckily, M-or-B has access to a hedging opportunity that gives $3,000 with certainty.

1. In the tables below, provide the expected values of the equity and each debt class in M-or-B when the firm does not hedge and when it does.
   
2. Using the above tables, describe the ways in which hedging may create value. Describe the gains and losses associated with the decision to hedge for each of the three classes of claimants on M-or-B’s cash flows. What type of agency problems may arise from this situation? Please provide a detailed discussion.

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