In: Accounting
The firm Lando expects cash flows in one year’s time of $90
million if the economy is in a good state or $40 million if it is
in a bad state. Both states are equally likely.
The firm also has debt with face value $65 million due in one
year.
Lando is considering a new project that would require an investment of $30 million today and would result in a cash flow in one year’s time of $47 million in the good state of the economy or $32 million in the bad state.
Investors are all risk neutral and the risk free rate is
zero.
(a) What are the expected values of the firm's equity and debt
without the new
project?
Lando can finance the project by issuing new debt of $30 million. If the firm goes bankrupt the new debt will have a lower priority for repayment than the firm’s existing debt.
(b) If the new project is accepted, what will be the value of the firm’s cash flow in each state after paying the original debtholders? What payment must Lando promise to the new debtholders in the good state of the economy?
(c) What will be the expected value of Lando’s equity? Will Lando’s managers choose to accept the project? Why/why not?
Alternatively, Lando can issue new equity of $30 million to finance the project.
(d) What proportion of its equity must Lando give to the new equityholders? Will Lando’s managers choose to accept the project now? Why/why not?
(e) Briefly discuss the agency problem of debt overhang with reference to answers to the previous parts of the question.
a)
await cash flow in one year = 90x0.5 + 40x0.5 = 65 million
debt price after one year = 65 million
the hazard free rate is 0 hence ,the present worth of cash flows stay same as the worth of cash flows after one year
whole firm worth after one year = 65 million
mortgage value is worth after one year = 65 million
equity value is firm value - debt value = 65 -65 = 0
b)
Since the hazard -free rate is zero therefore we can disregard the discounting impact on the cashflows.
Good state economy
Cash flows ot be acquire = real cash flows + cash flows through new work is = 90 + 47 = 137
cash flow after giving the original mortgage holder = 137 - 65 = 72 million
Lando can promise to give the full cash of 30 million to the new debtholders
Bad state economy
cash flows to be acquire = 40 +32 = 72
cash flows later repaying original debt holders = 72 - 65 = 7 million
c)
equity worth in case of fine economy = fv - dv = 137 - 65 - 30 = 42 million
equity worth in case of bad economy = 72 - 65 - 30 = limited to zero
so await equity worth = 42 x0.5 + 0x0.5 = 21 million
so As the worth greater than zero hence ,we should allow the new project