Question

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 your answers to the previous parts of the question. (120 words)

Answer 1

a.Expected value of firm without the new project= its probable cashflows, ie.

(50%*90)+(50%*40)=

65

millions

Value of debt= 65 mlns.

So, value of equity 65-65=0

b.Value of the firm's cash flows in good state, after paying original debt-holders=90+47-65=   72 mlns.

Value of the firm's cash flows in bad state, after paying original debt-holders=40+32-65= 7 mlns.

Expected Cash flow in good state ,if the project is accepted (as done)above --

90+47

137

mlns.

Cash flow available to new debt holders, after meeting the existing debt-holders=

137-65=

72

mlns.

Payment to be promised to new debtholders in the good state of economy is

full $ 30 mlns

c.Value of equity in good state= 72-30=42 mlns.

Value of equity in bad state(7-30)= 23 mlns.

So, expected value of equity=(50%*42)+(50%*-23)=

9.5

mlns.

YES. Value of equity has increased from 0 (without new debt) to 9.5 mlns. (with new debt)

d.Proportion of equity to new equity holders

Expected total value of firm (with new project) will be

(50%*(90+47))+(50%*(40+32))=

104.5

out of which existing debt= 65 mlns

so, equity=104.5-65=

39.5

mlns.

So, proportion of equity , to the firm's value=

39.5/104.5=

37.80%

e.Debt overhang in any company,is a problem where-in,the existing debt is so large that it is not easy for the owners to borrow money further , even , if the latter seems to be a good investment opportunity.

Here, arises an agency problem of underinvesting by the agents of the shareholders in a leveraged company such a above, that misses valuable investment opportunities because of the debt overhanging.