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

Ans (e)

Even if Bad state of economy happens the New project will score a 32Mill cash flow which will be a very good investment for new Debt holders but since existing debt holders have priority under same assumtion there is shortfall of 25 Mill (40-65) on existing Project and hence this shall be pulle dout of new project surplus and hence leaving the new debt holders with 7 mill only towards their 30 Mill.(refer C ii in above table)

Even though the new Investment is a lucrative one but debt overhang problem clearly exists as going with a Conservative approach new debt holders will be loosing