Question

Say you owned a firm that held illiquid assets that you did not want to sell. The value of the firm is 100m dollars. Your firm had absolutely no debt. It also had no real future investment opportunities that it wanted to pursue. Assume you and your family needed a significant amount of cash for personal reasons. You approached a bank and they said they would give you a loan today of 40m dollars. The terms of the loarequired paying back 60m dollars after 4 years. So the bank gives the firm 40m dollars today. Explain what the firm would do with the money. What would the economic balance sheet look like after all the transactions have taken place. Explain why your ownership stake in the firm is lower than what it was before all these transactions took place.

Answer 1

1. What the firm would do with the money?

Ans. As mentioned in the question, the family needs a amount of cash for personal reasons. So in that case the owners can withraw the money as a drawings and use it in the place. As the company have held illiquid assets which it does not want to sell, then it is quite a possibility where they have assets in real estate and they estimate the market price of those assets to raise.

2. What would the economic balance sheet look like?

Ans. The economic balance sheet will look like:

Balance Sheet

Fixed Assets $ Equity $

Land 100,000,000 Owners Equity 60,000,000

(assumed to be illiquid asset as land)

Current Assets Liabilities

- - Bank Loan 40,000,000  

Total 100,000,000.00 100,000,000.00  

3. Why the ownership stake in the firm is lower than what it was before all these transaction took place?

Ans. As we know that in the beginning there were no debts to the company. The company just had $100m in their illiquid assets. So in that case the owners equity was $100m. In the end, since the company required money for its personal use, they took a loan in the business and withdrew it for personal use. In that case the owners equity have fallen to $60m.

This is the reason why the owners stake is less in the end as compared to the beginning.