Question

A firm has debt with a face value of $100. Its projects will pay a safe $80 tomorrow. Managers care only about shareholders. A new quickie project comes along that costs $20, earns either $10 or $40 with equal probabilities, and does so by tomorrow. Assume that the time value of money is 0

     1. Is this a positive-NPV project?

    2. If the new project can only be financed with a new equity issue, would the shareholders vote for this? Would the creditors?

     3. Assume the existing bond contract was written in a way that allows the new projects to be financed with first collateral (superseniority with respect to the existing creditors). New creditors can collect $20 from what the existing projects will surely pay. Would the existing creditors be better off?

4. What is the better arrangement from a firm-value perspective?

Answer 1

_Solution:-

_{Current debt =$100}

_{Current cash flow =$80}

_{a) Calculation of NPV of project}

    _{NPV of project = PV of inflows -PV of outflows}

                                  _{=($10*0.50+$40*0.50)-$20}

                                  _=$25-$20=$5

                                  _{Hence the NPV of the project is positive.}

_{b) If the new project is to be financed by equity. Then $20 has to be paid by equity share holder.}

_{If the firm earn$10, then the equity share holder will lose $10 and will go to creditors from the newly invested capital. However if the firm earn$40, then shareholder will get $20 ($80+40=120,out of which $100 goes to debt holder) .}

_{The expected cash flow for equity holder =50%*0+$20*50%=$10.}

_{Hence share holders will not vote for the investment which give the $10 return to them by investing $20.}

_{The creditors will love the proposal, but the decision will be of share holder not of creditors.}

_{c) The existing creditors would now receive either $70 (60+10) or $100 (60+40) with equal probability. They would therefore expect to receive $85. Hence they are better off in this arrangement.}

_{d) The arrangement "c" is better from firm value perspective.}