Question

Montgomery Corp is currently worth $30 million as a company, but has $50 million of debt. There is a potential project that costs $60 million that would require shareholders to provide an additional $30 million to invest in. In one year, the project will yield $99 million or $55 million with 50% probability each. If the investment is not made, the firm will file for bankruptcy today. Suppose a 10% discount rate.

The shareholders will _____ the investment because they stand to _____. The investment is _____ for the firm and _____ for the debtholders.

(Ignore taxes and bankruptcy costs)

Group of answer choices

approve; gain $10 million; bad; bad

approve; gain $5.45 million; good; bad

disapprove; lose $10 million; bad; good

disapprove; lose $5.45 million; good; good

Answer 1

Firm Value = $30 million

Value of Debt = $50 million, Value of equity = Value of firm - value of debt = - $20 million

If Investment is not made, and company files for bankruptcy

Benefit to Debtholders= $30 -$50 = - $20 million

Benefit to Shareholders = 0 - (-$20 million ) = $20 million

If Investment is made

Cost of New project= $60 million ($30 million original value and $30 million additional equity)

Expected yield from project after one year = 0.5*$99 million +0.5*$55 million =$77 million

NPV of project = -$60 + $77/1.1 =$10 million

So, total value of firm =$30 million (original ) + $30 million (additional equity) +$10 million (NPV) =$70 million

Value of Debt =$50 million  ,Value of Equity = $70-$50 =$20 million

In case of Bankruptcy

Benefit  to Debtholders = $50 million

Benefit to Equityholders = $20 million

As Equity holders only get $20 million on investing $30 million additional ,shareholders will disapprove the project as they stand to lose $10 million, the investment is bad for the firm but good for the debtholders .... (3rd option)