Question

8. (Asset Substitution/Risk-Shifting – the Over-Investment Problem)
Consider Baxter, Inc., which is facing a financial distress.
 Baxter has a loan of $1 million due at the end of the year.
 Without a change in its strategy, the market value of its assets will be $900,000 at that time, and Baxter will default on its debt.
 Baxter is considering a new strategy
 The new strategy requires no upfront investment, but it has only a 50% probability of success.
 If the new strategy succeeds, it will increase the value of the firm’s assets by $400,000 (i.e., to $1.3 million).
 If the new strategy fails, the value of the firm’s assets will fall by $600,000 (i.e., to $300,000).

(i) What is the NPV of the new strategy? Should the manager invest in the new strategy if her goal is to maximize firm value? (Note: the new strategy requires no investment, only affects future expected payoff). (assume 0% discount rate).


(ii) Calculate the values of the firm’s assets, debt, and equity (1) without a change to strategy and (2) with a change to strategy (assume 0% discount rate).
(1) Without a change to strategy:

Payoffs	Assets	Debt	Equity
	900	900	0
Value (Discounted Expected Payoff)	900	900	0

(2) With a change to strategy: (Calculate payoffs for Assets/Debt/Equity State-by-State!)

Payoffs	Assets	Debt	Equity
Good State (p=.5)
Bad State (P=.5)
Value (Discounted Expected Payoffs)

(iii) Will the manager invest in the new strategy, if her goal is to maximize shareholders’ wealth? Explain.

Answer 1

(i) What is the NPV of the new strategy?

NPV = CASH INFLOW - CASH OUTFLOW

= { ($ .9M + $ .4M ) X .5 + ($ .9M - $ .6M) X .5 } - $ 1M

= ( $ 1.3M X .5 + .3M X .5) - $ 1M

= $ .8M - $ 1M

= - $ .2M

  

Should the manager invest in the new strategy if her goal is to maximize firm value?

No the manager should not invest in the new strategy if her goal is to maximize firm value because the new strategy expected firm value would be $ .8 M which is $ .1M below existing firm value i.e. $ .9M .

(ii) Calculate the values of the firm’s assets, debt, and equity

(1) Without a change to strategy:

Payoffs	Assets	Debt	Equity
	900	900	0

Baxter will ultimately default and equity holders will get nothing with certainty and Debt holders receives $ .9M .

(2) With a change to strategy:

Payoffs	Assets	Debt	Equity
Good State (p=.5)	$ 1.3M	$ 1M	$ .3M
Bad State (P=.5)	$ .3M	$ .3M	$ 0

If the strategy succeeds, equity holders will receive $300,000after paying off the debt.

If the strategy fails, equity holders receive zero.

Expected payoff of equity holder:

.5×$ .3M +.5×0 = $ .15M

Expected payoff of debt holder:

.5×$ 1 M +.5×$ .3M = $ .65M

Debt holders have a loss of $250,000 compared to the old strategy.

(iii) Will the manager invest in the new strategy, if her goal is to maximize shareholders’ wealth? Explain.

If Baxter does nothing, it will ultimately default and equity holders will get nothing with certainty. Equity holders have nothing to lose if Baxter tries the risky strategy. If the strategy succeeds, equity holders will receive $300,000 after paying off the debt. Given a 50% chance of success, the equity holders’ expected payoff is $150,000. Therefore manager should invest in the new strategy and there is 50% chance that they will suceed which will ultimately maimize shareholders' wealth.