Question

Consider a firm managed by an entrepreneur. The firm has two kinds of debt outstanding: senior debt under which it owes $150 to bondholders, and a subordinated bank loan that requires a repayment of $1,250. The firm’s assets have a current liquidation value of $400, but if the firm continues to operate, it will be worth $1,400 with probability 0.8 and zero with probability 0.2 one period hence. To manage the firm for an additional period, the entrepreneur incurs a personal cost of $25. The entrepreneur has declared that he wishes to file for bankruptcy and has contacted both the bank and the bondholders’ trustee. The bondholders wish to liquidate the firm immediately. What should the bank do? Assume universal risk neutrality and a risk-free (discount) rate of zero. The entrepreneur owns all of the firm’s equity.

Answer 1

Computation of expected payoffs at both continuation and liquidation

liquidation value of the firm is $400

bond holders will receive $150

bank wiil receive $400-$150=$250

Enterprenuer will not receive any amount

Continuation of the firm

bond holders will receive full amount with a probability of 80% and o witha probability of 20%

expected value of claim is $150*80%+0*20%=$120

expected value of bank is ($1400-150)*80%+0*20%=$1000

the Expenditure for Enterprenuer is $25

As the bond hondholders will receive the full amount at liquidation, the bond holders wish to liquidate immediately

the enterprenuer will incurr additional expenses so he also wishes for immediate liquidation

but the bank will choose for continuation

To ensure the most efficient plan is choosen during bankruptcy, the bank can buy out the senior debt for $150, more over the bank could agree to restructure the loan so that the enterprenuer owes only $1360 instead of $1400

now the continuation paln is acceptable to all the parties since enterprenuer expected payoff is

0.8*(1400-1360)-25= 7

The senior bond holders payoff is $150 & and the banks expected payoff is

0.8*1360-150=$938