In: Finance
Assume now that XYZ is hit by extremely bad news. In the current situation, XYZ’s assets therefore have a value of $550,000, which is problematic because XYZ owes $600,000 to the debt holders, who must be repaid in the near future. The management of XYZ is considering a new risky strategy that can either increase the value of XYZ’s assets to $700,000 or reduce its value to $200,000. Both outcomes are equally likely. XYZ can switch to the new strategy without having to make an upfront investment.
Question: What is the expected payoff to the equity holders and debt holders under the current and new strategy? Explain whether it is in the interests of the equity holders and debt holders to switch to the new strategy.
In case of financial disstress of XYZ, the debt holders will be repaid first over its equity holders. Equity holders will receive any money that is available after repayment to debt holders.
Value of total assets under current circumstances = $550,000
Value of total debt under current circumstances = $600,000
Hence, the expected payoff to the equity holders and debt holders under current situation is as follows
Strategy | Payoff to Equity Holders | Payoff to Debt Holders |
Current | $0 | $550,000 |
Under new strategy where value of assets may increase to $700,000 or decrease to $200,000, both the outcomes will have equal weightage i.e 50% each.
A) Expected payoff to the equity holders and debt holders under when value of assets increases to $700,000
Strategy | Payoff to Equity Holders | Payoff to Debt Holders |
Value of assets increases to $700,000 (50%) | $100,000 | $600,000 |
Equity holders will be repaid after repayment of $600,000 to debt holders out of total value of assets of $700,000
B) Expected payoff to the equity holders and debt holders under when value of assets decreases to $200,000
Strategy | Payoff to Equity Holders | Payoff to Debt Holders |
Value of assets decreases to $200,000 (50%) | $0 | $200,000 |
Equity holders will receive any money that is available after repayment to debt holders.
Effectively, it is in the interest of both equity and debt holders to switch to new risk strategy where they will be repaid fully if value of the assets rises to $700,000