Question

You are the sole shareholder and CEO of your own local newspaper. The company’s only assets are $25,000 in cash. In one year the company’s only bank loan is due. The principal together with the last interest payment amounts to $27,500. If the newspaper is unable to sell enough ads to repay, all its assets will be taken over by the bank. There are three investment opportunities available: (1) do nothing; (2) use the $25,000 to buy lottery tickets that will pay $2,500,000 in one year with probability 0.01 and $0 otherwise; and (3) investing the $25,000 in an advertisement salesperson training program that lasts one year and returns $50,000 with probability 0.50, and $25,000 otherwise. Assume the discount rate is 0%. Answer the following questions:

a) Which of the 3 investment opportunities would you prefer?

b) Which of the 3 investments would the bank prefer?

c) How much would the bank have to pay you to make you choose the investment project that the bank prefers? Hint: The payment has to make both the bank and the shareholder (you) at least as well off as compared to the choice from part a).

Answer 1

Answer to Question a)

Analysing the different Opportunities

1) Do Nothing - Cash Inflow - $ 0

2) Purchase of Lottery Tickets

Initial Outflow - -$25000

Expected Inflow - $2,500,000 * 0.01 = $ 25000

Net NPV - Outflow - Inflow = $0

3) Investing $ 25000 in Sales Training

Initial Outflow - -$25000

Expected Inflow - $50000*0.50+$25000*0.50 = $37500

Net NPV - $17500

Please note that as the discount rate is given as 0% no time value of money is to be considered and therefore present values of expected inflows are to be taken.

According to the above based on positive Expected NPV option 3 would be prefered.

Answer to Question b)

Based on the above working Bank would also prefer option 3.

Looking from the Banks point of view, the company owes to the bank about $27500. If Option 3 is selected even in the worst scenario the company will be able to earn as much as $25000 (50% probability). This will help bank cover its debt to the tune of $25000. This is anyways better than option 1 as there is a 50% probabilty of getting $ 50000 (in option 3). Banks would not prefer option 2 as in the worst case scenario the lottery prize might not be won and the bank might even not get back a penny of its loan.

Answer to Question c)

Option 3 has a positive NPV of $17500

The company already owes $27500 to the Bank.

The Best Case Scenario is an NPV of $ 25000

The Worst Case Scenario is an NPV of $ 0.

The bank would be willing to lend =Cash Balance of the Company + Expected NPV of Option 3 - Existing Loan of the Bank

=$ 25000 + $17500 - $27500

=$15000

As a shareholder of the company, the two positves of selecting option 3

1) Sales Training would help the employees become more professional and develop leading to a more stronger workforce.

2) the Additional amount that the bank would be willing to pay would help the company to utilize such resources in other investment opportunities.