Question

The following is the information for Last Chance Productions. The firm has a market value of assets of $10 million and a debt repayment amount of $40 million with maturity of 6 years. Clearly, this firm is highly leveraged. The standard deviation of asset returns for the firm is 30% and the risk-free rate in the economy is 1%. The firm is considering two projects. Project LoRise adds $3.75 million to the market value of the company. Further, taking the project does not raise the risk of the firm. Project LongShot has an NPV of –$2.0 million and it contributes to firm risk. Specifically, taking on Project LongShot increases the standard deviation of assets to 60%. 18) Given the information above, if Last Chance Productions were to take up Project LoRise its market value of equity would change from _______ million to _______ million. A) $0.371, $1.541 B) $0, $2 C) $0.191, $1.611 D) $0.191, $0.623 E) None of the above 19) If Last Chance Productions were to up Project LongShot its market value of equity would be _______ million. A) $1.611 B) $8 C) $0 D) $0.623 E) None of the above 20) The management of Last Chance Productions A) would prefer the negative NPV project because this will help hasten the process of the firm reaching its inevitable state of bankruptcy. B) would prefer the positive NPV project because firm value is always more important to managers whenever there is a conflict between firm value and shareholder value C) would prefer the negative NPV project because in a highly leveraged firm stock holders can only hope to gain if there is a large enough upside and only projects with high volatility can give that kind of an upside. D) would prefer the positive NPV project because debt holders will be more willing to finance future projects if the firm helps them cut their losses. E) Both B and C

Answer 1

In this question, we will have to value the equity as a call option on the asset of the firm with debt as strike price.

We will have to resort to Black Scholes Model for valuation of the call option. Please see the formula below.

As is equity valuation: First let's get the value of equity of the firm on as is basis without taking the impact of any of the new projects.

I have used excel for the same. Please see the snapshot below. Formula used in excel had been shown in the adjacent cells. The cell highlighted in yellow is the value of equity.

All financials are in $ mn

Value of Equity as of now without taking the impact of any of the new projects = 0.191 mn

If Last Chance Productions were to take up Project LoRise

Project LoRise adds $3.75 million to the market value of the company.

Value of the assets will now be = 10 + 3.75 = 13.75

We need to run the entire calculation with this revised value of S in the model. Please see the snapshot below.

Value of equity now = 0.623 (rounded off to three places of decimal)

18) Given the information above, if Last Chance Productions were to take up Project LoRise its market value of equity would change from $ 0.191 million to $ 0.623 million.

Hence, the correct answer is option D) $0.191, $0.623

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If Last Chance Productions were to up Project LongShot then:

Project LongShot has an NPV of –$2.0 million and it contributes to firm risk. Specifically, taking on Project LongShot increases the standard deviation of assets to 60%.

Value of the asset = 10 - 2 = 8 and σ changes to 60%

We need to run the entire model again. Please see the snapshot

Value of equity now = 1.611

19) If Last Chance Productions were to up Project LongShot its market value of equity would be $ 1.611 million.

Hence, the correct answer is option A) $1.611

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20) The management of Last Chance Productions ....

Correct answer is option B) would prefer the positive NPV project because firm value is always more important to managers whenever there is a conflict between firm value and shareholder value

The managers will always select projects with positive NPV.