Question

The firm Lando expects cash flows in one year’s time of $90 million if the economy is

in a good state or $40 million if it is in a bad state. Both states are equally likely.

The firm also has debt with face value $65 million due in one year.

Lando is considering a new project that would require an investment of $30 million

today and would result in a cash flow in one year’s time of $47 million in the good

state of the economy or $32 million in the bad state.

Investors are all risk neutral and the risk free rate is zero.

(a) What are the expected values of the firm's equity and debt without the new

project?

Lando can finance the project by issuing new debt of $30 million. If the firm goes

bankrupt the new debt will have a lower priority for repayment than the firm’s existing

debt.

(b) If the new project is accepted, what will be the value of the firm’s cash flow in

each state after paying the original debtholders? What payment must Lando

promise to the new debtholders in the good state of the economy?

(c) What will be the expected value of Lando’s equity? Will Lando’s managers

choose to accept the project? Why/why not?

Alternatively, Lando can issue new equity of $30 million to finance the project.

(d) What proportion of its equity must Lando give to the new equityholders?

Will Lando’s managers choose to accept the project now? Why/why not?

Answer 1

As the risk free rate is 0 hence we can ignore the discounting effect on the cashflows.

b.

Good state economy

Cash flows ot be received = original cash flows + cash flows from new project = 90 + 47 = 137

cash flow afte rpaying the original debt holder = 137 - 65 = 72 million

Lando can promise to pay the full amount of 30 million to the new debtholders

Bad state economy

cash flows to be recieved = 40 +32 = 72

cash flows after repaying original debt holders = 72 - 65 = 7 million

c

equity value in case of good economy = firm value - debt value = 137 - 65 - 30 = 42 million

equity value in case of bad economy = 72 - 65 - 30 = limited to 0

so expected equity value = 42 *0.5 + 0*0.5 = 21 million

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