Question

Value Tree has suffered a series of negative shocks and is now facing the following situation:

(1) It has debt outstanding of par value $40 million which is due next year.

(2) Next year, its assets have the following prospects:

	Probability	Asset value ($ million)
Good scenario	0.5	100
Bad scenario	0.5	10

The 1-year risk-free interest rate is now at zero.

(a) Determine the payoff to debt and equity holders next year in the two scenarios. What is the current value of Value Tree's debt and equity?

(b) The firm now has a new project, which requires a new investment of $12 million and yields $30 million in the good state and -$10 million in the bad state next year. What is the NPV of this project?

(c) Will the equity holders take on this project? How much will the value of the firm (debt plus equity) change if Value Tree announces the project?

Answer 1

a.Pay-off to	Debt	Equity	Total
Good scenario	40	10	50	(100*0.5)
Bad scenario	5	0	5	(10*0.5)

Given that the 1-year risk-free interest rate is now at zero
we will assume next yr's values without discounting	Mlns.
Current value of debt=	40
Current value of Equity (total assets-debt)
((100*0.5)+(10*0.5))-40=	15
Total Value of firm	55

b. NPV of new investment= -12+((30*0.50)+(-10*0.5))=

-2

c. NO.

The equity holders will not take on this project, as its NPV is likely to be NEGATIVE

value of the firm (debt plus equity) will change (decrease ) by

$ 2 million

if Value Tree announces the project