Question

G.W. Zoo Inc.’s only asset is a plot of vacant land, and its only liability is debt of $5 million due in one year. If left vacant, the land will be worth $3 million in one year. Alternatively, the firm can acquire 30 tigers and 20 lions at an upfront total cost of $10 million. The land with exotic animals will be worth $15 million in one year. Suppose the risk-free interest rate is 10%, assume all cash flows are risk-free, and assume there are no taxes.

a) If G.W. Zoo chooses not to acquire the tigers and lions, what is the value of the G.W. Zoo's equity today? What is the value of the debt today?

b) What is the NPV of acquiring the exotic animals?

c) Suppose the firm raises $10 million from equity holders to acquire the exotic animals. In that case, what is the value of the firm's equity today? What is the value of the firm's debt today?

d) Given your answer to part (c), would equity holders be willing to provide the $10 million needed to acquire the tigers and lions?

e) briefly explain the concept of “asset substitution”.?

Answer 1

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Question (a)

Value of Equity would be equal to the owner's stake in the firm

Current Value = 3/(1+10%)^1

= $2.73 Million

Value of Debt

= 5/(1+10%)^1

= $4.55 Million

Question (b)

NPV = [15/(1+10%)^1]-10

= 13.64-10

= $3.64 Million

Question (c)

Equity = 10+2.73

= $ 12.73 Million

Debt = $4.55 Million

Question (d)

Yes. Since the investment would be profitable based on the NPV calculated above as $3.64 Million

Question (e)

Asset substitution is an investment strategy that business managers take by investing in a riskier project than the company's debt holders expected in an attempt to maximize shareholder's wealth.