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? Explain your answers.

Answer 1

a. Payoff of Debt:

Good Scenario = $40 M

Bad Scenario = $10 M

Payoff of Equity:

Good Scenario = $100 - Payoff to debt = 100 - 40 = $60 M

Bad Scenario = $0

Current Value of Debt = 40 * 0.5 + 10 * 0.5 = $25 M

Current Value of Equity = 60 * 0.5 + 0 * 0.5 = $30 M

b. NPV of project = Expected Cash Inflow - Investment

NPV of project = 30 * 0.5 - 10 * 0.5 - 12

NPV of project = - $2 M

c. Th equity share holders will not take the project as it will result in negative NPV. the Value of Firm will decrease by $2 Million as the project will result in negative NPV if the company announces the project.