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.

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?

Answer 1

b). Good state cash flow = expected cash flow + cash flow from new project = 90 + 47 = 137 million.

Firm's cash flow after paying original debtholders = 137 -65 = 72 million

Bad state cash flow = 40 + 32 = 72 million

Firm's cash flow after paying original debtholders = 72 - 65 = 7 million

In the good state of economy, Lando must promise full repayment of 30 million to the new debtholders.

c). Expected equity value in Good state = cash flow - new debtholders = 72 - 30 = 42 million.

Expected equity value in Bad state = 7 - 30 = 0 (since the entire remaining cash flow of 7 million will go to the new debtholders)

Expected value of equity = (0.5*42) + (0.5*0) = 21 million (as both states of the economy are equally likely)

The managers will accept the project as payoff to equity is positive.