Question

. A firm has debt with a face value of $100. Its projects will pay a safe $80 tomorrow. Managers care only about shareholders. A new quickie project comes along that costs $30, earns either $0 or $70 with equal probabilities, and does so by tomorrow. Assume that the time value of money is 0

     1. Is this a positive-NPV project?

    2. If the new project can only be financed with a new equity issue, would the shareholders vote for this? Would the creditors?

     3. Assume the existing bond contract was written in a way that allows the new projects to be financed with first collateral (superseniority with respect to the existing creditors). New creditors can collect $30 from what the existing projects will surely pay. Would the existing creditors be better off? 4. What is the better arrangement from a firm-value perspective if the old bondholders have veto power

Answer 1

1)
The payoff = (0.50*0)+(0.50*70)=$35
NPV=$35-$30=$5
hence this isa positive NPV project

2)The shareholders would vote for the project since this si a positive NPV project. However the bond holders would not prefere because it can result in their earnings being wiped out completely

3) IF the new creditors can collect $30, they would be better off but at the expense of old creditors. Existing creditors shall be worse off as they have been subordinated and they cannot receive much cash flow.

4) If old creditors had veto they shall look for their interest and the firm value may decrease as the firm would not be allowed to take much risk. Henc eit is not a better arrangement.