Question

Data for questions 56, 57 and 58 Assuming it maintains its current strategy, a firm will be worth $910,000 one year from now. The firm owes $1,010,000 in debt that is due one year from now. The firm could undertake a new strategy that requires no upfront investment but will only have a 50% chance of success. If the new strategy is successful, the value of the firm one year from now will be $1,300,000 but if it fails the value of the firm’s assets will fall to only $300,000 one year from now.

Question 56 What is the expected value of the firm one year from now if it undertakes the new strategy?

a) $800,000 b) $1,300,000 c) $700,000 d) $700,000 e) $910,000

Question 57 If the firm undertakes the new strategy, what is the expected cost of such decision to the existing debtholders? a) $210,000 b) $90,000 c) $330,000 d) $110,000 e) $700,000

Question 58 Would shareholders be in favour of this?

a) Yes, it would increase the value of the firm. b) No, it would only strengthen the debtholder’s claim. c) Both they and debtholders would be indifferent as the company will go insolvent anyway. d) They would be in favour of it because if successful shareholders will benefit. e) None of the above.

Show work/explanations for all 3 parts! thanks you

Answer 1

56) Statement showing expected value of the firm

Particulars	Probability	Value of asset	Probability x value of asset
Success	50%	1300000	650000
Faliure	50%	300000	150000
Expected value of the firm	800000

Thus Expected value of firm = $800,000

Ans a)  $800,000

57) Expected loss to the bond holder = Value of asset after one year - Expected value of the asset

=$910,000 -$800,000

=$110,000

Thus ans d) $110,000

58) Ans d) They would be in favour of it because if sucessful shareholders will benefit

If project is sucessfull than value of asset will be $1300,000 which is more than actual claim of bond holders i.e  $1,010,000, thus even after repaying their full claim, equity share holders will be benifitted