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All investors are risk-neutral, the discount rate is zero, and there are no taxes

Finance

All investors are risk-neutral, the discount rate is zero, and there are no taxes. Next period cash flows will be either 200 or 100 with equal probability. The firm has debt outstanding with a face value of 150, which is due next period. Also, managers make all investment decisions in the interest of equity holders. (a) What is the value of the firm? What is the value of the firm's equity? What is the value of the firm's debt? Now assume that the firm has two possible investment projects (Projects A and B). Each individual project requires additional financing of 30. If the firm invests in Project A, the cash flows next period will increase by 40 for sure. In other words, if the firm invests in Project A, cash flows will be either 240 or 140 with equal probability. If the firm invests in Project B, cash flows increase by 50 in the high state and decrease by 50 in the low state. In other words, if the firm invests in the project, cash flows will be either 250 or 50 with equal probability. (b) Assume that there are covenants prohibiting the issue of additional debt. Which project would the manager choose if she had the money? Will shareholders be willing to put in the 30 for the investment? (c) The manager asks the debt holders to waive the covenant, so that the company could issue senior debt. Assume that the manager only has the safe project available, and that the debt holders know this. Would the company be able to raise new senior debt of 30 to finance this project? Will the existing debt holders agree to waive the seniority covenant? Assume that the new senior debt will be paid off before the existing debt in case of default. (d) Assume again that manager asks the debt holders to waive the covenant, so that the company could issue senior debt, but that debt holders now believe that there is a 50% chance that the manager also has the risky project available. Would the company be able to raise new senior debt to finance the project if existing debt holders waived the covenant? Will the existing debt holders be willing to waive the seniority covenant?

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