Company X is currently all-equity financed and has no cash on hand. The company has assets in place and a single investment project available. The value of the assets in place depends on whether a recent cost-cutting initiative at the company was successful or not. Assets in place are worth $16M if the initiative was successful and $12M if it was unsuccessful. The CEO of the company knows whether the cost-cutting initiative was successful or not, but investors in the market do not. Investors believe that there is a 50% chance that it was successful and a 50% chance that it was unsuccessful. The project available to the company requires investing $8M today and will generate future cash flows with a present value of $12M (so the NPV of the project is $4M). The market is aware of the existence of the project as well as its cost and payoff. 4a) (7 points) Suppose that you, as a CEO, care only about maximizing the value of current shareholders' claims. You have the following choices: i) Issue debt to raise $8M and invest in the project. If the company issues debt, it will incur $8M of financial distress costs, even if the company does not actually default. ii) Issue equity to raise $8M and invest in the project. iii) Turn down the investment. If you were the CEO of Company X, which one of these three options would you choose if you knew that the cost-cutting initiative was successful, and why? Which one of these options would you choose if you knew the cost-cutting initiative was unsuccessful, and why? Hint: Notice that the project generates substantial value and that the financial distress costs are high. Because of these factors, it is reasonable for investors to expect that the company would invest in the project and finance the project by issuing equity whether its cost-cutting initiative was successful or not (rather than passing up the project or issuing debt, which will generate substantial financial distress costs). The market would then price an equity issue based on a 50% chance that the cost-cutting initiative was successful and a 50% chance that it was unsuccessful. 4b) (7 points) Suppose that everything is exactly as in part (a), except that the distress costs are $80,000 instead of $8M. If you were the CEO of Company X, which one of the three options would you choose if you knew that the cost-cutting initiative was successful, and why? Which one would you choose if you knew the cost-cutting initiative was unsuccessful, and why? Hint: Note that the project continues to generate substantial value but that financial distress costs are small. Because of these factors and the fact that a company with a successful cost-cutting initiative will face equity underpricing, it is reasonable for investors to expect the company would invest in the project and finance the investment with equity if its cost-cutting initiative was unsuccessful but with debt if its cost-cutting initiative was successful. Hence, the market will price equity issues as coming from a company that had an unsuccessful cost-cutting initiative. 4c) (6 points) Suppose the company has 1M shares outstanding. Compute the change in the price of the shares if the company issues equity in the scenarios described in parts (a) and (b) and explain the difference. Hint: The company's value today should reflect its expected value, which is the average of the value of the company if its cost-cutting was successful and the value if its cost-cutting was unsuccessful, account for its optimal financing choices in each case. You have already computed these values in parts (a) and (b).

Answer rating: 100% (QA)

4a If the CEO of Company X knows that the costcutting initiative was successful the optimal choice would be to issue equity to raise 8M and invest in the project This choice maximizes the value of cur... View the full answer