Eli Mask has just graduated from college and is looking to become an entrepreneur. Eli has...

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Eli Mask has just graduated from college and is looking to become an entrepreneur. Eli has two start-up ideas that require the same investment of 60 at t=0. The first idea is an electric car company that will generate at t=2 a cash- flow of 100 with probability 0.7 or a cash-flow of 30 with probability 0.3. The second idea is a space travel company that will generate at t=2 a cash-flow of 150 with probability 0.3 or a cash-flow of 30 with probability 0.7. Eli has no money to invest in his ideas, and must raise the investment funds externally. The discount rate is 0, there are no taxes, Eli is risk neutral, and all potential investors are risk neutral too. a) [5 marks] Assume that Eli approaches a bank to raise the funds, and that the bank believes that Eli will invest in the electric car company. What is the face value of the debt? Calculate Eli's payoff. Will Eli invest in the electric car company? b) [12 marks] Assume that the bank continues to believe that Eli will invest in the electric car company. What is the maximum level of face value of debt compatible with Eli choosing to invest in the electric car company? With this face value of debt, how much additional financing would Eli require to make the investment? c) [8 marks] Comment on the following statement "Risk shifting may destroy value for the firm, but it generates value for shareholders". Assume that Eli raises at time 0 a mix of equity and debt and invests in the electric car company. The face value of the outstanding debt that will mature at time t-2 is 60. At time 1, Eli has the possibility to invest 12 in a new division of his firm that will focus on driverless cars. This division will generate a certain cash flow at time 2 of 15. Eli acts in the best interest of shareholders. d) [10 marks] Would Eli be able to finance the driverless car division by raising additional funds from his shareholders? Would Eli be able to finance the driverless car division by raising new junior debt? Explain. e) [15 marks] Assume that Eli decides to renegotiate the debt with its bank. Find the range for the values of debt for which equity holders would invest in the project. Comment on the difficulties for companies to renegotiate their debt in practice. Eli Mask has just graduated from college and is looking to become an entrepreneur. Eli has two start-up ideas that require the same investment of 60 at t=0. The first idea is an electric car company that will generate at t=2 a cash- flow of 100 with probability 0.7 or a cash-flow of 30 with probability 0.3. The second idea is a space travel company that will generate at t=2 a cash-flow of 150 with probability 0.3 or a cash-flow of 30 with probability 0.7. Eli has no money to invest in his ideas, and must raise the investment funds externally. The discount rate is 0, there are no taxes, Eli is risk neutral, and all potential investors are risk neutral too. a) [5 marks] Assume that Eli approaches a bank to raise the funds, and that the bank believes that Eli will invest in the electric car company. What is the face value of the debt? Calculate Eli's payoff. Will Eli invest in the electric car company? b) [12 marks] Assume that the bank continues to believe that Eli will invest in the electric car company. What is the maximum level of face value of debt compatible with Eli choosing to invest in the electric car company? With this face value of debt, how much additional financing would Eli require to make the investment? c) [8 marks] Comment on the following statement "Risk shifting may destroy value for the firm, but it generates value for shareholders". Assume that Eli raises at time 0 a mix of equity and debt and invests in the electric car company. The face value of the outstanding debt that will mature at time t-2 is 60. At time 1, Eli has the possibility to invest 12 in a new division of his firm that will focus on driverless cars. This division will generate a certain cash flow at time 2 of 15. Eli acts in the best interest of shareholders. d) [10 marks] Would Eli be able to finance the driverless car division by raising additional funds from his shareholders? Would Eli be able to finance the driverless car division by raising new junior debt? Explain. e) [15 marks] Assume that Eli decides to renegotiate the debt with its bank. Find the range for the values of debt for which equity holders would invest in the project. Comment on the difficulties for companies to renegotiate their debt in practice.

Answer rating: 100% (QA)

a To calculate the face value of the debt we need to determine the expected cash flows and probabilities for the electric car company Expected cash flow at t2 for the electric car company Cash flow of ... View the full answer