X Corp. needs to spend $4.8 million in year 0 to develop a new car. The demand for the car is uncertain in year 0: the demand for the car will be either high (probability 60%) or low (probability 40%). In year 1, however, X will learn whether the demand for the car is high or low. To continue the project, X must decide whether to spend an additional $4 million in year 1. If X decides to continue the project, the car will produce in year 2 a cash flow of $20 million if demand is high, and $7 million if demand is low. If X does not make the investment in year 1, there will be no cash flows in year 2.

a) Assume that X intends to finance the original (year 0) outlay of $4.8 million with senior debt held by a diffuse group of bondholders. Will X be able to finance the initial (year 0) investment in the project? If so, find the face value of the debt that X must issue at year 0 to obtain the $4.8 million, and the year-0 expected payoff of the project for X's equity holders.

b) Assume now that the bond issued in year 0, although still senior, is issued to a single bank. Suppose that, while the bank cannot finance the year 1 investment, it can reduce the face value of the year 0 bond in year 1. In which conditions would the bank be willing to reduce the bond’s face value, and by how much would it choose to reduce the face value? Will X be able to finance the initial (year 0) investment in the project? If so, find the original face value of the debt that X must issue at year 0 to obtain the $4.8 million and the year-0 expected payoff of the project for X’s equity holders.

Answer rating: 100% (QA)

a If X intends to finance the original year 0 outlay of 48 million with senior ... View the full answer