If it is managed efficiently, Remel Inc. will have assets with a market value of $50 million, $100 million, or $150 million next year, with each outcome being equally likely. However, managers may engage in wasteful empire building, which will reduce the firm’s market value by $5 million in all cases. Managers may also increase the risk of the firm, changing the probability of each outcome to 50%, 10%, and 40%, respectively.
a. What is the expected value of Remel’s assets if it is run efficiently?
Suppose managers will engage in empire building unless that behavior increases the likelihood of bankruptcy. They will choose the risk of the firm to maximize the expected payoff to equity holders.
b. Suppose Remel has debt due in one year as shown below. For each case, indicate whether managers will engage in empire building, and whether they will increase risk. What is the expected value of Remel’s assets in each case?
i. $44 million
ii. $49 million
iii. $90 million
iv. $99 million
c. Suppose the tax savings from the debt, after including investor taxes, is equal to 10% of the expected payoff of the debt. The proceeds from the debt, as well as the value of any tax savings, will be paid out to shareholders immediately as a dividend when the debt is issued. Which debt level in part (b) is optimal for Remel?