Air VnV Incorporated has assets in place that will generate the following state-dependent cash flows in one

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Question:

Air VnV Incorporated has assets in place that will generate the following state-dependent cash flows in one year: $130 million if the economy is good and $40 million if the economy is bad. Each state of the economy is equally likely. The company has a debt with a face value of $65 million due in one year. All agents are risk-neutral, the discount rate is zero and there are no taxes. The firm is run by a manager who acts in the interest of the equity holders.

a) Find the value of the firm, the value of equity, and the value of debt.

Now assume that the firm has an investment project that requires an investment of $20 million today and creates a cash flow of $25 million for sure in one year.

b) Would you advise the equity holders to finance the project with their own money? What is the value of debt if the project is undertaken? Discuss your answer.

c) The manager of AirVnV is considering to renegotiate the company’s debt. Find the range for the values of debt for which the company’s equity holders would be willing to invest in the project. Explain and discuss your results.

d) Discuss the difficulties that a company may face in renegotiating its debt in practice.