(Answer Parts c,d,e please)

Consider Company X, which has a life of one period. The companys existing assets will produce cash flows of either 400 or 200 at the end of the period with equal probability. The firm currently has zero-coupon debt outstanding with a face value of 300 due at the end of the period. This debt contains a covenant that prohibits the rm from issuing any additional debt without the approval of the existing creditors. There are no taxes or direct costs of financial distress, all investors are risk-neutral, and the discount rate is zero. The managers of the firm always act in the interests of existing shareholders.

When answering each question, state any additional assumptions you may need to make. Show all working/calculations.

(a) Determine the market values of the rm, its debt, and its equity.

Now assume the rm has two possible additional mutually exclusive investment projects in the pipeline, A and B, each requiring additional financing of 60. Project A will increase Company Xs

end-of-period cash flows by 80 with certainty, whereas Project B, will increase cash flows by 100 in the good state and decrease cash flows by 100 in the bad state.

(b) Which project would the managers/shareholders prefer if they had the money? Will shareholders be willing to provide the 60 required for the investment? Explain.

(c) Suppose that the managers ask the companys existing debtholders to waive the covenant so that the company can choose to issue senior debt to nance the investment. These new senior debtholders would be paid before the existing creditors in the event of default. Assume that the company only has Project A available, and debtholders know this. Will the firm be able to raise this new senior debt if the covenant is waived? Will existing debtholders agree to waive the covenant? Will the managers decide to pursue the investment? Demonstrate and explain.

(d) Repeat part (c), except this time assume that the rms existing creditors believe that there is a 50% chance that the managers also have Project B available. Creditors cannot control project selection after financing is obtained.

(e) Making specific reference to your answers in parts (b), (c), and (d), comment on the incentive problems of debt identified in your calculations, and the role played by senior debt financing as a potential remedy to these problems.