Assume that an entrepreneur in the Republic of Banana owns a firm with assets worth A...
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Assume that an entrepreneur in the Republic of Banana owns a firm with assets worth A and debt worth D. The entrepreneur is presented with an opportunity to invest in a project at cost I. The firm has enough internal resources to invest in the project A > I. This project can either succeed or fail, and pay, respectively, either CH or C, with probabilities p and 1 - p. Assume that C₁ > I and that the firm goes bankrupt if C₁ is realized such that 0≤ C₁ <D-A + I. Assume that before the investment decision the firm can either be solvent such that A > D, or insolvent such that A < D. Insolvent firms can decide whether to invest in the project before filing for bankruptcy. If the firm files for bankruptcy, debtholders take over the firm and appropriate all the firm's assets. The discount rate is zero. (a) [10 marks] Find the conditions under which the entrepreneur will like to invest in the project if A > D. Find the conditions under which the entrepreneur will like to invest in the project if A <D, and under the assumption that CH - I -D+A > 0. Hint: if a firm with A < D does not invest in the project it files for bankruptcy. (b) [10 marks] How does your answer to question (a) change if CH - I - D + A <0 and if A <D? Can the inequality CH-I-D+A < 0 hold if A > D? Explain. (c) [10 marks] Find the condition under which the manager will want to invest in the project under the new bankruptcy regime if A< D. Hint: Consider both the cases where CH - I -D+A> 0 and CH - I-D + A < 0. (d) [10 marks] Find the conditions under which there is underinvestment under the old bankruptcy procedure if A < D. Hint: underinvestment occurs when managers forgo positive NPV projects. (e) [10 marks] Based on your answers to the previous questions, does the bankruptcy regime alleviate the underinvestment that occurs under the old bankruptcy regime? Discuss. Assume that an entrepreneur in the Republic of Banana owns a firm with assets worth A and debt worth D. The entrepreneur is presented with an opportunity to invest in a project at cost I. The firm has enough internal resources to invest in the project A > I. This project can either succeed or fail, and pay, respectively, either CH or C, with probabilities p and 1 - p. Assume that C₁ > I and that the firm goes bankrupt if C₁ is realized such that 0≤ C₁ <D-A + I. Assume that before the investment decision the firm can either be solvent such that A > D, or insolvent such that A < D. Insolvent firms can decide whether to invest in the project before filing for bankruptcy. If the firm files for bankruptcy, debtholders take over the firm and appropriate all the firm's assets. The discount rate is zero. (a) [10 marks] Find the conditions under which the entrepreneur will like to invest in the project if A > D. Find the conditions under which the entrepreneur will like to invest in the project if A <D, and under the assumption that CH - I -D+A > 0. Hint: if a firm with A < D does not invest in the project it files for bankruptcy. (b) [10 marks] How does your answer to question (a) change if CH - I - D + A <0 and if A <D? Can the inequality CH-I-D+A < 0 hold if A > D? Explain. (c) [10 marks] Find the condition under which the manager will want to invest in the project under the new bankruptcy regime if A< D. Hint: Consider both the cases where CH - I -D+A> 0 and CH - I-D + A < 0. (d) [10 marks] Find the conditions under which there is underinvestment under the old bankruptcy procedure if A < D. Hint: underinvestment occurs when managers forgo positive NPV projects. (e) [10 marks] Based on your answers to the previous questions, does the bankruptcy regime alleviate the underinvestment that occurs under the old bankruptcy regime? Discuss.
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Related Book For
Income Tax Fundamentals 2013
ISBN: 9781285586618
31st Edition
Authors: Gerald E. Whittenburg, Martha Altus Buller, Steven L Gill
Posted Date:
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