Consider One Year Left (OYL) Corporation. OYL will be closed down in one year from today...

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Consider One Year Left (OYL) Corporation. OYL will be closed down in one year from today after all available cash flows from its assets have been distributed to creditors and shareholders. OYL's managers, who act in the interest of OYL's shareholders, have a strategic choice in how to run operations in this final year. They could either choose a risky strategy (R) that results in end-of-year cash flows of either £800 million or £0 million with equal probability. Or they could choose a safe strategy (S) that results in end-of- year cash flows of either £600 million or £400 million with equal probability. There is no cost for implementing either strategy. No other cash flows arise during the course of the year. OYL has a single liability on its balance sheet: Some pre-existing debt (a discount bond) which matures in one year from today with a total amount payable to creditors of £F million. The bond has a covenant associated with it, but does not give bondholders any control over OYL's operational strategy or payout policy in the final year. The appropriate discount rate for all cash flows in this problem is 0. (b) (2 marks) Compute the Net Present Values of strategies S and R. (c) (3 marks) Suppose F = 100. Which strategy will OYL's managers adopt? Would OYL's creditors have made the same choice had they been able to select the strategy? If not, explain the source of disagreement. (d) (5 marks) Suppose F = 300. Which strategy will OYL's managers adopt? Would OYL's creditors have made the same choice had they been able to select the strategy? If not, explain the source of disagreement. (e) (10 marks) Now maintain the assumption that F = 300. Suppose that, right at the beginning of its final year before any strategy choice has been made, OYL's managers discover that some of their assets are redundant, i.e., they can sell these assets immediately and leave the end-of-year cash flows associated with each strategy completely unchanged. Before deciding on strategy, they immediately sell the redundant assets, generating an excess cash amount of £ C million where 0 <C<200. Managers now have two choices: They can either pay out this excess cash to shareholders immediately via a special dividend or they can retain it inside the firm to be divided amongst claimants-bondholders and shareholders - according to their respective seniority, at the end of the year. The choice of strategy is made after the choice of whether to retain or pay out the excess cash. Before managers decide what to do with OYL's excess cash, the OYL's bondholders have the option of employing top lawyers to immediately enhance their bond covenant to prevent the paying out of this excess cash to shareholders (and instead having it retained inside the firm until the end of the year). However, such speedy and complex legal work comes at a steep price (because it requires the law firm to stop work on all other cases) and thus bondholders would have to pay an eye-watering £ 55 million in legal fees for this service. Compute the minimum value of C for which bondholders would be willing to pay this legal fee to enhance their covenant. Explain your answer carefully. Consider One Year Left (OYL) Corporation. OYL will be closed down in one year from today after all available cash flows from its assets have been distributed to creditors and shareholders. OYL's managers, who act in the interest of OYL's shareholders, have a strategic choice in how to run operations in this final year. They could either choose a risky strategy (R) that results in end-of-year cash flows of either £800 million or £0 million with equal probability. Or they could choose a safe strategy (S) that results in end-of- year cash flows of either £600 million or £400 million with equal probability. There is no cost for implementing either strategy. No other cash flows arise during the course of the year. OYL has a single liability on its balance sheet: Some pre-existing debt (a discount bond) which matures in one year from today with a total amount payable to creditors of £F million. The bond has a covenant associated with it, but does not give bondholders any control over OYL's operational strategy or payout policy in the final year. The appropriate discount rate for all cash flows in this problem is 0. (b) (2 marks) Compute the Net Present Values of strategies S and R. (c) (3 marks) Suppose F = 100. Which strategy will OYL's managers adopt? Would OYL's creditors have made the same choice had they been able to select the strategy? If not, explain the source of disagreement. (d) (5 marks) Suppose F = 300. Which strategy will OYL's managers adopt? Would OYL's creditors have made the same choice had they been able to select the strategy? If not, explain the source of disagreement. (e) (10 marks) Now maintain the assumption that F = 300. Suppose that, right at the beginning of its final year before any strategy choice has been made, OYL's managers discover that some of their assets are redundant, i.e., they can sell these assets immediately and leave the end-of-year cash flows associated with each strategy completely unchanged. Before deciding on strategy, they immediately sell the redundant assets, generating an excess cash amount of £ C million where 0 <C<200. Managers now have two choices: They can either pay out this excess cash to shareholders immediately via a special dividend or they can retain it inside the firm to be divided amongst claimants-bondholders and shareholders - according to their respective seniority, at the end of the year. The choice of strategy is made after the choice of whether to retain or pay out the excess cash. Before managers decide what to do with OYL's excess cash, the OYL's bondholders have the option of employing top lawyers to immediately enhance their bond covenant to prevent the paying out of this excess cash to shareholders (and instead having it retained inside the firm until the end of the year). However, such speedy and complex legal work comes at a steep price (because it requires the law firm to stop work on all other cases) and thus bondholders would have to pay an eye-watering £ 55 million in legal fees for this service. Compute the minimum value of C for which bondholders would be willing to pay this legal fee to enhance their covenant. Explain your answer carefully.

Answer rating: 100% (QA)

b The Net Present Value NPV of strategy S can be computed as follows NPVS 05 600 million 1 0 05 400 million 1 0 500 million The NPV of strategy R can ... View the full answer