Firm X recently entered the Chinese market and the jury is still out as to whether this was a good, medium or bad strategy, three scenarios that remain equally likely. Today (year 0), the firm has assets the value of which next year (year 1) will be $100m if the strategy turns out to be good, $30m if it’s medium, and $5m if it’s bad. The firm has $35m in debt due in year 1. To simplify, use a 10% discount rate for all cash flows.

a. What is the value of firm X’s debt? What is the value of its equity?

In year 0, firm X has a project: Investing $15m would generate a safe cash-flow of $22m in year 1. Yet, the company lacks the cash to fund the investment.

b. What is the project’s net present value (NPV)?

c. Show that shareholders will not fund it if they have to inject $15m themselves. Explain.

Since the existing shareholders will not add more money into the company to fund the project, they are considering funding the $15m with different sources of outside finance.

d. Say firm X funded the project by issuing equity: What fraction of the equity would firm X need to issue? If firm X has 1 million shares, how many new shares would it need to issue? Would shareholders agree to this? Why?

e. Say firm X funded the project with new debt junior to the existing debt, i.e., the new debt gets paid only after the existing debt has been paid in full. What amount would firm X have to promise in year 1 to the new creditors to raise $15m from them? Would shareholders agree to this? Why?

f. Say firm X funded the project with new debt senior to the existing debt, i.e., the existing debt would be junior to the new debt. What amount would firm X have to promise in year 1 to the new creditors to raise $15m from them? Would shareholders agree to this? Why?

Assume that the existing debt has covenants barring firm X from issuing new senior debt without all creditors consent. The shareholders and creditors must therefore negotiate.

g. Say a negotiator tables the following deal: firm X issues new equity to fund the project, and creditors write down 10% of face value to $31.5m, i.e., face value reduced by 10%35=$3.5m. Will shareholders agree if the only alternative is the status quo? Will creditors agree? Explain.

h. Say a negotiator tables the following deal: firm X issues new equity to fund the project, and creditors write down 20% of face value to $28m, i.e., face value reduced by 20%35=$7m. Will shareholders agree if the only alternative is the status quo? Will creditors agree? Explain.

i. Say a negotiator tables the following deal: The firm issues new equity to fund the project and creditors swap their debt against 30% of the equity. Will shareholders agree? Will creditors agree? Explain.

j. Say a negotiator tables the following deal: The firm issues new equity to fund the project and creditors swap their debt against 40% of the equity. Will shareholders agree? Will creditors agree? Explain.

Answer rating: 100% (QA)

a In this question you are asked to value both equity and debt You need to identify the firm s key value drivers and build a model to project the firm s cash flows The discount rate is given The first ... View the full answer