Mr I. M. A. Star is the sole equity holder and manager of Stellar Company (SC)....

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Mr I. M. A. Star is the sole equity holder and manager of Stellar Company (SC). Today (t = 0) SC has assets in place that will generate a final cash flow of either £100 million or £0 in one year's time (at t = 1) with equal probability. There are no other cash flows from existing assets. Mr Star has very recently won the lottery and has a lot of money in the bank (tens of millions) and is thus planning to close down SC in a year's time after these cash flows are obtained. There are no other cash flows, no taxes of any kind, and the discount rate for all cash flows is 0. SC has pre-existing debt on its balance sheet (a discount bond) which matures at t = 1 with a face value of £12 million. Assume that at t = 0 it is not possible to renegotiate SC's debt in any way and any new debt issued must be junior to existing debt. At t = 0, SC has access to a new riskless project (Project 1) that costs £10 million to implement today and pays £15 million at t = 1. Clearly, having won the lottery, Mr Star has the personal resources to invest in this project if it is in his personal interest to do so. (a) (6 marks) Would Mr Star choose to contribute £10 million of his own resources to finance Project 1? Would his willingness to contribute have been different if (counterfactually) SC had no debt on its balance sheet? Show your work and explain your reasoning. (b) (5 marks) Suppose that SC instead had access to a different riskless project: Project 2. Project 2 also costs £10 million to implement at t = 0 but pays a higher amount of £18 million at t = 1. Given the debt on SC's balance sheet, would Mr Star be willing to finance Project 2 from his own resources? Show your work and interpret your finding in the context of part (a). (c) (6 marks) Suppose, counterfactually, that SC owed £18 million to its creditors at t = 1 (instead of £12 million). Would Mr Star's willingness to finance Project 1 or Project 2 differ from parts (a) and (b)? Show your work and interpret your findings. (d) (8 marks) While times are now rosy for Mr Star, they were not always so. Indeed, SC's current debt of £12 million was taken on a year ago (at t = -1) when SC was in dire straits and needed to raise as much liquidity as it could by borrowing. At t = -1, Mr Star and SC's potential creditors all knew that SC would have t = 1 cash flows (as described above) in two years. They also knew that SC would have access at t = 0 to either Project 1 or Project 2 (each as described above), but did not know which project would become available: At t = -1, everybody believed that at t = 0 SC would have access to Project 1 with probability p and to Project 2 with probability 1 - p. SC had two options for borrowing at t = -1: To sell a two-year discount bond with a face value of £12 million or to sell a two-year discount bond with a face value of £18 million. Under the guidance of Mr Star, SC chose to take on debt with a face value of only £12 million, despite its dire need for cash. Following his lottery win, Mr Star recently gave an interview to his university alumni magazine. Interestingly, when asked during this interview why he chose the lower level of debt at t = -1 (amongst the two choices available to him), Mr Star said mysteriously: "Upon reflection, I realized that issuing higher face value debt would raise less money." Can you shed light upon Mr Star's puzzling comment? What does Mr Star's choice say about the relative probabilities assigned by Mr Star and SC's creditors at t = -1 about the prospects of SC having access Project 1 vs Project 2 at t = 0? What general lessons can be learned from this specific example? Discuss. Mr I. M. A. Star is the sole equity holder and manager of Stellar Company (SC). Today (t = 0) SC has assets in place that will generate a final cash flow of either £100 million or £0 in one year's time (at t = 1) with equal probability. There are no other cash flows from existing assets. Mr Star has very recently won the lottery and has a lot of money in the bank (tens of millions) and is thus planning to close down SC in a year's time after these cash flows are obtained. There are no other cash flows, no taxes of any kind, and the discount rate for all cash flows is 0. SC has pre-existing debt on its balance sheet (a discount bond) which matures at t = 1 with a face value of £12 million. Assume that at t = 0 it is not possible to renegotiate SC's debt in any way and any new debt issued must be junior to existing debt. At t = 0, SC has access to a new riskless project (Project 1) that costs £10 million to implement today and pays £15 million at t = 1. Clearly, having won the lottery, Mr Star has the personal resources to invest in this project if it is in his personal interest to do so. (a) (6 marks) Would Mr Star choose to contribute £10 million of his own resources to finance Project 1? Would his willingness to contribute have been different if (counterfactually) SC had no debt on its balance sheet? Show your work and explain your reasoning. (b) (5 marks) Suppose that SC instead had access to a different riskless project: Project 2. Project 2 also costs £10 million to implement at t = 0 but pays a higher amount of £18 million at t = 1. Given the debt on SC's balance sheet, would Mr Star be willing to finance Project 2 from his own resources? Show your work and interpret your finding in the context of part (a). (c) (6 marks) Suppose, counterfactually, that SC owed £18 million to its creditors at t = 1 (instead of £12 million). Would Mr Star's willingness to finance Project 1 or Project 2 differ from parts (a) and (b)? Show your work and interpret your findings. (d) (8 marks) While times are now rosy for Mr Star, they were not always so. Indeed, SC's current debt of £12 million was taken on a year ago (at t = -1) when SC was in dire straits and needed to raise as much liquidity as it could by borrowing. At t = -1, Mr Star and SC's potential creditors all knew that SC would have t = 1 cash flows (as described above) in two years. They also knew that SC would have access at t = 0 to either Project 1 or Project 2 (each as described above), but did not know which project would become available: At t = -1, everybody believed that at t = 0 SC would have access to Project 1 with probability p and to Project 2 with probability 1 - p. SC had two options for borrowing at t = -1: To sell a two-year discount bond with a face value of £12 million or to sell a two-year discount bond with a face value of £18 million. Under the guidance of Mr Star, SC chose to take on debt with a face value of only £12 million, despite its dire need for cash. Following his lottery win, Mr Star recently gave an interview to his university alumni magazine. Interestingly, when asked during this interview why he chose the lower level of debt at t = -1 (amongst the two choices available to him), Mr Star said mysteriously: "Upon reflection, I realized that issuing higher face value debt would raise less money." Can you shed light upon Mr Star's puzzling comment? What does Mr Star's choice say about the relative probabilities assigned by Mr Star and SC's creditors at t = -1 about the prospects of SC having access Project 1 vs Project 2 at t = 0? What general lessons can be learned from this specific example? Discuss.

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a To determine whether Mr Star would choose to contribute 10 million of his own resources to finance Project 1 we need to compare the present value of ... View the full answer