The firm Domino has perpetual bonds with £33 million payable in one year. It also has a loan of £4.75 million from its bank, payable in one year, which is subordinated to the perpetual bonds. Domino expects cash flows of £28 million in one year from its existing operations. It has a single project it can choose to undertake now that will require a capital investment now of £5.5 million and will generate a positive cash flow in one year of £19.5 million  (probability 50%) or a negative cash flow of £11 million (probability 50%).  The discount rate is zero, and there are no taxes or bankruptcy costs. Assume risk neutrality.

(a) What is the net present value of the project? (2 marks)

(b) If Domino asks its shareholders for additional equity of £5.5 million to fund the project, what is the expected payoff to the equity holders? Will they agree to the share offer? (5 marks)

(c) If it does not undertake the project, Domino can liquidate for a value of £34  million. What would be the payoffs to the bondholders, bank, and equity holders? (3 marks)

(d) Suppose Domino asks its bank for an additional £5.5 million loan now to fund the project. Assume that if Domino does not obtain this additional loan, it will liquidate now for a certain £34 million.

(i) What expected payment would the bank need to receive in one year? (3 marks)

 (ii) What must the face value of this new debt be? (3 marks)

 (iii) What are the expected payoffs to the bondholders, the bank, and the equity holders? Will the managers of Domino accept the project, assuming that their incentives are in line with those of the equity holders? (4 marks)

(e) Discuss the agency problem illustrated in this case, with reference to your answers to parts (a) to (d) of the question. 

Answer rating: 100% (QA)

a The net present value of the project is given by the expected cash flows in one year discounted at the rate of zero which is Expected cash flow 05 x ... View the full answer