The Managers of ABC have two possible projects to undertake now, Project P and Project Q Project P requires investment of 4 million now and will generate certain cash flow of £25 million one year. Project Q also requires investment of 4 milion now and will ate cash flows of ether £31 million (probability 50%) or C15 million (probability 50%) in one year. Ether Project P or Project Q can be chosen, but not both ABC has cash now of 4 million which can be used for the initial investment of wither Project Q or Project Q

ABC has no other project cash flows. The firm has debt of £20 million which je due for repayment in one year, Mon's managers wish to maximise the wealth of their shareholders

The discount rate zero and investors are risk neutral

(a) For each of the two projects, what will be the expected value of the firm's debt and equity if it is chosen? Which project will ABC's managers choose, and (6 marks)

(b) Suppose that ABC's managers can restructure its debt, by using its cash of 4 million to buy back E4 million of the debt now. After this is done, the firm can ask its shareholders for additional equity of £4 million for investment.

What are the expected payoffs of each project to the equity holders and to the debtholders after this strategy, and which project will ABC's managers choose? Will the shareholders agree to provide the additional equity finance? Explain why or why not (7 marks)

(c) Will ABC's managers choose the debt restructuring strategy in part (b)? Explain why or why not. (5 marks)

Answer rating: 100% (QA)

a To determine the expected value of the firms debt and equity for each project we need to calculate the present value of the cash flows generated by ... View the full answer