Zed Corp is a start-up company where managerial compensation is linked to the value of the firms
Question:
Zed Corp is a start-up company where managerial compensation is linked to the value of the firm’s stock. The company has only two investment opportunities, A and B, and must choose between them. In the case of investment opportunity A, an already established technology would be used, and the project would generate next year $122 million with certainty. Project B, however, relies on a brand new untested technology, and as such has only a limited probability of success. A research team at Zed Corp forecasts that project B will succeed with probability 1/3. If successful, the project will generate free cash flows over the next year of $180 million. If it fails, free cash flows will only be $90 million. Both project A and project B cost $100 million, that the company wants to raise through debt financing. Assume that everyone in the economy is risk neutral and the risk-free rate is zero.
a) What is the NPV of each project? Could Zed Corp obtain $100 million in debt financing by issuing a zero coupon bond with face value equal to $100 million? Which project would the firm management undertake, if it could issue such a bond?
b) What interest should Zed Corp promise to pay at the end of the year in order to raise $100 million from lenders? How does the default premium relate to managerial incentives to focus on equity value maximization? Explain.
c) Assume now that the firm’s management is credibly committed to maximize firm value, rather than equity value. What bond would the firm issue to raise the $100 million it needs? Would equity value in this case be larger or smaller than in the case where management focuses on equity value maximization?
Introduction To Statistical Investigations
ISBN: 9781118172148
1st Edition
Authors: Beth L.Chance, George W.Cobb, Allan J.Rossman Nathan Tintle, Todd Swanson Soma Roy