A firm has a senior bond obligation of $20 due this period and $100 due next per

Question

A firm has a senior bond obligation of $20 due this period and $100 due next period. It also has a subordinated loan of $40 owed to Jack and Jill and due next period. It has no projects that provide cash flows this period. Therefore, if the firm cannot get a new loan for $20, it must liquidate. The firm has a current liquidation value of $120. If the firm does not liquidate, it can take on one of two projects with no additional investment funding needed. If it takes project A, the project will generate a cash flow of $135 next year for sure. If it takes project B, the project will generate a cash flow next year of $161 or $69 with equal probability. Assume risk-neutrality, a zero interest rate, no direct bankruptcy costs, and no taxes.

(a) If the firm were entirely equity financed, would it decide to liquidate, adopt project A, or adopt project B?

(b) The firm has approached Jack and Jill and asked them for a $20 (subordinated) loan. The $20 loan proceeds will be used to pay off the $20 of senior debt that is currently due. The firm promises to pay Jack and Jill back $20.5 next period on this new loan plus the $40 on the original loan. If Jack and Jill agree to the loan, which project will be taken by the firm? Should Jack and Jill agree to the loan? Justify your answer with the relevant calculations.

Explanation / Answer

a. Compare present value of liquidation with present value of projects.

The present value of liquidation is $120.

The present value of project A is $135. This is because, the interest rate is zero.

The present value of project B is $115.5. This is because, the interest rate is zero and the probability of both cash flows is equal.

The present value of project A is the highest so the project A should be accepted.

b. The project A has the highest present value so the project A should be accepted. The J&J should provide the loan because the firm will have enough cash inflow of $135 to pay of the $60.50 subordinate debt. The firm will have with $74.50 after paying J&J’s debt. Also by liquidating its assets for $120 will be able to pay senior bond obligation of $100, and after payment of senior bond obligation the firm will have a total of $94.50 surplus cash.

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