For next year, there is a 60 percent chance the economy will do well and Importe
ID: 2764748 • Letter: F
Question
For next year, there is a 60 percent chance the economy will do well and Importers Unlimited will have a firm value of $321,000. If the economy tanks, the firm's value will decline to $241,000. The firm owes its bondholders $250,000. What is the value of this firm to its shareholders?
a. no, because the project will lower the firm by $500
b. no, because the project will lower shareholder value by $500
c. no, because the firm will be worth less in a recession than it is currently
d. yes, because the project will increase both firm and shareholder value by $1,000
e. yes, because shareholder value will increase $1,000 at a cost of $1,500 to the bondholders
For next year, there is a 60 percent chance the economy will do well and Importers Unlimited will have a firm value of $321,000. If the economy tanks, the firm's value will decline to $241,000. The firm owes its bondholders $250,000. What is the value of this firm to its shareholders?
a. no, because the project will lower the firm by $500
b. no, because the project will lower shareholder value by $500
c. no, because the firm will be worth less in a recession than it is currently
d. yes, because the project will increase both firm and shareholder value by $1,000
e. yes, because shareholder value will increase $1,000 at a cost of $1,500 to the bondholders
Explanation / Answer
Solution:
The total value of a firm’s equity is the discounted expected cash flow to the firm’s stockholders. Since the company owes its bondholders $250,000 at the end of the year, its stockholders will receive $321000-250000= $71000 if the expansion continues. If there is a recession, its stockholders will not receive any amount becuase the vlaue of firm is lesser than the value of the debt. So, assuming a discount rate of 14 percent, the market value of company's equity will be :
= [.60($71000) + .40($0)] / 1.14 = $37368
The bondholders will receive $250,000 whether there is a recession or a continuation of the expansion. So, the market value of company's debt is:
= [.60($250,000) + .40($250,000)] / 1.14 = $219298
Hence the total value of the firm will be = $256667
Hence the option e is the right option that the shareholder value will increase 1000 at the cost of 1500 to the bond holders.
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