B3. (Asset substitution) Mich igan Mining and Manufacturing has a debt obligatio

Question

B3. (Asset substitution) Mich igan Mining and Manufacturing has a debt obligation Wh S0. Prior MMM is consid en this happens, the value of the d with a value of $90 million. This debt must be doffvs o paying off the debt, MMM has an opportunity to make a high-risk invest investment of $20 million (from existing assets) that will e value of the debt will be $90 million and the value of q S40 million or zero. The of equity will ering an million (NPV = the value of the payoff minus the investment paid for with the firm's liquid cash holdings. e investment would have an NPV of either $20 million o wou a. Ifthe $4 0 million payoff (NPV = $20 million) occurs, what is the value of equity? ). The investment wonl is the value of debt? b. If the zero payoff (NPV= value of debt? $20 million) occurs, what is the value of equity? What ithe c. Assume the probability of the h is 0.75. the firm? at is the expected NPV of the investment? What is the expected value df igh payoff is 0.25 and the probability of the low pay at is the expected value of equ1

Explanation / Answer

a)

New asset value = 90 + 20 = 110

Value of equity = max(0,asset value – debt)

Value of equity = max(0,110 – 100) = 10 million

Debt value = 100 million

b)

New asset value = 90 - 20 = 70

Value of equity = max(0,asset value – debt)

Value of equity = max(0,70 – 100) = 0 million

Debt value = min (debt obligation, asset value)

Debt value = min(100,70) = 70 million

c)

Expected value of NPV = (0.25*20)+(0.75*-20) = - 10 million

Firm value = 90 – 10 = 80 million

d)

Expected value of equity = (0.25*10)+(0.75*0) = 2.5 million

Expected value of debt = Expected firm value – Expected equity

Expected value of debt = 80 – 2.5 = 77.5 million

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