Ray Company has $70 million in debt and $30 million in equity. The debt natures

Question

Ray Company has $70 million in debt and $30 million in equity. The debt natures in 1 year and has a 10% interest rate, so the company is promising to pay back $77 million to its debtholders 1 year from now.

The company is considering two possible investments, each of which will require an upfront cost of $100 million, each investment will last for 1 year, and the payoff from each investment depends on the strength of the overall economy. There is a 50% chance that the economy will be weak and a 50% chance it will be strong. Please Show All Work.

Following table shows the expected payoffs from two investments:

                         Payoff in 1 year if the        Payoff in 1 year if theExpected

                         Economy is weak         Economy is strongPayoff        

Investment A              $90.00                          $130.00                                       $110.00

Investment B 50.00                            170.00                                         110.00

Note that two projects have the same expected payoff, but project B has higher risk. The debtholders always get paid first and the stockholders receive any money that is available after the debtholders have been paid.

Assume that if the company does not have enough funds to pay off its debtholders 1 year from now, then Ray will declare bankruptcy. If bankruptcy declared, the debtholders will receive all available funds, and the stockholders will receive nothing. Show all work.

Explanation / Answer

Soln : Initial cost required = $100 million, cost of debt = 10%, Debt value = $70 mn, Equity = $ 30 mn

Now if project A is considered and lets say economy is weak , in that case the pay off = $90 million

So, net payment made to debt holders = $77mn and payment to equity holders = 90-77 = $ 13 mn

Equity holders will get paid only $13 million out of their 30 Million

If project B os being choosen, in that case pay off = $50 million

So, Total payment made to debt holders = $50 million return on equity = 0 and company will go bankrupt.

In case if economy is good and project A is choosen , then debt holders will get paid in both investments and Equity holders get paid A = 130-77 = $53 million , return on equity = 23/30 = 76.67%

If project B is choosen , equity holders will receive total money = 170-77 = $ 93 million

return on equity = (93-30)/30 = 63/30 = 210%

In case if we are considering the net pay off = $110 million , the debt holders will receive their money full and equity holders will also get 10% return = (110-77-30)/30 ,

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