Ms. Blavatsky is proposing to form a new start-up company with initial assets of

Question

Ms. Blavatsky is proposing to form a new start-up company with initial assets of $10 million. She can invest this money in one of two projects. Each project has the same expected payoff, but one has more risk than the other. The relatively safe project offers a 40 percent chance of a $12.5 million payoff and a 60 percent chance of an $8 million payoff. The risky project offers a 40 percent chance of a $20 million payoffand a 60 percent chance of a $5 million payoff. Ms. Blavatsky’s financial advisorproposed two alternative financing options.

Financing Option A: Raise $10 million through an issue of straight debt with a promised payoff, to the lenders, of $7 million. Ms. Blavatsky will receive any remaining payoff.

Financing Option B: Raise $10 million through an issue of a convertible bond with a promised payoff, to the lenders, of $7 million and the right for bondholders to convert their investments into 50 percent share of the value of the company. Ms. Blavatsky will receive any remaining payoff.

a) Calculate the possible payoffs and the expected payoffs to the lender from the two projects under Financing Option A (a straight-bond financing).

b) Calculate the possible payoffs and the expected payoffs to Ms. Blavatsky from the two projects under Financing Option A (a straight-bond financing).

c) Calculate the possible payoffs and the expected payoffs to the lender from the two projects under Financing Option B (a convertible-bond financing).

d) Calculate the possible payoffs and the expected payoffs to Ms. Blavatsky from the two projects under Financing Option B (a convertible-bond financing).

e) Compare the expected payoffs to the lender and to Ms. Blavatsky. Which project is Ms. Blavatsky likely to choose? Which project will the lender want her to choose? Discuss the benefits of using convertible bond financing in this case.

Explanation / Answer

a) & b) Financing Option A,

The lenders will receive the promised payment which is 7 million.

Safe Project :

Now Ms. Blavatsky has

40% chance of receiving 12.5 million

60% chance of receiving 8 million

Thus for lenders:

(0.4 * 7 million) + ( 0.6 * 7million) = 7 million

For Ms. Blavatsky

(0.4 * (12.5- 7)) + (0.6 * (8- 7)) = 2.8 million

Risky project :

Now Ms. Blavatsky has

40% chance of receiving 20 million

60% chance of receiving 5 million

Thus for lenders:

(0.4 * 7 million) + ( 0.6 * 7million) = 7 million

For Ms. Blavatsky

(0.4 * (20 - 7)) + (0.6 * ( 5 - 7)) = 4 million

c) & d) Financing Option B,

The lenders will receive the promised payment which is 7 million along with option of converting the investment into 50 % shares of the value of the company

Safe Project :

Now Ms. Blavatsky has

40% chance of receiving 12.5 million

60% chance of receiving 8 million

For Company

(0.4 * 12.5) + (0.6 * 8) = 9.8 million

So lender can either take 7 million or can take 50% of 9.8 million

So lender payoff: 7 million

Ms. Ms. Blavatsky payoff = 2.8 million

Risky project :

Now Ms. Blavatsky has

40% chance of receiving 20 million

60% chance of receiving 5 million

Thus for Company:

(0.4 * 20 ) + (0.6 * 5 ) = 13 million

So lender can either take 7 million or can take 50% of 11 million

So lender payoff: 7 million

Ms. Ms. Blavatsky payoff = 4 million

e)

Lenders are getting same payoff irrespective of the project choosen. So they are comfotable in choosing either of safe or risky project.

But Ms. Blavatsky has higher payoff in risky project, so she will choose the risky project.

Benefits of using convertible is that it case save lenders from lossing money and at the same time give them room to earn more if the project is a huge hit. If the 50% expected value of company exceeds the fixed payoff, debt will be converted to equity and extra return will be earned which is not the case with straight debt

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