#2. Emruss Industries has no cash flow this year, but it expec

ts to have a cash flow of $1.5

million next year if the firm is able to lower its costs, and a

cash flow of $.5 million next

year if the firm is unable to lower its costs. There is a .5 p

robability that the firm will be

able to lower its costs next year, and a .5 probability that th

ey will be unable to lower their

costs. The firm can be liquidated immediately for $1.2 million

. The firm has both junior

debt and senior debt outstanding. For simplicity, assume that

future cash flows are not

discounted (i.e. assume that th

e appropriate discount rate is 0

%).

Due immediately Due next year

Senior debt $150,000 $1,000,000

Junior debt $0 $200,000

(a)

If Emruss does not pay the $150,0

00 due immediately, it will be

forced into

liquidation (i.e. Chapter 7). If

APR is followed in liquidatio

n, how much will the

junior debtholders rece

ive in liquidation?

(b)

Suppose the management of Emruss asks the junior debtholders fo

r $150,000 in

exchange for a new junior bond that promises repayment of $250,

000 in one year.

The old junior bond will remain outstanding (i.e., it will not

be canceled). Will the

junior debtholders agree to this deal? Will Emruss management

be willing to offer

this deal? Will the senior debtholders be happy if the junior

debtholders accept this

offer?

Finance 414 - Problem Set #4 - Fall 2016 Due at the start of class on Wednesday, October 19th Questions on assignment should be directed to the class TA, Alex Ferko either via email (ferko@broad.msu.edu) or by attending his Tuesday office hours #1. A firm has a value of $72 million if it is not liquidated and a value of $56 million if it is liquidated. The firm has $48 million in senior debt outstanding and $40 million in junior debt outstanding. The firm proposes the following restructuring: senior debtholders exchange their debt for 70% of the firm's equity junior debtholders exchange their debt for 10% of the firm's equity equityholders keep 20% of the reorganized firm's equity Which of the security holders prefer this reorganization plan to what they would get in liquidation assuming that the Absolute Priority Rules (APR) would be followed in liquidation? (a) equityholders (b) senior debtholders (c) junior debtholders #2. Emruss Industries has no cash flow this year, but it expects to have a cash flow of $1.5 million next year if the firm is able to lower its costs, and a cash flow of $.5 million next year if the firm is unable to lower its costs. There is a .5 probability that the firm will be able to lower its costs next year, and a .5 probability that they will be unable to lower their costs. The firm can be liquidated immediately for $1.2 million. The firm has both junior debt and senior debt outstanding. For simplicity, assume that future cash flows are not discounted (i.e. assume that the appropriate discount rate is 0%). Senior debt Junior debt Due immediately $150,000 $0 Due next year $1,000,000 $200,000 (a) If Emruss does not pay the $150,000 due immediately, it will be forced into liquidation (i.e. Chapter 7). If APR is followed in liquidation, how much will the junior debtholders receive in liquidation? (b) Suppose the management of Emruss asks the junior debtholders for $150,000 in exchange for a new junior bond that promises repayment of $250,000 in one year. The old junior bond will remain outstanding (i.e., it will not be canceled). Will the junior debtholders agree to this deal? Will Emruss management be willing to offer this deal? Will the senior debtholders be happy if the junior debtholders accept this offer? #3. 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