2)

Shareholder - Debtholder Problem:

Assume that a firm is worth $1,000.

Debtholders hold claims to

the first $900, and equity has claim to the remainder.

Equity holders have an opportunity to invest in a

project that costs $500 today, and with 40% probability, the project will be worth $1,000 tomorrow.

With 60% probability, the project will be worthless tomorrow.

Again, for simplicity, assume that there is

no time value of money here.

Also, for simplicity, assume that if the value of the project equals zero,

then the project will not be undertaken.

a) What is the NPV of this project, and should it be accepted or rejected based on the NPV?

-

$100, accept

-

$100, reject

$140, accept

$140, reject

b) What is the value of this project to shareholders, and would they rationally accept or reject?

-$100, accept

-$100, reject

$140, accept

$140, reject

c) Assume that the debtholders had negotiated a covenant based on a leverage ratio (here, Debt

/ Equity ratio) in the initial contract. Typically, the covenant would dictate the maximum

amount of leverage that a company can assume. If the company's leverage ratio exceeds this

mandate, then the company is in technical default (which is not good!). What is the maximum

D/E ratio that would have aligned shareholder and debtholder incentives for this project?

3.50

2.75

2.50

2.00

d) Assume that instead, the debtholders had negotiated a covenant based on the maximum

amount of investment (so, they set a maximum on the amount of investment, such as the $

5

00

in project costs).

Assume that the probabilities and returns are proportionate (so, 40%

probability that you double your money, and 60% chance that you lose your investment).

What

is the maximum amount of investment into this type of project that would allow shareholder

and debtholder incentives to be aligned (should be less than $

5

00 in this instance)?

$

150

$2

00

$

250

$

300

FIN 305

Assignment 1

e

) Your answer in part (d) above assumed a covenant based on this type of investment (namely,

double your money with 40% chance, lose your money with 60% chance). What if the

investment were to be like a highly risky "lottery ticket?" For instance, with a miniscule chance

of winning big, and an extremely high likelihood of losing your investment. What is the

maximum amount of investment into this type of project that would allow shareholder and

debtholder incentives to be aligned?

$100

$150

$200

$250