3) Conflicts of Interests and Financing Securities Suppose you are the owner of company ABC. The company has debt maturing next year with face value 100. Current operation of ABC will produce two possible outcomes next year when the debt is due: The company will have 120 or 60 with equal probability. There is no further production after the next year. Assume risk neutrality and no discounting a. Based on the information, what is the market value of debt and equity? (2 marks) b. Now suppose you have an opportunity to invest another 20 that can yield additional 25 with certainty on top of the currently projected outcomes. What is the NPV of this additional investment? What is the market value of debt and equity after the investment? If you, as the owner, have to fund the investment out of pocket, should you invest? (5 marks) c. Explain your intuition for part b WITHOUT using numbers. (4 marks) d. If you instead issue new equity to finance the investment, what fraction of the new company do you need to sell? Should you issue equity and invest? Compared with b., discuss how out-of- pocket equity finance and external equity finance affect your investment decision? (7 marks) If you issue debt that is more senior than the current debt to finance the new investment, what is the fair face value? What is the market value of the original debt and equity? Should you issue this debt and invest? Compared with d, briefly discuss your investment decision. (7 marks) e. 3) Conflicts of Interests and Financing Securities Suppose you are the owner of company ABC. The company has debt maturing next year with face value 100. Current operation of ABC will produce two possible outcomes next year when the debt is due: The company will have 120 or 60 with equal probability. There is no further production after the next year. Assume risk neutrality and no discounting a. Based on the information, what is the market value of debt and equity? (2 marks) b. Now suppose you have an opportunity to invest another 20 that can yield additional 25 with certainty on top of the currently projected outcomes. What is the NPV of this additional investment? What is the market value of debt and equity after the investment? If you, as the owner, have to fund the investment out of pocket, should you invest? (5 marks) c. Explain your intuition for part b WITHOUT using numbers. (4 marks) d. If you instead issue new equity to finance the investment, what fraction of the new company do you need to sell? Should you issue equity and invest? Compared with b., discuss how out-of- pocket equity finance and external equity finance affect your investment decision? (7 marks) If you issue debt that is more senior than the current debt to finance the new investment, what is the fair face value? What is the market value of the original debt and equity? Should you issue this debt and invest? Compared with d, briefly discuss your investment decision. (7 marks) e
