5. Tern Corporation expects cash flows from its risky assets in one year's time of either $110 million or $30 million, with equal probability. The firm also has debt with face value $50 million due in one year. Tern is considering a new project that would require an investment of $16 million today and would result in a certain cash flow in one year's time of $24 million. Tern has $16 million in cash which can be used to invest in the project if it is accepted. If the cash is not invested, it will be distributed to equityholders as a dividend. Page 4 of 8 UL20/0423 5/8 Investors are all risk neutral and the risk free rate is zero. (a) What are the expected values of the firm's equity and debt now? (4 marks) (b) What are the expected values of the firm's equity and debt if the new project is undertaken? What is the incremental value to the equityholders if the project is undertaken? (5 marks) (c) Assume that if Tern does not undertake the project, it could sell off some of its risky assets for $20 million in cash. Tern can pay this $20 million and its existing cash of $16 million to its equityholders as a dividend. If the firm chooses to do this, the cash flows from its risky assets in one year's time will be reduced to either $80 million or zero with equal probability. What will be the expected values of the firm's equity and debt? (5 marks) (d) If the managers of Tern are committed to maximising the wealth of their equityholders, what are they likely to choose to do? Explain. (5 marks) (e) Discuss strategies that providers of debt finance might use to protect their own position before lending to firms. (120 words) (6 marks)