Question
A firm has $10 million of debt on its books. The debt does not contain any covenants restricting the issuance of additional debt with equal
A firm has $10 million of debt on its books. The debt does not contain any covenants restricting the issuance of additional debt with equal seniority (i.e., pari passu debt). The CFO wants to take advantage of this. Specifically, he plans to issue additional equal-seniority debt with a face value of $10 million and keep the proceeds as cash in the companys bank account. Due to default risk, investors will discount the debt issue, and the company will only be able to raise $8 million. The CFO argues that this transaction will benefit equity holders at the expense of existing debt holders. The CEO disagrees. In her words: I cannot see the benefit to equity holders of raising $8 million and parking the cash in a bank account. Doing so makes the equity holders worse off since they are implicitly paying for the default premium without getting anything back in return. Who is right, the CFO or the CEO? Assume that the discount rate is zero and ignore taxes. Please explain.
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