A UK company, All Weather Plc., has two assets in place at t = 0. The fifirst is a sunglasses

business, the second asset is an umbrella business. The company has debt maturing in

one year (t = 1) with face value of 1200 and coupon rate equal to the risk-free rate.

During the year, two states of nature may prevail: sunny (S) and rainy (R), and because

this is how Britain is, the probability of S is only 0.4. The current risk-free rate is 0%

and the market risk premium is 10%. Thereafter, sums are in million. At t = 1, the

sunglasses business generates cash flflows of 1000 in S and 500 in R, and the umbrella

business generates cash flflows of 500 in S and 1000 in R. At t = 0, the asset betas for

sunglasses and umbrella businesses are 0.7692 and

0.5882, respectively.

a) Calculate the current unlevered value of All Weather Plc.

b) Calculate the current value of equity and debt and their cost of capital. What is the

WACC for All Weather Plc.?

c) Determine the risk-neutral probability of the two states of nature.

The CEO of All Weather Inc. can divest the company of one of its two businesses at

its fair value and use the proceeds to pay a dividend at t = 0. She considers selling only

one business, to keep the fifirm ongoing and maintain her employment.

d) To maximize shareholders value, should the CEO sell one of the two businesses? If

so, which one? What would be the related incremental value of equity? What type

of agency conflflict is this? Would this agency issue create a violation of Modigliani

Millers Proposition I?

e) Considering the agency conflflict in (d), the debt holders decide to add a covenant to

the debt indenture at t = 0. This covenant allows the CEO to sell assets, but forbids

her to disbourse the proceeds from the sale to the shareholders at t = 0, i.e., the

proceeds have to be kept as cash within the fifirm until t = 1. What action would the

CEO take to maximize the equity value with this covenant? Would such a covenant

protect the debt holders value?

f) Alternatively to the covenant from (e), assume that the debt holders can specify

that one of the two assets is pledged as collateral, and therefore cannot be sold.

Which asset should they choose for this purpose? Would such a collateral protect

their value from the actions taken by the CEO to maximize the shareholders value?

g) Finally, assume that the debt holders use both the covenant from (e) and the collat

eral arrangement from (f) to secure their debt. Which asset should they choose as

collateral? Would this combination protect the debt value from the actions taken

by the CEO to maximize the shareholders value?