Question
Abby Incorporated has assets in place that will generate the following state dependent cash flows in one year: $64 million, $150 million and $210 million.
Abby Incorporated has assets in place that will generate the following state dependent cash flows in one year: $64 million, $150 million and $210 million. The probabilities of realization of each cash flow depends on whether the manager chooses to adopt a safe strategy or a risky strategy. The probabilities are as in Table 1 below. Assume that there are no taxes and the discount rate is zero.
Table 1
Manager adopts safe strategy |
| Manager adopts risky strategy | ||
Probabilities | Cash Flows | Probabilities | Cash Flows | |
1/3 | $64 million | 0.5 | $64 million | |
1/3 | $150 million | 0 | $150 million | |
1/3 | $210 million | 0.5 | $210 million |
- Find the value of the firm, if the manager adopts the safe strategy and if the manager adopts the risky strategy.
[3 marks]
Assume that the firm has an outstanding debt with face value of $50 million that matures in one year.
- Assume that the manager acts in the interest of the equity-holders. Find the value of debt and the value of equity under each scenario. Will the manager choose to adopt the safe strategy or the risky strategy?
Discuss your answer.
[7 marks]
Now assume that the firm has an outstanding debt with face value of $115 million that matures in one year.
- Assume that the manager acts in the interest of the equity-holders. Find the value of debt and the value of equity under each scenario. Will the manager choose to adopt the safe strategy or the risky strategy?
Discuss your answer.
[8 marks]
- Use your findings at Questions 4b and 4c to discuss the following statement: the high level of debt is at the origin of an agency cost for the firm of 5 million.
[7 marks]
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