Abby Incorporated has assets in place that will generate the following state-dependent cash flows in one year: $100 million if the economy is good and $40 million if the economy is bad. Each state of the economy is equally likely. The company has a debt with a face value of $70 million due in one year. All agents are risk-neutral, the discount rate is zero, and there are no taxes. The firm is run by a manager who acts in the interest of the equity holders.

1. a) Find the value of the firm, the value of equity, and the value of debt. [4 marks]

Now assume that the firm has an investment project that requires an investment of $15 million today and creates a cash-flow of $20 million for sure in one year.

1. b) Assume that there are covenants prohibiting the issue of additional debt. Would you advise the equity-holders to finance the project with their own money? What is the value of debt if the project is undertaken? Discuss your answer. [7 marks]

The manager asks the debt-holders to waive the covenant so that the company could issue senior debt in order to raise the funds necessary for the investment.

1. c) Would the company be able to raise new senior debt of $15 million to finance the project? Will the existing debt holders agree to waive the covenant? Explain and discuss your results. [7 marks]

Now assume that the firm has access to a second project that also requires an investment of $15 million today, in one year, this project increases the cash-flows of the firm by $25 million in the good state and decreases the cash-flows by $25 million in the bad state. The two projects are mutually exclusive.

1. d) Will the existing debt holders agree to waive the seniority covenant in this case? Explain and discuss your results. [7 marks]