Based on the example on Page 39, slide of Part 2 Chapter 19, propose a way to swap debt with equity, so that debt overhang problem is eliminated. Note that in this example, ignore the cost of repurchasing the debt. THIS IS DEBT RESTRCUTURING, NOT DEBT FORGIVING ON THE SLIDE

Financial Restructuring? In principle, restructuring could avoid the inefficiency: Debt for equity exchange Debt forgiveness or rescheduling Suppose creditors reduce the face value of debt to $24M conditionally on the firm raising new equity to fund the project. Restructure? State NO Good Bad Proba. 1/2 1/2 Assets 100 10 Creditors 35 10 Shareholders 65 0 YES Good Bad 1/2 1/2 122 32 24 24 98 8 Will shareholders go ahead with the project? 39 / 85 Financial Restructuring? Incremental cash flow to shareholders from restructuring: 98-65 = $33M with probability 1/2 8-0 = $8M with probability 1/2 They will go ahead with the restructuring deal because: -15 + [(1/2)x33 + (1/2)*8]/1.1 = $3.6M > 0 Creditors are also better-off because they get: (24-35)/2+(24-10)/2= $1.5M 3 40 / 85 Financial Restructuring? In principle, restructuring could avoid the inefficiency: Debt for equity exchange Debt forgiveness or rescheduling Suppose creditors reduce the face value of debt to $24M conditionally on the firm raising new equity to fund the project. Restructure? State NO Good Bad Proba. 1/2 1/2 Assets 100 10 Creditors 35 10 Shareholders 65 0 YES Good Bad 1/2 1/2 122 32 24 24 98 8 Will shareholders go ahead with the project? 39 / 85 Financial Restructuring? Incremental cash flow to shareholders from restructuring: 98-65 = $33M with probability 1/2 8-0 = $8M with probability 1/2 They will go ahead with the restructuring deal because: -15 + [(1/2)x33 + (1/2)*8]/1.1 = $3.6M > 0 Creditors are also better-off because they get: (24-35)/2+(24-10)/2= $1.5M 3 40 / 85