Data table (Click on the following icon in order to copy its contents into a spreadsheet.) Strategy Probability of Success Firm Value if Successful (in $ million) Print A 100% 51 Done B 83% 60 66% 69 D 49% 78 - X Petron Corporation's management team is meeting to decide on a new corporate strategy. There are four options, each with a different probability of success and total firm value in the event of success, as shown here:. Assume that for each strategy, firm value is zero in the event of failure. Also, suppose Petron Corp. has debt with a face value of $38 million outstanding. For simplicity assume all risk is idiosyncratic, the risk-free interest rate is zero, and there are no taxes. a. What is the expected value of equity, assuming Petron will choose the strategy that maximizes the value of its equity? What is the total expected value of the firm? b. Suppose Petron issues equity and buys back its debt, reducing the debt's face value to $6 million. If it does so, which strategy will it choose after the transaction? Will the total value of the firm increase? c. Suppose you are a debt holder, deciding whether to sell your debt back to the firm. If you expect the firm to reduce its debt to $6 million, what price would you demand to sell your debt? d. Based on your answer to (c), how much will Petron need to raise from equity holders in order to buy back the debt? e. How much will equity holders gain or lose by recapitalizing to reduce leverage? How much will debt holders gain or lose? Would you expect Petron's management to choose to reduce its leverage? a. What is the expected value of equity, assuming Petron will choose the strategy that maximizes the value of its equity? What is the total expected value of the firm? Calculate the equity values below (millions): (Round to one decimal place.) Strategy A B $ D Equity Value $ $ The expected value of the firm is $ million. (Round to one decimal place.) With $38 million face value of debt, the firm will choose strategy (Input either A, B, C, or D.) b. Suppose Petron issues equity and buys back its debt, reducing the debt's face value to $6 million. If it does so, which strategy will it choose after the transaction? Will the total value of the firm increase? Calculate the equity values below (millions): (Round to one decimal place.) Strategy $ O A. O B. O C. O D. None of the above. Price will be at a discount. Price will be face value. Price will be at a premium. A Equity Value $ $ $ With $6 million in debt outstanding, management will choose strategy. (Input either A, B, C, or D.) c. Suppose you are a debt holder, deciding whether to sell your debt back to the firm. If you expect the firm to reduce its debt to $6 million, what price would you demand to sell your debt? (Select the best choice below.) B C d. Based on your answer to (c), how much will Petron need to raise from equity holders in order to buy back the debt? (Select the best choice below.) O A. Petron will need to raise $6 million from equity holders (as the debt is risk-free and has a face value of $6 million). O B. Petron will need to raise $38 million from equity holders (as the debt is risk-free and has a face value of $38 million). O C. Petron will need to raise $19 million from equity holders (as the debt is risk-free and has a face value of $19 million). O D. Petron will need to raise $32 million from equity holders (as the debt is risk-free and has a face value of $32 million). e. How much will equity holders gain or lose by recapitalizing to reduce leverage? How much will debt holders gain or lose? Would you expect Petron's management to choose to reduce its leverage? (Select the best choice below.) O A. The expected value of equity after the transaction is $45.0 million, but equity holders had to contribute $32 million to buy back the debt. Thus, the net expected payoff to equity holders is $13.0 million. If they had not done the buyback, equity would have been worth $20.5 million. Thus, equity holders lost $7.5 million as a result of the buyback. O B. Debt holders received $32 million, and still hold $6 million in risk-free debt, for a total payoff of $38 million after the buyback. Had Petron not done the buyback, the debt would have been worth 66% $38 million = $25.1 million. Thus, debt holders gained $12.9 million as a result of the buyback. O C. Even though the total value of the firm increases by $7.5 million by reducing leverage and eliminating agency costs, the debt holders capture more than $7.5 million, and thus equity holders lose. Therefore, even though Petron has an inefficiently high level of leverage, the ratchet effect of debt overhang implies that it will not choose to reduce its leverage. O D. All of the above
