Question
Firm X currently has a single project which ends next term with the possible payoffs $150 and $100, each equally likely. You lent to the
- Firm X currently has a single project which ends next term with the possible payoffs $150 and $100, each equally likely. You lent to the firm debt with face value $140 due in one year. You discover that a new project has become available to X that requires an investment of $40 and will generate $50 guaranteed next year. The firm does not have the capital so must seek outside funding for the $40. Due to a pari passu covenant in the debt contract any new financing must be junior to them without your approval.
(a) Could the manager/owner of X fund the project with Junior Debt (and thus avoid violating the pari passu covenant)? Demonstrate through a numerical analysis. [7 points]
(b) The owner of X asks you to forgive Debt to $115 so that the attractive project can be undertaken with Junior debt financing. If you were to do that, would you expect the project to get funded and undertaken? Demonstrate numerically by showing the terms of the Junior debt. [6 points]
(c) Is it in your interest as the debtholder to agree to the restructuring in part b as is? If not, what share of the equity would you need in order to obtain half of the surplus created by the restructuring? [4 points]
(d) If you were uninterested in owning equity in X, might it be attractive to you to simply allow the firm to issue senior debt (what is called DIP financing) and thus permit them to simply override the pari passu covenant? Demonstrate numerically. [6 points]
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