Question
Fun Toy Corporation estimates that there is 25% chance of a recession economy next year, a 50% chance of a normal economy next year, and
Fun Toy Corporation estimates that there is 25% chance of a recession economy next year, a 50% chance of a normal economy next year, and a 25% chance of a boom economy next year. The corporation will exist until the end of next year and then it will cease to exist. Spartan has $80 of debt that must be repaid next year. Assume a 0% discount rate for all cash flows (in other words, there is no discounting). Fun Toy has a low risk project that yields a cash flow of $70 in a recession, $100 in a normal economy, and $130 in a boom. If Fun Toy chooses this low risk project: what is the value of Fun Toy's debt? what is the value of Fun Toy's equity? Fun Toy has a high risk project that yields a cash flow of $30 in a recession, $100 in a normal economy, and $160 in a boom. If Fun Toy chooses this high risk project: what is the value of Fun Toy's debt? what is the value of Fun Toy's equity? Which project will Fun Toy choose? Given your answers to (a) and (b), when Fun Toy sells the bonds would it like to include a covenant that would prohibit it from taking the high-risk project? Explain your answer.
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