Question
If it is managedefficiently, Remel,Inc., will have assets with a market value of $49.3 million, $99.8 million, or $151.2 million nextyear, with each outcome being
If it is managedefficiently, Remel,Inc., will have assets with a market value of $49.3 million, $99.8 million, or $151.2 million nextyear, with each outcome being equally likely.However, managers may engage in wasteful empirebuilding, which will reduce the market value by $5.4 million in all cases. Managers may also increase the risk of thefirm, changing the probability of each outcome to 45%, 16%, and 39%, respectively.
a. What is the expected value ofRemel's assets if it is runefficiently?
Suppose managers will engage in empire building unless that behavior increases the likelihood of bankruptcy. They will choose the risk of the firm to maximize the expected payoff to equity holders.
b. Suppose Remel has debt due in one year as shown below. For eachcase, indicate whether managers will engage in empirebuilding, and whether they will increase risk. What is the expected value ofRemel's assets in eachcase?
i.$42.8 million, ii.$45.2 million, iii.$85.3 million, iv.$98.6 million.
c. Suppose the tax savings from thedebt, after including investortaxes, is equal to 8% of the expected payoff of the debt. The proceeds from thedebt, as well as the value of any taxsavings, will be paid out to shareholders immediately as a dividend when the debt is issued. What is the expected value ofRemel's assets, including the taxsavings, for each debt level in part (b)? Which debt level in part (b) is optimal forRemel?
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