Question
Mary's Berries is in financial trouble. They have $4M of debt that matures in one year and $3M of cash on hand. If they can't
Mary's Berries is in financial trouble. They have $4M of debt that matures in one year and $3M of cash on hand. If they can't pay their debt, then they will be liquidated and debt holders will get whatever is left, leaving the equity holders with nothing. If the firm is able to repay the debt, then they will pay $4M to the debt holders and the remainder belongs to the equity holders. The debt has a covenant that prevents the company from paying dividends or repurchasing stock.
There are two investment projects available. Each requires an investment of $3M today and the project payoffs will be realized just before the debt matures.
Project A has an 15% chance of generating a cash flow of $7M, and an 85% chance of generating a cash flow of $2M.
Project B has a 40% chance of generating a cash flow of $3.5M and a 60% chance of generating a cash flow of $4.5M.
a) Assume Mary applies an equal discount rate of 10% to both projects. b) Which project would equity holders prefer? Is that consistent with firm value maximization? (Be sure to answer both parts of the question.)
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