Question 1

Sapphire Ltd. is a company where managerial compensation is linked to the value of the firms stock. The company has only two investment opportunities, A and B, and must choose between them. In the case of investment opportunity A, an already established technology would be used, and the project would generate next year $150 million with certainty. Project B relies on a brand new untested technology, and as such has only a limited probability of success. A research team at Sapphire Ltd. forecasts that project B will succeed with probability 30%. If successful, the project will generate free cash flows over the next year of $270 million. If it fails, free cash flows will only be $90 million. Both project A and project B cost $100 million, that the company wants to raise through debt financing.

Assume that everyone in the economy is risk neutral and the risk-free rate is 5%. In questions (b)-(d), assume that lenders are rational (i.e., they can anticipate that the companys management acts in the interests of equity holders), but they cannot include any protective covenants in a loan agreement.

a) What is the NPV of each project? (2 marks)

b) Will lenders be interested to fund the $100M project of Sapphire Ltd. by a zero coupon bond with face value equal to $105 million? Explain. Hint: think and show which project the firms management undertakes, if it can issue such a bond. (6 marks)

c) What interest should the company promise to pay on its debt in order to raise $100 million from lenders? Does the promised rate coincide with the expected rate? What is a default premium requested by lenders? (12 marks)

d) Discuss the type of agency problem in the question. (4 marks)

e) Assume now that lenders are able to include protective covenants in a loan agreement, that forces the companys management to be credibly committed to maximise firm value, rather than equity value. Which interest rate will lenders require on the $100 million loan? Explain in two lines how it would affect equity value compared to the case where management focuses on equity value maximisation. (4 marks)