Question: Assume that you are the owner of Scorpius, a company which has debt maturing next year with a face value equal to 100m. Current operations of Scorpius will produce two possible cash flow outcomes next year when the debt is due: either 130m with probability 60% or 60m with probability 40%. There is no further production after the next year. Assume risk neutrality and no discounting.

Required:

1. Based on the information provided, what is the market value of debt and equity in efficient capital markets?

(4 marks)

2. Now suppose you have an opportunity to invest another 20m that can yield additional 25m with certainty on top of the currently projected outcomes. What is the NPV of this additional investment? What is the market value of debt and equity after the investment? If you, as the owner, have to fund the investment out of pocket, should you invest?

(5 marks)

3. Explain your intuition for part b) without using any calculations.

(4 marks)

4. If you instead issued debt that is more senior than the current debt to finance the new investment, what is the face value of the new debt? What are the market values of the original debt and equity claims? Should you issue this debt and invest? Explain.

(7 marks)

[Total: 20 marks]