The financial manager of the firm is deciding whether he should take on one last risky project before the firm is liquidated next year. If this project is taken on, then the potente liquidation value could be much higher next year, but it could also be much lower. If the manager does not take on the risky project, we will assume that the manager does nothing instead. bj Suppose that the financial manager decides to do nothing- In this case, the market value of the firm will equal either $60M (state A] or $40M [state B) next year, with equal probability. It follows that upon liquidation next year, the bondholder with either receive the $30M they are owed (state A] or only $40M state B). In each state, the stockholders receive whatever is left over elter the bondholder is ped off. Whet is the expected liqu dation value of the firm? What is the expected peyoff to the bondholder? What is the expected peyoff to the stockholders! c suppose that the financial manager decides to take on the risky project. In this case, the market value of the firm will equel either $90M (state A) or zero (state 8) next year, with equal probebility. It follows that upon liquidation next year, the bond holder with either receive the 530M they are owed (state A] or nothing (state B)- In each state, the stockholders receive whetever is left over after the bondholder is ped off. What is the expected liquidation value of the firm! What is the expected peyoff to the bondholder? What is the expected payoff to the stockholders! Assume that the maneger wents to maximize the expected peyoff to the stockholders. Would he choose to do nothing (as in part (b)) or take on the risky project (es in part [c) ? Explain. The financieremeger decides to take on the risky project from pert [c). This is detrimental to the bondholder because there is now a chance that the bondholder will not be repaid any off 530M he is owed. If you were the bondholder and wanted to completely protect yourself against the state of the world where the firm does not pay you beck (so that the option peyoff is 50M in state B ) would you buy s (call or put) option on the finel market value of the assets of the firm, and et whet strike price! This option you purchase hes a price of $20M. You decide to borrow $20M from the bank to pay for the option. The bank charges you a 108 interest rate per year, and you must pay back the loon with interest in one year. Whet is your peyoff in state A? (This is calculated es the payoff from the bond plus the peyoff from the option minus the loan repayment.) Whet is your peyoff in state B? What is your expected payoff? would you be better off purchasing the option? Firms thet go bankrupt are typically unable to fully repay all of their bondholders. Bondholders cen protect themselves from these benkruptcy events by purchasing a "Credit Defeult Swap," an agreement in which the bondholder pays a third counterparty s fee or a sequence of fees over time; in exchange, the third counterparty repays the bondholder what he is owed in the event that the firm goes bankrupt end cannot repay the bondholder