United Packaging Systems (UPS) provides packaging services in Arlington, Texas. Five years

ago, they have invested $400mil to build their current production platform (platform A). The

platform is being depreciated straight line to a salvage value of zero over a 10-year period.

However, UPS expects to sell platform A for $25mil at the end of its life time. Expected before

tax revenues are $220mil per year. Platform A works with electricity. The unpredictable

situation in the energy market is expected to a ect operating costs of the platform. In the

good state of the world (low energy prices) operating costs will be $20mil a year. In the bad

state of the world (high energy prices) operating costs will be $180mil per year. The good and

bad states are equally likely. Marginal corporate tax rate is 40%, and UPS has a cost of capital

of 12%. UPS has substantial outstanding long-term debt, in the form of publicly traded bonds,

with present market value of $500mil.

(a) (15 points) What are the cash ows in the good and bad states of the world? What are

the present value of platform A in the good and bad states of the world. Use the expected

value of annual cash ows to calculate the NPV of platform A and the total value of UPS's

assets. Assume that the only other asset UPS has, besides platform A, is $240mil cash.

[Hint: recall that cash is risk-free.]

(b) (20 points) UPS is considering moving to platform B which utilizes solar panels as the

source of energy. Even though platform B has no e ect on revenues, it a ects operating

costs in two ways: (i) it makes costs independent of energy prices, and (ii) it provides

expected cost savings. Thus, compared to the expected operating cost in part (parta),

there is a $60mil expected cost saving per year. Purchasing platform B has an immediate

(c) (15 points) Fill out the following table (units are in $mil) by plugging in the appropriate

values for Assets, Debt, and Equity. Given selection of platform A or B, the table should

reect the present value of assets and the nancial structure of the rm (in present value)

depending on possible outcomes for energy prices. Establish whether shareholders interests

will conict those of the debt-holders. From shareholders' perspective, does the value

of option to default when platform A is taken overcome the value of cost savings under

platform B? [Hint: you may have same values for Good/Bad states of the world.]

Platform A Platform B

State of the world Assets = Debt + Equity Assets = Debt + Equity

Good

Bad

Expected

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cost of $500mil that may be capitalized and depreciated a straight line to a zero salvage

value over a ve-year period. UPS expects to sell platform B for $150mil after ve years.

Assume that the market value of platform A, after transaction costs, is $300mil today.

Both platforms require the same amount of working capital. Provided that UPS pays the

initial outlay for platform B using its internal funds, does the asset-replacement decision

make economic sense? [Hint: you need to extract the book value of platform A from the

information provided about UPS earlier.]

(d) (20 points) Part (c) introduces a potential conict among stakeholders in a rm. Which

party's behavior is \wealth expropriating" in this case, and what could have been done to

mitigate this conict? Suppose that the conict is resolved by adoption of your sugges-

tions. Use three graphs to describe all possible paths UPS stock price may take as UPS

announces its move from Platform A to Platform B (assuming that there is no leakage

of information prior to the announcement). Which path reects the price behavior in an

ecient market?

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