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A firm has debt with a face value of $100. Its projects will pay a safe $80 tomorrow. Managers care only about shareholders. A new quickie project comes along that cost $20, earns either $10 or $40 with equal probabilities, and does so by tomorrow.

(a) Is this a positive -NPV project?

(b) If the new project can only be financed with a new equity issue, would the shareholders vote for this? Would the creditors?

(c) Assume the existing bond contract was written in a way that allows the new projects to be financed with first collateral (super seniority with respect to the existing creditors). New creditors can collect $20 from what the existing projects will surely pay. Would the existing creditors be better off?

(d) What is the better arrangement from a firm-value perspective?

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  • Reference No.:- M940517

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