Problem:
A firm has a senior bond obligation of $20 due this period and $100 due next period. It also has a subordinated loan of $40 owed to Jack and Jill and due next period. It has no projects that provide cash flows this period. Therefore, if the firm cannot get a new loan for $20, it must liquidate. The firm has a current liquidation value of $120. If the firm does not liquidate, it can take on one of two projects with no additional investment funding needed. If it takes project A, the project will generate a cash flow of $135 next year for sure. If it takes project B, the project will generate a cash flow next year of $161 or $69 with equal probability. Assume risk-neutrality, a zero interest rate, no direct bankruptcy costs, and no taxes.
Requirement:
(a) If the firm were entirely equity financed, would it decide to liquidate, adopt project A, or adopt project B?
(b) The firm has approached Jack and Jill and asked them for a $20 (subordinated) loan. The $20 loan proceeds will be used to pay off the $20 of senior debt that is currently due. The firm promises to pay Jack and Jill back $20.5 next period on this new loan plus the $40 on the original loan. If Jack and Jill agree to the loan, which project will be taken by the firm? Should Jack and Jill agree to the loan? Please justify your answer with the appropriate calculations and formulas.