Company ABC just sold their most profitable division for $100 million in cash. The company has a market value balance sheet shown below (in millions). The bonds outstanding have an annual payment that is due in one month that equals 10% of the book value (400 x .10 = $40 million). Note: If the payment is not made on time it accrues a penalty of 1% or $400,000 per month unpaid:   Assets              BV     MV     Liabilities             BV      MV Cash                $100    $100    LT bonds             $400   $100 Fixed Asset     $900        $0    Equity                 $600       $0 Total             $1,000    $100    Total                    $600   $100   The board is considering using the $100 million to sponsor a music festival that might be a success or a failure. The expected payoffs are as follows:   Probability                              Payoff         5%                                   $500       25%                                   $200       50%                                     $50       20%                                       $0   B) Instead of the music festival, the company has the opportunity to participate in a government sponsored program that guarantees a return of 10%. This program requires minimum participation of $200 million that is paid in cash and the discount rate is 5%.   (i) If the company issues $100 million in new equity to fund the obligation, what are the expected market values on the balance sheet (ignore the interest payment on the debt)   (ii) The company issues $100 million in debt at an interest rate of 20% to fund the opportunity, does this help the stockholders position? (Note: consider all the amounts due the debtholders)

Question

Company ABC just sold their most profitable division for $100 million in cash. The company has a market value balance sheet shown below (in millions). The bonds outstanding have an annual payment that is due in one month that equals 10% of the book value (400 x .10 = $40 million). Note: If the payment is not made on time it accrues a penalty of 1% or $400,000 per month unpaid:

 

Assets              BV     MV     Liabilities             BV      MV

Cash                $100    $100    LT bonds             $400   $100

Fixed Asset     $900        $0    Equity                 $600       $0

Total             $1,000    $100    Total                    $600   $100

 

The board is considering using the $100 million to sponsor a music festival that might be a success or a failure. The expected payoffs are as follows:

 

Probability                              Payoff

        5%                                   $500

      25%                                   $200

      50%                                     $50

      20%                                       $0

 

B)

Instead of the music festival, the company has the opportunity to participate in a government sponsored program that guarantees a return of 10%. This program requires minimum participation of $200 million that is paid in cash and the discount rate is 5%.

 

(i) If the company issues $100 million in new equity to fund the obligation, what are the expected market values on the balance sheet (ignore the interest payment on the debt)

 

(ii) The company issues $100 million in debt at an interest rate of 20% to fund the opportunity, does this help the stockholders position? (Note: consider all the amounts due the debtholders)

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