Q3. 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                           (a) What is the stockholders best move right now in the above scenario? (Assume there are no restrictions on corporate actions and there are no agency problems because the board and management of the company will take actions in the stockholders’ best interest).   (b) 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   (i) What is the net present value of the music festival? (Assume the investment is immediate (time 0) and the payoff is one year from now (time 1) and the discount rate is 20%)   (ii) Update the market value balance sheet above to reflect the expected market values in one year if the company takes the project (ignore adjusting for owed interest on the debt)?   (c) 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

Q3. 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

 

                       

(a) What is the stockholders best move right now in the above scenario? (Assume there are no restrictions on corporate actions and there are no agency problems because the board and management of the company will take actions in the stockholders’ best interest).

 

(b) 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

 

(i) What is the net present value of the music festival? (Assume the investment is immediate (time 0) and the payoff is one year from now (time 1) and the discount rate is 20%)

 

(ii) Update the market value balance sheet above to reflect the expected market values in one year if the company takes the project (ignore adjusting for owed interest on the debt)?

 

(c) 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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