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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

Bedrock Company has $70 million in debt and $30 million in equity. The debt matures in 1 year and has a 10% interest rate, so the company is promising to pay back $77 million to its debtholders 1 year from now.

The company is considering two possible investments, each of which will require an upfront cost of $100 million. Each investment will last for 1 year, and the payoff from each investment depends on the strength of the overall economy. There is a 50% chance that the economy will be weak and a 50% chance it will be strong.

Here are the expected payoffs (all dollars are in millions) from the two investments:

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Note that the two projects have the same expected payoff, but Project H has higher risk. The debtholders always get paid first and the stockholders receive any money that is available after the debtholders have been paid.

Assume that if the company doesn’t have enough funds to pay off its debtholders 1 year from now, then Bedrock will declare bankruptcy. If bankruptcy is declared, the debtholders will receive all available funds, and the stockholders will receive nothing.

  1. a. Assume that the company selects Investment L. What is the expected payoff to the firm’s debtholders? What is the expected payoff to the firm’s stockholders?
  2. b. Assume that the company selects Investment H. What is the expected payoff to the firm’s debtholders? What is the expected payoff to the firm’s stockholders?
  3. c. Would the debtholders prefer that the company’s managers select Project L or Project H? Briefly explain your reason.
  4. d. Explain why the company’s managers, acting on behalf of the stockholders, might select Project H, even though it has greater risk.
  5. e. What actions can debtholders take to protect their interests?

a.

Summary Introduction

To determine: The expected payoff to the firm’s debt holders and firm’s stockholders assuming that the company selects Investment L.

Stockholder-Debt Holder Conflict:

The disagreement can occur between the stockholder and debt holder. Debt holders are those groups to which a company is liable to pay a fixed sum irrespective of the company’s performance. The stockholders are the owners of the company, whenever the company’s value increases the value of the stockholder’s also increases.

Explanation

The expected pay off to the debt holders.

Particulars

Amount

($)

Requirement of funds for next year: 
Payment of interest 7 million
Repayment of Debenture 70 million
Total money payable to debt holders77 million

Table (1)

The expected pay off to firm’s stockholders.

  Weak StrongTotal
Particulars

Cash flow

($)

(A)

Probability

(B)

Cash flow

($)

(C)...

b.

Summary Introduction

To determine: The expected payoff to the firm’s debt holders and firm’s stockholders assuming company select investment H.

Stockholder-Debt Holder Conflict:

The disagreement can occur between the stockholder and debt holder. Debt holders are those groups to which a company is liable to pay a fixed sum irrespective of the company’s performance. The stockholders are the owners of the company, whenever the company’s value increases the value of the stockholder’s also increases.

c.

Summary Introduction

To identify: The debt holders prefer the company’s manager select Project L or Project H.

Stockholder-Debt Holder Conflict:

The disagreement can occur between the stockholder and debt holder. Debt holders are those groups to which a company is liable to pay a fixed sum irrespective of the company’s performance. The stockholders are the owners of the company, whenever the company’s value increases the value of the stockholder’s also increases.

d.

Summary Introduction

To identify: The reason for the company’s managers acting on behalf of the stockholders, might select Project H even it has greater risk.

Stockholder-Debt Holder Conflict:

The disagreement can occur between the stockholder and debt holder. Debt holders are those groups to which a company is liable to pay a fixed sum irrespective of the company’s performance. The stockholders are the owners of the company, whenever the company’s value increases the value of the stockholder’s also increases.

e.

Summary Introduction

To identify: The actions that the debt holders take to protect their interest.

Stockholder-Debt Holder Conflict:

The disagreement can occur between the stockholder and debt holder. Debt holders are those groups to which a company is liable to pay a fixed sum irrespective of the company’s performance. The stockholders are the owners of the company, whenever the company’s value increases the value of the stockholder’s also increases.

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