Wolverine Software has just completed an R&D project that required borrowing sen

Question

Wolverine Software has just completed an R&D project that required borrowing senior debt from a bank. The bank has been promised a repayment of $140 million. This R&D effort has resulted in an investment opportunity that will cost an additional $200 million and will result in a cash flow of $180 million with probability .5 and $420 million with probability .5. The firm has no cash on hand and no other assets except for this investment opportunity. Assume risk-neutrality, a zero interest rate, no direct bankruptcy costs, and no taxes.

(a) Could the firm fund the investment opportunity with an equity issue?

(b) Could the firm fund the investment opportunity with an issue of junior debt

(c) Could the firm fund the investment opportunity with a sale of senior debt to a new investor with a promised repayment of $240 (assuming that this is allowed in the existing bank loan agreement)?

(d) Could the firm fund the investment opportunity with an issue of new senior debt with a promised repayment of greater than $242.0 (assuming that this is allowed in the bank loan agreement). What would you predict for the minimum face value (i.e., promised repayment) of the new debt that would be necessary to raise funds for the investment opportunity?

Explanation / Answer

a. The bank can consider funding the new issue via equity, since the bank already has a bank payable of 140 mn, taking additional loan would be burdensome, thus bank should consider funding the requirement of 200 mn via equity option.

b. Issuing a junior debt would mean firm has to offer a higher rate of interest , which means less credibility of the issue. This may be treated as a junk bond. The issue may go undersubscribed and might not fulfill the entire requirement of 200 mn
Moreover, the internal rate of return on the project is
Expected inflow = 0.50 * 180 + 0.50 * 420 = 300
The return required = 300/200 - 1 = 15%

If the interest offered on the junior debt is higher that this rate of return, it will not be beneficial for the company at all.

c. It is feasible to opt for a senior bond with a promised payment of 240 mn, which is lower than the expected cashflows of the project.

d. The answer would be same as no c.
The minimum face value of the new debt required would be 140 + 200 = 340 mn. $140mn is used to repay the bank and balance is used to generate the cashflows of the new project, however , after the minimum payment of 242 mn , the company will be left with 300 - 242 = $58 mn

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