Fun Toy Corporation estimates that there is 30% chance of a recession economy ne

Question

Fun Toy Corporation estimates that there is 30% chance of a recession economy next year, a 40% chance of a normal economy next year, and a 30% chance of a boom economy next year. The corporation will exist until the end of next year and then it will cease to exist. Fun Toy has $80 of debt that must be repaid next year. Assume a 0% discount rate for all cash flows (in other words, there is no discounting). Ignore tax issues regarding debt financing.

(a) Fun Toy has a low risk project that yields a cash flow of $50 in a recession, $100 in a normal economy, and $150 in a boom. If Fun Toy chooses this low risk project:
(i) what is the value of Fun Toy’s debt?
(ii) what is the value of Fun Toy’s equity?

(b) Fun Toy has a high risk project that yields a cash flow of $20 in a recession, $90 in a normal economy, and $170 in a boom. If Fun Toy chooses this high risk project:
(i) what is the value of Fun Toy’s debt?
(ii) what is the value of Fun Toy’s equity?

(c) Which project will Fun Toy choose, if its manager makes investment decisions on behalf of shareholders? Explain your answers.

(d) Suppose the bondholders are fully aware of the discrepancy between maximizing the firm’s value and maximizing equity’s value. To minimize the agency costs, bondholders use a bond covenant to stipulate that when the firm takes on high-risk projects, bondholders can demand a higher debt payment. By how much would the bondholders need to raise the debt payment so that the stockholders would be indifferent between the two projects?

Explanation / Answer

For low Risk Project a.) Economic state Cash Flows Probability Estimated Cash Flows(Cash Flows*probability) Recession $50 30% $15 Normal $100 40% $40 Boom $150.00 30% $45 Total $100 Outstanding Debt to be repaid $80 After a year Project will produce $100 of cash from which debt can be repaid and the rest amount is equity. (i) Therefore, value of debt of Fun Toys after a year is equal to NIL, as from $100 all debt will be paid off. (ii) Fun toys equity = $100-$80 = $20 For High Risk Project b.) Economic state Cash Flows Probability Estimated Cash Flows(Cash Flows*probability) Recession $20 30% $6 Normal $90 40% $36 Boom $170.00 30% $51 Total $93 Outstanding Debt to be repaid $80 After a year Project will produce $93 of cash from which debt can be repaid and the rest amount is equity. (i) Therefore, value of debt of Fun Toys after a year is equal to NIL, as from $93 all debt will be paid off. (ii) Fun toys equity = $93-$80 = $13 c.) On behalf of shareholders management must select the low risk project as it is creating more wealth ($7) for them as compared to high risk project. d.) Bondholders should increase debt payments beyond $100 to make management indifferent towards the selection of projects.

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