A firm has £ 100m cash in hand and a debt obligation of £ 100m due at the end of the year. With this amount of cash, it can take one of two projects, A or B, which cost £ 100m each. At the end of the year, project A pays £ 120m if the economy is favourable and £ 60m if the economy is unfavourable. In contrast, project B pays £ 101m regardless of the state of the economy. Assume that the firm is not able to raise any additional funds. Further, assume that investors are risk-neutral, there are no taxes and no direct costs of bankruptcy, the risk-free rate of interest is nil, and the probability of each state of the economy is equal. i. What is the NPV of each project? ii. Which project will equity holders want the firm's manager to take? Explain. iii. Calculate the magnitude of the agency cost of risk shifting.
A firm has £ 100m cash in hand and a debt obligation of £ 100m due at the end of the year. With this amount of cash, it can take one of two projects, A or B, which cost £ 100m each. At the end of the year, project A pays £ 120m if the economy is favourable and £ 60m if the economy is unfavourable. In contrast, project B pays £ 101m regardless of the state of the economy. Assume that the firm is not able to raise any additional funds. Further, assume that investors are risk-neutral, there are no taxes and no direct costs of bankruptcy, the risk-free rate of interest is nil, and the probability of each state of the economy is equal. i. What is the NPV of each project? ii. Which project will equity holders want the firm's manager to take? Explain. iii. Calculate the magnitude of the agency cost of risk shifting.
Chapter1: Financial Statements And Business Decisions
Section: Chapter Questions
Problem 1Q
Related questions
Concept explainers
Cost of Debt, Cost of Preferred Stock
This article deals with the estimation of the value of capital and its components. we'll find out how to estimate the value of debt, the value of preferred shares , and therefore the cost of common shares . we will also determine the way to compute the load of every cost of the capital component then they're going to estimate the general cost of capital. The cost of capital refers to the return rate that an organization gives to its investors. If an organization doesn’t provide enough return, economic process will decrease the costs of their stock and bonds to revive the balance. A firm’s long-run and short-run financial decisions are linked to every other by the assistance of the firm’s cost of capital.
Cost of Common Stock
Common stock is a type of security/instrument issued to Equity shareholders of the Company. These are commonly known as equity shares in India. It is also called ‘Common equity
Question
A firm has £ 100m cash in hand and a debt obligation of £ 100m due at the end of the year. With this amount of cash, it can take one of two projects, A or B, which cost £ 100m each.
At the end of the year, project A pays £ 120m if the economy is favourable and £ 60m if the economy is unfavourable. In contrast, project B pays £ 101m regardless of the state of the economy. Assume that the firm is not able to raise any additional funds. Further, assume that investors are risk-neutral, there are no taxes and no direct costs of bankruptcy, the risk-free rate of interest is nil, and the probability of each state of the economy is equal.
i. What is the NPV of each project?
ii. Which project will equity holders want the firm's manager to take? Explain.
iii. Calculate the magnitude of the agency cost of risk shifting.
iv . Assume that the firm's manager works on behalf of the equity holders. Should debtholders engage in debt forgiveness and accept a lower debt obligation equal to £ 82m? Explain.
Expert Solution
This question has been solved!
Explore an expertly crafted, step-by-step solution for a thorough understanding of key concepts.
This is a popular solution!
Trending now
This is a popular solution!
Step by step
Solved in 4 steps
Knowledge Booster
Learn more about
Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, accounting and related others by exploring similar questions and additional content below.Recommended textbooks for you
Accounting
Accounting
ISBN:
9781337272094
Author:
WARREN, Carl S., Reeve, James M., Duchac, Jonathan E.
Publisher:
Cengage Learning,
Accounting Information Systems
Accounting
ISBN:
9781337619202
Author:
Hall, James A.
Publisher:
Cengage Learning,
Accounting
Accounting
ISBN:
9781337272094
Author:
WARREN, Carl S., Reeve, James M., Duchac, Jonathan E.
Publisher:
Cengage Learning,
Accounting Information Systems
Accounting
ISBN:
9781337619202
Author:
Hall, James A.
Publisher:
Cengage Learning,
Horngren's Cost Accounting: A Managerial Emphasis…
Accounting
ISBN:
9780134475585
Author:
Srikant M. Datar, Madhav V. Rajan
Publisher:
PEARSON
Intermediate Accounting
Accounting
ISBN:
9781259722660
Author:
J. David Spiceland, Mark W. Nelson, Wayne M Thomas
Publisher:
McGraw-Hill Education
Financial and Managerial Accounting
Accounting
ISBN:
9781259726705
Author:
John J Wild, Ken W. Shaw, Barbara Chiappetta Fundamental Accounting Principles
Publisher:
McGraw-Hill Education