Question

Lux Enterprise is considering an investment project that generates a cash flow of $1,800,000 next year if the economy is favorable but generates only $900,000 if the economy is unfavorable. The probability of favorable economy is 55% and of unfavorable economy is 45%. The project will last only one year and be closed after that. The cost of investment is $1,300,000 and Lux Enterprise plans to finance the project with $350,000 of equity and $950,000 of debt. Assuming the discount rates of both equity and debt are 0%. What is the expected cash flow to Lux Enterprise s creditors if the enterprise invests in the project?

		$950,000
		$850,000
		$927,500
		$0
		$900,000

Answer 1

A	B	C	D	E	F	G	H	I
2
3		Debt Amount	$950,000
4
5		Creditors are paid first, then remaining amount is distributed to equity owners.
6		Since the discount rate of debt is 0%, therefore cash flow to creditors after one year
7		should be $950,000 if the project is worth higher than $950,000.
8		However, if the project value is lower than $950,000 then the cash flow to creditor will be the project value.
9
10		Status	Probability	Project Value	Cash Flow to Creditor
11		Favourable	55%	$1,800,000	$950,000
12		Unfavourable	45%	$900,000	$900,000
13
14		Expected Cash flow to creditors	=0.55*$950,000+0.45*$900,000
15			$927,500	=SUMPRODUCT(D11:D12,F11:F12)
16
17		Hence cash flow to creditors is	$927,500
18		Thus the third option is correct.
19