Question

Use the information below answer questions 1-3: • Management is considering five different projects (Alpha, Beta, Delta, Gamma, Theta) • There are no cash flows to consider besides the initial cash outlay and the payoff • All payoffs are expected in two years Project Alpha Beta Delta Gamma Theta Probabilty [Failure] 80% 60% 50% 40% 20% Payoff [Success] $ 320 $ 280 $ 400 $ 150 $ 150 Payoff [Failure] $ 280$ $ 200 $ $ 190 $ $ 140 $ $ 120 $ Initial Outlay (200) (200) (200) (100) (100) • Management's primary objective is to maximize NPV • Management can pursue multiple projects as long as the creditor is willing to make the loan The creditor will not allow management to pursue any project, or combination of projects, that put the creditor's principle at risk • The creditor offers the company $200M today and expects no payments over the next 24 months, but does expect $242M to be repaid in full at the end of year two 1. The creditors offer is best described as a(n): a. Fully Amortizing Loan b. Zero Coupon Bond c. Interest Only Loan d. Municipal Bond e. Sinking Fund 2. Which project(s) would management most likely want to pursue, but creditors not allow: a. Beta b. Delta c. Gamma d. Beta, Delta e. Delta, Gamma, Theta

Answer 1

Ans 1 Option b Zero Coupon Bond

Zero Coupon Bond is a bond where there are no intermediate coupon payments . The entire principal amount along with interest is repaid at the maturity of the loan

Ans 2 Option a Beta, Option b Delta , Option c Gamma

Although Beta,Delta and Gamma generates positive NPV , these projects are fully leveraged and no equity risk capital is involved .

Explanation and Working

Project Name	Initial Outlay	Probability of Failure	Probability of Success	Payoff Failure	Payoff Success	Expected Value at Time -End of year 2	Less Creditors Payment -End of year 2	Expected Value -Creditors Repayment	Equity Risk Capital invested	NPV	Leverage Ratio Debt /Capital
Beta	-200.00	0.80	0.20	280.00	320.00	288.00	242.00	46.00	-	Positive	1.00
Delta	-200.00	0.50	0.50	190.00	400.00	295.00	242.00	53.00	-	Positive	1.00
Gamma	-100.00	0.40	0.60	140.00	150.00	146.00	121.00	25.00	-	Positive	1.00
Theta	-100.00	0.20	0.80	120.00	150.00	144.00	121.00	23.00	-	Positive	1.00
Beta,Delta	-400.00					583.00	242.00	341.00	200.00	Positive	0.50
Delta,Gamma,Theta	-400.00					585.00	242.00	343.00	200.00	Positive	0.50