Question

Petron​ Corporation's management team is meeting to decide on a new corporate strategy. There are four​ options, each with a different probability of success and total firm value in the event of​ success, as shown​ here: LOADING.... Assume that for each​ strategy, firm value is zero in the event of failure.​ Also, suppose Petron Corp. has debt with a face value of $ 42 million outstanding. For simplicity assume all risk is​ idiosyncratic, the​ risk-free interest rate is​ zero, and there are no taxes.

a. What is the expected value of​ equity, assuming Petron will choose the strategy that maximizes the value of its​ equity? What is the total expected value of the​ firm?

b. Suppose Petron issues equity and buys back its​ debt, reducing the​ debt's face value to $ 5 million. If it does​ so, which strategy will it choose after the​ transaction? Will the total value of the firm​ increase?

c. Suppose you are a debt​ holder, deciding whether to sell your debt back to the firm. If you expect the firm to reduce its debt to $ 5 ​million, what price would you demand to sell your​ debt?

d. Based on your answer to ​(c​), how much will Petron need to raise from equity holders in order to buy back the​ debt?

e. How much will equity holders gain or lose by recapitalizing to reduce​ leverage? How much will debt holders gain or​ lose? Would you expect​ Petron's management to choose to reduce its​ leverage?

table -

Strategy
	A	B	C		D
Probability of Success	100 %	81 %	62 %		43 %
Firm Value if Successful​ (in $​ million)	52	64	76		88

Answer 1

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