Question

Company A just sold their most profitable division for $100 million in cash. The company has a market value balance sheet shown below (in millions). The bonds outstanding have an annual payment that is due in one month that equals 10% of the book value (400 x .10 = $40 million). Note: If the payment is not made on time it accrues a penalty of 1% or $400,000 per month unpaid:

Assets BV MV Liabilities BV MV

Cash $100 $100 LT bonds $400 $100

Fixed Asset $900 $0 Equity $600 $0

Total $1,000 $100 Total $600 $100

(a) What is the stockholders best move right now in the above scenario? (Assume there are no restrictions on corporate actions and there are no agency problems because the board and management of the company will take actions in the stockholders’ best interest).

(b) The board is considering using the $100 million to sponsor a music festival that might be a success or a failure. The expected payoffs are as follows:

Probability Payoff

5% $500

25% $200

50% $50

20% $0

(i) What is the net present value of the music festival? (Assume the investment is immediate (time 0) and the payoff is one year from now (time 1) and the discount rate is 20%)

(ii) Update the market value balance sheet above to reflect the expected market values in one year if the company takes the project (ignore adjusting for owed interest on the debt)?

(c) Instead of the music festival, the company has the opportunity to participate in a government sponsored program that guarantees a return of 10%. This program requires minimum participation of $200 million that is paid in cash and the discount rate is 5%.

(i) If the company issues $100 million in new equity to fund the obligation, what are the expected market values on the balance sheet (ignore the interest payment on the debt)

(ii) The company issues $100 million in debt at an interest rate of 20% to fund the opportunity, does this help the stockholders position? (Note: consider all the amounts due the debtholders)

Answer 1

Answer:

a) Stockholders best move right now in the given scenario is to pay 10% of book of bonds as annual payment which is outstanding i.e. $ 40 million .

Reasons:

1. It does not hamper the cash position much as it is annual obligation to pay bondholders.

2. Even after outstanding annual payment company has $ 60 million in hand as return for stockholders which it can use to pay them or retain it for further expansion

3. If company pay it on time then , penalty will be avoided.

b) The board is considering using the $100 million to sponsor a music festival that might be a success or a failure

Expected Payoff calculation :

Probability	Payoff $ million	Calculation	Expected Payoff $ million
5%	500	= 5% x 500	= 25
25%	200	= 25% x 200	= 50
50%	50	= 50% x 50	= 25
20%	0	= 20% x 0	= 0
	Total		100

i)

Net present value of the music festival? (Assume the investment is immediate (time 0) and the payoff is one year from now (time 1) and the discount rate is 20%)

Year	Particulars	$ Million	Discount Factor @ 20%	Discounted Cash Flow
0	Investment	( 100 )	1	= 1 x (100 )= (100 )
1	Expected Payoff	100	0.8333	= 0.8333 x 100 = 83.33
	NPV			( 16.67 )

NPV is - $ 16.67 million

ii) Market value balance sheet above to reflect the expected market values in one year if the company takes the project (ignore adjusting for owed interest on the debt)

Liabilities	Calculations	MV $ Million	Assets	Calculations	MV $ Million
Equity	no change	0	Fixed Asset	no change	0
LT Bonds	no change	100	Investment in Project music festival	$ 100 million	100
			Cash	= $ ( 100-100 ) million	0
Total		100	Total		100

c) Instead of the music festival, the company has the opportunity to participate in a government sponsored program that guarantees a return of 10%. This program requires minimum participation of $200 million that is paid in cash and the discount rate is 5%.

(i) If the company issues $100 million in new equity to fund the obligation, what are the expected market values on the balance sheet (ignore the interest payment on the debt)

Liabilities	Calculations	MV $ Million	Assets	Calculations	MV $ Million
New + Old Equity	= $ 100 million + 0	100	Fixed Asset	no change	0
LT Bonds	no change	100	Investment in Project government program	=$ 200 million	200
			Cash	= $ ( 100+100 - 200 ) million	0
Total		200	Total		200

(ii) The company issues $100 million in debt at an interest rate of 20% to fund the opportunity, does this help the stockholders position? (Note: consider all the amounts due the debt holders)

Liabilities	Calculations	MV $ Million	Assets	Calculations	MV $ Million
Equity	no change	0	Fixed Asset	no change	0
LT Bonds 10% of $ 100 million 20% of $ 100 million	= $ ( 100 + new 100 )	200	Investment in Project government program	= $ ( 100 +100 ) million	200
			Cash	= $ ( 100+100 -200 ) million	0
Total		200	Total		200

Here we need to understand the obligations :

1. 20% interest on bonds $ 40 million on every year till the period of bonds

2. It gives negative impact on the market value of stock of the company as it increases the obligation at 20% i.e $ 40 million and return on investment be 10% on $ 200 million i.e $ 20 million which is lesser than the liability