Question

1. (30 points) Bedrock Company has $70 million in debt and $30 million in equity. The debt matures in 1 year and has a 10% interest rate, so the company is promising to pay back $77 million to its debtholders 1 year from now. The company is considering two possible investments, each of which will require an upfront cost of $100 million. Each investment will last for 1 year, and the payoff from each investment depends on the strength of the overall economy. There is a 50% chance that the economy will be weak and a 50% chance it will be strong. Here are the expected payoffs (all dollars are in millions) from the two investments: Payoff in 1 Year If the Economy Is Weak $90.00 Payoff in 1 Year If the Economy Is Strong $130.00 170.00 Expected Payoff Investment L Investment H $110.00 110.00 50.00 Note that the two projects have tlhe same expected payoff, but Project H has higher risk. The debtholders always get paid first and the stockholders receive any money that is available after the debtholders have been paid.

Answer 1

Part a)

The expected payoff to the firm's debtholders and stockholders is calculated as below:

Expected Payoff to Debtholders = Current Value of Debt*(1+Interest Rate) = 70*(1+10%) = $77 million

Expected Payoff to Stockholders = (Payoff in Year 1 if Economy is Weak - Expected Payoff to Debtholders)*Probability of Weak Economy + (Payoff in Year 1 if Economy is Stock - Expected Payoff to Debtholders)*Probability of Strong Economy = (90 - 77)*50% + (130 - 77)*50% = $33 million

_____

Part b)

The expected payoff to the firm's debtholders and stockholders is calculated as below:

Expected Payoff to Debtholders = Probability of Weak Economy*Payoff in Year 1 if Economy is Weak + Probability of Strong Economy*Value of Debt*(1+Interest Rate) = 50%*50 + 50%*70*(1+10%) = $63.5 million

Expected Payoff to Stockholders = (Payoff in Year 1 if Economy is Weak - Expected Payoff to Debtholders)*Probability of Weak Economy + (Payoff in Year 1 if Economy is Stock - Expected Payoff to Debtholders)*Probability of Strong Economy = (50 - 50)*50% + (170 - 77)*50% = $46.50 million

_____

Notes:

If the economy is weak, the entire amount of $50 million will be paid to debtholders. Therefore, stockholders will not get anything in case of a weak economy. However, if the economy is strong, the stockholders will receive the amount ($93 million) that will be left after the debtholders have been paid off.

_____

Part c)

Based on the calculations performed in Part a and Part b, it can be clearly seen that debtholders are better off with investment L. In other words, debtholders would prefer investment L because it is less risky and provides them with a higher return/payoff.

_____

Part d)

Project H provides better return/payoff/cash flow (which is $46.50 million) to shareholders when compared with Project L (which is $33 million). It is because of this reason that managers (acting on behalf of shareholders) may prefer Project H over Project L even when Project H carries higher risk.

_____

Part e)

Restrictive covenants can be included in the bond/loan/debt agreements by the debtholders. Such covenants can restrict managers from procuring more debt, offering higher interest rates to attract more debt, paying dividends to shareholders, undertaking risky investments/projects (such as investment H in this case) and so on.