1. Revisiting assumptions about the Scooter project CF
We assum the Scooter CF is a random walk. This means that at any point, expect
or negative, the project will be abandoned. In the project simulation and decision t
Obvously, this isn't the only plausible assumption. At the other extreme, the CF co
distribution.) In that case, a negative CF in any period, is only a temporary set bac
fallen by the current loss. A project like this (with a positive expected CF) will neve
survive to the next period. With bad luck resulting in a string of negative CF, the pr
achieved by holding liquid assets in the balance sheet, borrow, or raise more equity
crisis of 2008. But even in that case, if the distribution of future CF is promising, eq
sure to happen once in a while) must be taken into account.
2. Assumption about CF and debt financing.
We take on the case of a stationary distribution. Obviously, the firm can borrow as
happen. Any time CF falls below interest expense, the firm will reach into its cash
with a stationary distribution of CF will require a low risk premium on debt, but not z
possibility, however remote.
The non-stationary case, with a possibility of expected future CF falling to any low
always looms, and risk premiums on debt must be significant.
In reality, CF distributions are somewhere in between the two extreme cases. Rea
Therefore, for the sake of a realistic yet simple illustration, we choose a random wa
rate on debt vs. the
rate on debt.
Suppose the debt is issued at par value and hence, the coupon rate equals the yie
promised payments will be made, that is, no bankruptcy. Since bankruptcy is a pos
When we compute the market value of the debt, we must take the expected interes
that debt. The required rate on the debt is based on its systematic risk. The beta o
The required rate on a firm's debt will be higher the greater the debt ratio. Notice th
expected interest expense, not the required rate. However, the greater REQUIRED
to economic conditions increases, that is, the beta of the debt grows with the debt r
The wedge between the debt coupon rate and required rate must be a part of any
relative to the required rate on debt, so that debt holders will expect to earn the req
In the worksheet 'decision tree and coupon rates' we examine whether the assump