Solutions_wk11 - Solutions Tutorial Week 11 Chapter 18 6....

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Solutions – Tutorial Week 11 Chapter 18 6. a. SOS stockholders could lose if they invest in the positive NPV project and then SOS becomes bankrupt. Under these conditions, the benefits of the project accrue to the bondholders. b. If the new project is sufficiently risky, then, even though it has a negative NPV, it might increase stockholder wealth by more than the money invested. This is a result of the fact that, for a very risky investment, undertaken by a firm with a significant risk of default, stockholders benefit if a more favorable outcome is actually realized, while the cost of unfavorable outcomes is borne by bondholders. c. Again, think of the extreme case: Suppose SOS pays out all of its assets as one lump-sum dividend. Stockholders get all of the assets, and the bondholders are left with nothing. These conflicts of interest are severe only when the company is in financial distress. Adherence to a moderate target debt ratio limits the conflicts. 9. Other things equal, the announcement of a new stock issue to fund an investment project with an NPV of $40 million should increase equity value by $40 million (less issue costs). But, based on past
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This note was uploaded on 05/12/2010 for the course COMMERCE finc at University of Sydney.

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Solutions_wk11 - Solutions Tutorial Week 11 Chapter 18 6....

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