But due to its positive npv debt holders would

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But due to its positive NPV, debt-holders would takeover the firm with more valuable assets. In other words, the project would not save the shareholders but it would make [141]
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debt-holders better off. However, since the management forgoes the project, debt-holders would not get the benefit. The firm has a debt obligation of 100 due at t=1. The current asset value is 95; that is, the firm is under financial distress. The management believes that the asset value is most likely to remain at 95 at t=1 and the firm would go under. The firm has an investment project at the present time that requires 10 as initial investment. The value of the project has a 50% chance to become 13 (that is, a gain of 3) and equal chance to become 9 (that is, a loss of 1). The WACC for the project is 5 percent. Clearly, the NPV of the project is positive. The expected cash flow at time 1= 13(.50)+9(.50)=11 NPV= -10+ 11/(1+.05)=.48 Using the calculator: [-10 CF J , 11 CF J , 5 I/YR, orange key NPV]=.48 Although the NPV is positive, the management may choose not to do the project because if it succeeds, the value of the firm is equal to 95+3=98, which is still not enough to cover the debt to rescue shareholders. If it fails, the value of the firm is equal to 95-1=94 and shareholders are wiped out. Apparently, doing the project does not benefit shareholders. If the management does not do the project and the firm fails at t=1 as predicted, debt- holders take over the firm with a value of 95. However, if the management does the project, there are two outcomes for the debt-holders: a. The project succeeds and debt-holders receive 98; b. The project fails and debt-holders receive 94. The expected cash flow for debt holders at t=1 is equal to 96 (=.50(98)+.50(94)), which is higher than 95. Apparently, doing the project would benefits debt-holders. Since the management is unlikely to do the project because it doesn’t help the shareholders, debt- holders suffer a loss. An agency problem that may occur in general condition: Replacing existing assets with more risky assets Managers have the incentive to replace the existing assets with more risky ones. More risky assets, if turn out successful, would have a higher value than the safer ones. As discussed above, if manager create additional value for the firm, shareholders usually receive most of the benefit because bondholders still receive the same interest income. On the other hand, if the more risky assets turn out sour, it would have a lower value than the safer ones. Consequently, if the more risky assets fail and the firm goes under, bondholder would take over a less valuable firm. Shareholders do not suffer the consequence of a lower asset value because if the bondholders takes over the firm; it doesn’t matter to the shareholders how low the asset value goes. Since shareholders receive most of the potential benefits and debt-holders assume most of the potential losses, the value of debt decreases and the value of equity increases. In other words, there is a transfer of wealth from debt-holders to. Since managers act on behalf of the [142]
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V D/V U V L V V D
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Christopher Reinemann
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