Reference no: EM132804460
Question - A company is currently in severe financial distress, and its ability to make future payments on outstanding debt is questionable. If the firm were forced into bankruptcy at this time, the common shareholders would get almost nothing and the bondholders are expected to suffer certain loss as well.
Although the company has limited financial resources, its cash flows are sufficient to support one of two mutually exclusive projects, each costing $15 million and having a 10-year expected life. These projects have the same market risk, but different total risk as measured by the variance of returns. Each project has the following after-tax cash inflows for 10 years: (Assume that the cash flow from either project will not change from year to year and there is no residual value left at the end of the 10th year.)
State of Annual Cash Inflows Nature Probability
Project A Project B
Failure 0.5 $3m $1m
Success 0.5 $3.5m $5m
Assume that both projects have the same market risk as the company's average project. The company's weighted average cost of capital is 15%.
Required -
a. What is the expected annual cash inflow from each project?
b. Which project has the greater total risk as measured by standard deviation of cash inflows?
c. Calculate the NPV of the project under different scenario and determine which project would the shareholder choose?
d. Which project would the bondholders prefer to see management select? Why?
e. If the choices conflict, what "protection" do the bondholders have against the company's making a decision that is contrary to their interests?
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