Reference no: EM133056943
Super Company Inc. needs to spend $100,000 at year 0 to develop a new product. The demand for product is uncertain at year 0. At year 1, Super Company and prospective investors will learn whether the demand for the product is high (probability 1/2) or low (probability 1/2). To continue operations after demand is observed, Super Company must spend an additional $60,000 at year 1 to market the product. If Super Company markets the product, the product will generate cash flow in year 2 of $360,000 if demand is high and $120,000 if demand is low. The project will generate no additional cash flow after year 2. Assume that Super Company can only raise funds at year 1 by issuing new equity. Super Company owns no other assets. Assume no discounting, no taxes, and no bankruptcy costs
(a) Assume that Super Company intends to finance the original $100,000 at year 0 by issuing senior debt that matures in year 2. Will Super Company be able to do so? If it can, calculate the face value of the senior debt. Calculate the value of Super Company's equity right after it raises the $100,000 by issuing senior debt. Hint: The face value of the debt must be at least $100,000 for creditors to break even on average.
(b) Suppose that the face value of debt is as you calculated in part a. Assume that creditors could get together and renegotiate the face value of the debt in the case of low demand. If demand is low, will the creditors agree to renegotiate their debt? If so, what is minimum amount by which they will be willing to reduce the face value of the debt when demand is low?
(c) Suppose that creditors anticipate that they will renegotiate the face value of debt in the case of low demand by the amount you computed in part b. What is the face value of the debt that Super Company must issue at year 0 in order to raise the $100,000 it needs to develop the new product? What is the value of Super Company's equity at year 0, right after the company raises the $100,000 it needs to develop the product? Briefly explain why the face value of the debt is higher or lower than in part a and why the value of the equity is higher or lower than in part a.
(d) Now, assume that in the case of high demand Super Company can spend $60,000 to market the product at year 1 in one of two different mutually exclusive ways: • Safe marketing, which yields a CF of $360,000 at year 2 • Risky marketing, which yields a cash flow at year 2 of either $1.2 million, with probability 0.2, or $0, with probability 0.8. Super Company plans to finance as much as possible of the initial investment at year 0 by issuing senior debt and the rest by issuing equity. Up to how much of the initial $100,000 can Super Company finance with senior debt? Assume in this part of the question that creditors cannot renegotiate Super Company's debt in year 1 when demand is low.