Reference no: EM132376924

An owner-manager has some assets that are expected to generate a liquidation value in one year of $250 with a 60% probability and $175 if things go badly with probability of 40%.  The payoffs assume the assets are properly maintained. The firm has debt claims that require it to pay debt holders $198 in one year. There is only one debt holder (a bank). Assume investors are risk neutral and everybody expects a 10% return on a one-year investment regardless of risk level.

The firm has $10 of cash on hand. To maintain the assets, the entire $10 must be spent. If it is not spent on maintenance, the value of the assets will drop to $235 in the good state and $160 in the bad state. It turns out that the debt contract does not exclude dividend payments in any circumstance. 

The firm can do one of two things:

Pay a $10 dividend and do nothing on maintenance or Pay no dividend and spend the money on maintenance

If the firm were all equity, would the manager maintain the assets

What will the manager do? Maintain assets or pay the dividend - back your answer with numbers.

If the firm had a covenant that restricted dividends at elevated debt to equity levels, would the firm invest in maintenance of firm assets? Why?

If the dividend were allowable, could the lenders and the managers of the firm work out a deal that would make both better off than in the outcome where the asset values are not maintained? What would the deal look like?