What face value do they need to set

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Reference no: EM132179955

Question - A firm wants to raise $30m to invest in a project. After the $30m investment, the firm will have a total asset value of $100m. The risk-free rate is 10%, and the volatility of the return on assets is 20%.

(a) If the firm wants to issue 10-year debt (zero-coupon), what face value do they need to set?

(b) Now imagine that the bond has been issued (with a face value that you found in the previous part), but that the stockholders can choose an action that changes the nature of the cash flows. Namely, the shareholders can: (1) do nothing, (2) take an action that will immediately reduce the value of the assets from $100m to $99m and at the same time raise the volatility to 30%. Will the shareholders take this action?

(c) If the bondholders anticipated this possibility when they were offered to invest in the company, what do you expect they would have demanded as a face value?

(d) Would the shareholders have an incentive to include a covenant prohibiting the action in part (b) above?

Reference no: EM132179955

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