Your company's management team is considering three corporate strategies. The probability of success and total firm value next year in the event of success of the three strategies are shown below:
Strategies A B C
Probability of success 100% 70% 50%
Firm value if successful $70M $90M $115M
Assume that for each strategy, firm value is zero next year in the event of failure. Assume also that all risk is idiosyncratic and the risk-free rate is zero. There are no taxes, no bankruptcy costs, and no asymmetric information.
a) Which strategy results in the highest firm value today?
Your company currently has debt of $50M due next year. Suppose the management team will choose the strategy that leads to the highest equity value today.
b) Which strategy will management choose?
c) What is the equity value today? What is the total firm value today?
d) Suppose the company issues equity and buys back its debt, reducing the debt due next year to $10M.
i. What strategy will management choose after the transaction?
ii. What will be the total value of the firm after the transaction?
e) Suppose you own 1% of the company's debt. You are deciding whether to sell your debt back to the firm. If you expect the firm to reduce its debt to $10M, what price would you demand to sell your debt?
f) Based on your answer to (e), how much will the company need to raise from equity holders in order to buy back the debt?
g) How much will equity holders gain or lose by recapitalizing to reduce leverage? How much will debt holders gain or lose?
h) Based on your answer to (g), would you expect your company to choose to reduce its leverage?
$115M