Fun Toy Corporation estimates that there is twenty percent chance of a recession economy next year, a 50% chance of the normal economy next year, and a 25% chance of a boom economy next year. The corporation will exist till the end of next year and then it will cease to exist. Spartan has $80 of debt that should be repaid in next year. Assume a 0% discount rate for all cash flows (in other words, there is no discounting).
(a) Fun Toy has a low risk project that yields a cash flow of $70 in a recession, $100 in a normal economy, and $130 in a boom. If Fun Toy choices this low risk project:
(i) What is value of Fun Toy’s debt?
(ii) What is value of Fun Toy’s equity?
(b) Fun Toy has a high risk project that yields a cash flow of $30 in a recession, $100 in a normal economy, and $160 in a boom. If Fun Toy selects this high risk project:
(i) What is value of Fun Toy’s debt?
(ii) What is value of Fun Toy’s equity?
(c) Which project will Fun Toy select? Given your answers to (a) and (b), when Fun Toy sells the bonds would it like to comprise a covenant that would prohibit it from taking the high-risk project? Describe your answer.