Consider the case of Ajax Manufacturing which just completed an R&D project on widgets that required a $70 million bond obligation. The R&D effort resulted in an investment opportunity that will cost $75 million and generate cash flows of $85 million in the event of a recession ( prob. = 20%) and $150 million if economic conditions are favorable ( prob. = 80%). What is the NPV of the project assuming no taxes, no direct bankruptcy costs, risk neutrality, and a risk-free interest rate of zero? Can the firm fund the project if the original debt is a senior obligation that doesn’t allow the firm to issue additional debt?
Assume now that if Ajax Manufacturing uses a more capital-intensive manufacturing process, it can produce a greater number of widgets at a lower variable cost.
Given the greater fixed costs, the cash flows are only $5 million in an unfavorable economy with the capital-intensive process but are $170 million in a favorable economy. Hence, equity holders would receive $100 million in the good state of the economy ($170 million ? $70 million) and zero in a recession because $5 million is less than the $70 million debt obligation. Can the firm issue equity to fund the project?