60.1K

Verified Solution

Link Copied!

Credit Rationing: Here are Multi-Universal's Project Payoffs on a $100m. investment: Cash Flow if State of the Economy is Good Bad Probability of Expected Good Value Project A $130 million 0.8 $114 $50 million million Project B $150 million $50 million 0.2 $ 70 million Assume that investors are risk neutral and that the risk-free required rate of return is zero. Suppose bondholders assume that the firm will choose Project A. Then the stated interest rate will be 12.5% because at this stated rate, the expected return to bondholders will be exactly 0%, which is the equilibrium risk-free required rate of return. This can be seen from the table below: Project A Payoff to project Payoff to bondholders Payoff to equityholders 130 112.5 17.5 Good State (p=0.8) Bad State (p=0.2) 50 50 0 Expected Payoff 114 100 14 However, if bondholders make this assumption and require a stated rate of interest of only 12%, stockholders have an incentive to choose project B. This can be seen by comparing the above payoff matrix with the following payoff matrix detailing payoffs from project B: Project B Payoff to project Payoff to bondholders Payoff to equityholders However, if bondholders make this assumption and require a stated rate of interest of only 12%, stockholders have an incentive to choose project B. This can be seen by comparing the above payoff matrix with the following payoff matrix detailing payoffs from project B: Project B Payoff to project Payoff to bondholders Payoff to equityholders 150 112.5 37.5 Good State (p=0.2) 50 50 0 Bad State (p=0.8) Expected Payoff 70 62.5 7.5 Complete the payoff matrix from the Credit Rationing Problem with a 0% risk-free required rate of return for the case where the bondholders assume project B will be chosen. In particular, answer the question as to which project equity holders will choose under this assumption. Credit Rationing: Here are Multi-Universal's Project Payoffs on a $100m. investment: Cash Flow if State of the Economy is Good Bad Probability of Expected Good Value Project A $130 million 0.8 $114 $50 million million Project B $150 million $50 million 0.2 $ 70 million Assume that investors are risk neutral and that the risk-free required rate of return is zero. Suppose bondholders assume that the firm will choose Project A. Then the stated interest rate will be 12.5% because at this stated rate, the expected return to bondholders will be exactly 0%, which is the equilibrium risk-free required rate of return. This can be seen from the table below: Project A Payoff to project Payoff to bondholders Payoff to equityholders 130 112.5 17.5 Good State (p=0.8) Bad State (p=0.2) 50 50 0 Expected Payoff 114 100 14 However, if bondholders make this assumption and require a stated rate of interest of only 12%, stockholders have an incentive to choose project B. This can be seen by comparing the above payoff matrix with the following payoff matrix detailing payoffs from project B: Project B Payoff to project Payoff to bondholders Payoff to equityholders However, if bondholders make this assumption and require a stated rate of interest of only 12%, stockholders have an incentive to choose project B. This can be seen by comparing the above payoff matrix with the following payoff matrix detailing payoffs from project B: Project B Payoff to project Payoff to bondholders Payoff to equityholders 150 112.5 37.5 Good State (p=0.2) 50 50 0 Bad State (p=0.8) Expected Payoff 70 62.5 7.5 Complete the payoff matrix from the Credit Rationing Problem with a 0% risk-free required rate of return for the case where the bondholders assume project B will be chosen. In particular, answer the question as to which project equity holders will choose under this assumption

Answer & Explanation Solved by verified expert

See Answer