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ECO 359 Practice Problems 5

1. (DEBT OVERHANG) Air Ontario is in deep financial trouble. If everything goes well, next

period Air Ontario will be worth $100 million, but this event only occurs with probability 1/5.

With probability 4/5, the company is ultimately bankrupt -- it will be worth 0. Mrs. Lulu, a

smart investor from Macao, contemplates saving Air Ontario. She believes she can turn

around the business, but it would cost her F = $20 million. If she enters, Air Ontario is worth

$100 million with probability 1/5 + Âµ and 0 with probability 4/5 - Âµ. If Mrs. Lulu gets

involved, she would get all extra profits that the company makes. Assume there are no

discounting, no interest rates, and no taxes.

(a) For which values of Âµ does Mrs. Lulu's engagement in Air Ontario have a positive net

present value?

From now on assume Âµ = 0.3. All that stands between Mrs. Lulu and the company's

turnaround are the union. As it stands, workers have a legal claim of face value B = $40

million in the next period (you can think about this as a debt-obligation).

(b) If the union insists on workers' claims, would Mrs. Lulu get involved? Explain your

answer carefully.

(c) How much of their claim does the union have to give up so that Mrs. Lulu gets involved?

(d) Is there a reasonable amount of claim that Mrs. Lulu can ask the union to give up without

reducing workersâ€™ expected welfare?

2. (DEBT OVERHANG) Consider the following example of a manager owned firm: There are two

periods t = 1, 2, the owner-manager is risk-neutral, the interest rate is zero and capital markets

are competitive. The firm's cash-flows and assets in period 1 and 2 are as follows:

The firm has outstanding debt with face value B repayable in period t = 2. The firm's cash-

flow in period t = 2 will be 200 with probability 0.1 and 0 with probability 0.9.

At t = 1 the owner-manager has to decide whether to undertake a new project at cost F = 40

(which he has to pay out of his own pocket). If the project is undertaken, the future cash-flow

becomes 200 with probability 0.1 + Âµ and 0 with probability 0.9 - Âµ.

(a) Compute the NPV of the new project. For which values of Âµ is it positive?

From now on assume that Âµ = 0.4.

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