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Practice problem--it's very helpful ~

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Department
Economics
Course Code
ECO359H5
Professor
Sun

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ECO359/2011UniversityofToronto
PracticeProblems5rSolution  DepartmentofEconomics
Page1of3
ECO 359 Practice Problems 5 –Suggested Solution
1. (DEBT OVERHANG)
(a) Air Ontario’s expected value is Dsrr/HrätErHräzLDtr/
If Mrs. Lulu gets involved and invests, Air Ontario’s expected value becomes
Dsrr/H:rätEä;ErH:räzFä;LDtr/EDsrr/Hä.
The NPV of the project for Mrs. Lulu is
028 LFDtr/E>:Dtr/EDsrr/Hä;FDtr/?,
since her initial investment is F = 20 million dollars, and she gets all the extra profit the
company makes >:Dtr/EDsrr/Hä;FDtr/?.
Mr. Lulu will invest if and only if 028 Rr, i.e.,
028 LFDtr/EDsrr/HäRr\äRrät
(b) No. The trick is in the word “extra” – if the union insists that workers have a legal claim of
face value B = $40M before Mr. Lulu, the “extra” profits for Mrs. Lulu’s investment is
:rätEräu;:Dsrr FDvr;Frät
:Dsrr FDvr;LDsz/
The cost of the project is $20M, which is above the $18M expected profits.
(c) Mr. Lulu is willing to invest if and only if is the NPV of the project is non-negative.
Suppose the union agrees that workers have a legal claim of face value $Û, the maximum
value of $Û workers can get satisfies:
028 LFDtr/E>:rätEräu;:Dsrr F$Û;Frät
:Dsrr Fvr;? Lr\$
ÛLuxä
So the union has to give up at least (40-36) = $4M.
(d) The maximal amount the union is willing to give up is such that the payoff to workers
with project and with debt relief is the same as the payoff to workers without project and
without debt relief. Let $Û be the minimum debt level the union would accept, then
rätHvr EräzHrL:rätEräu;H$
ÛE:sFrätFräu
;Hr\$
ÛLDsxM
So the maximum amount that Mrs. Lulu can ask the union to give up is (40-16) = $24M.
2. (DEBT OVERHANG)
(a)  LFvr Etrr:räsEä;Ftrr HräsL Fvr Etrrä
 Pr\äPrät
(b) For the owner-manager, the expected payoff before the project is:
räsH:trr Ftr;Erä{HrLszâ
The expected payoff with the investment project is
:räsEräv;H:trr Ftr;Erä{HrFvr Lwrä
The owner-manager is better off with the investment project
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Description
ECO3592011 UniversityofToronto PracticeProblems5HSolution DepartmentofEconomics ECO 359 Practice Problems 5 Suggested Solution 1. (DEBT OVERHANG ) (a) Air Ontarios expected value is ,IHH 0 HJ - H 0 Hz L ,JH If Mrs. Lulu gets involved and invests, Air Ontarios expected value becomes ,IHH 0 :HJ - ; - H 0 :Hz . ; L ,JH - ,IHH 0 . The NPV of the project for Mrs. Lulu is & L .,JH - ,JH - ,IHH 0 . ,JH , ; ? since her initial investment is F = 20 million dollars, and she gets all the extra profit the company makes >:,JH - ,IHH 0 . ,JH . ? Mr. Lulu will invest if and only if & 4 H, i.e., & L .,JH - ,IHH 0 4 H 4 HJ (b) No. The trick is in the word extra if the union insists that workers have a legal claim of face value B = $40M before Mr. Lulu, the extra profits for Mrs. Lulus investment is :HJ - HK ,IHH . ,LH . HJ ,IHH . ,LH L ,Iz; The cost of the project is $20M, which is above the $18M expected profits. (c) Mr. Lulu is willing to invest if and only if is the NPV of the project is non-negative.
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