The Cost Associated with the Asset Substitution Problem Unoit Industries has two mutually exclusive €50 million investment opportunities, R and S, which it plans to fund with debt. Project S pays off €60 million for certain, and project R pays off only €20 million when the economy is poor and €90 million when the economy is good. For simplicity, assume that investors are risk neutral. a What is the NPV of each project, assuming the economy is equally likely to be favourable or unfavourable, and the discount rate is 0 per cent? Suppose Unoit can raise the £50 million by issuing a bond with a face value of £50 million (because the lender naively believes the company will take the safe project). b Which project will Unoit shareholders prefer? c What is the expected pay-off to the naive lenders? Now suppose the debt holders are sophisticated. d What must the debt holders be promised, which project will the company select, and what do the shareholders gain? Answer: a NPV = 0.5(£60 million) + 0.5(£60 million) - £50 million = £10 million NPVR = 0.5(£20 million) + 0.5(£90 million) - £50 million = £5 million b With naive debt holders, the pay-off to equity holders with project S is 0.5(£60 million - £50 million) + 0.5(£60 million + £50 million) = £10 million The pay-off to equity holders with project R is 0.5 (£0) + 0.5(£90 million - £50 million) = £20 million Thus, if the firm's managers act in the interest of shareholders, they will choose project R. c d Given that project R is chosen, the naive debt holders do not receive full payment in the poor state of the economy. On average, they receive only 0.5(£20 million) + 0.5(£50 million) = £35 million. Sophisticated lenders, aware of both projects, will realize that equity holders have an incentive to invest in the riskier project. For the £50 million loan, they will require a promised future payment of £80 million. With the selection of project R, they receive an expected pay-off of 0.5(£20 million) +0.5 (£80 million) = £50 million, so on average they recover their investment. In this situation, the pay-off to equity holders selecting project R is 0.5(0) + 0.5(£90 million - £80 million) = £5 million. The pay-off is zero if project S is selected, because in neither state of the economy can the £80 million obligation be met Thus equity holders will select proiect R despite its lower NPV If
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
In this question they say that lenders would need a promised payment of 80 million. How is this solved for in question d. How can i derive this mathmatically
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