A struggling company currently has a total value of $700,000. It owes $500,000 from debt financing (assume these are loans from the bank if you wish). The value of the company to the owners is the difference between the total value and the amount owed to the debt holders. What is the current value of the firm to the owners?

Now assume that a project is presented to the owners that results in a loss of the entire value of the company with a probability of 50% and results in a gain in value of $500,000 with probability 50% (resulting in a total value of $1,200,000). Show that this in expectation decreases the firm

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Beverley SmithLv2

16 Jun 2019

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The net worth of a firm is equal to the value of the firm's assets (things the firm owns) minus the value of the firm's liabilities (things the firm owes).

In our model, the representative firm owns capital, K. One way to value capital is at replacement cost. Simply put, this means the value of capital is the value of the investment goods the firm would have to buy to replace its entire capital stock.

To replace the capital stock, the firm would need I = K units of investment goods. This has a nominal value of P K. We have not discussed the liabilities of the firm in class. A substantial amount of the money owed by firms is in the form of loans owed to banks and bonds. Both loans and bonds are promises by the firm to pay a fixed amount of dollars. Assume the total fixed amount of dollars the firm has promised to pay is B.

This means that the net worth of the firm is given by NW = P KB 1 What happens to the net worth of firms in response to the bank closures in i)?

jadellama35

This assignment requires the following knowledge: For k different events, if the probability that each of them happens is p (0 < p < 1) and all events happen independently, the probability that all events happen together is p^k.
1. Five firms, namely A, B, C, D and E, issue discounted bonds with face value $1,000 and maturity 5 years in the market. All firms are pretty risky and each of them has a chance of 0.5 of collapse during the five years (thus bankrupted and can not pay back the bond accordingly). The bonds are all sold at an interest rate of 50% (the value is not surprising due to the extremely high risk of default).
(1) What is the present value of the bond given the interest rate, the face value and the maturity? Hint: we temporarily do not consider the issue of default.
(2) Say now you buy one bond from each of the five firms, what is the total amount you lend out today? Eventually only one firm does not fail and pays back the bond, what is the money you collect back 5 years later? You gain or loss in this case? If more than one firm pays back the bond, will you get more money back?
(3) What is the chance (probability) that you get nothing back assuming that firms fail independently? Together with the answer in (2), is it a good deal to buy one bond from each of the five firms?
(4) Repeat (2) and (3) with the only difference that now you buy 5 bonds from a single firm.
(5) Now we assume that the five firms all have similar businesses in Greece (and those are their only businesses), therefore, all firm fail together if the economy in Greece fails. Will you answer in (3) change?

The Gibson Company is a United States (US) firm that is considering a joint venture with Brasilia, DF, a Brazilian firm that grows and processes coffee beans. Gibson has a patent for a new coffee processing method. This intellectual property is motivating Gibson to expand beyond importing coffee to engaging in a joint venture to process the coffee. Gibson will invest $8 million in the proposed joint venture project, which will help to finance Brasilia 's production using the newly patented process.

The Brazilian government has guaranteed that the after-tax profits (denominated in Reals, the Brazilian currency) can be converted to US dollars at the current exchange rate and sent to the Gibson Company each year. Current exchange rates can be found at http://www.oanda.com.

For each of the first five years, 60 percent of the total profits will be distributed to Brasilia, while the remaining 40 percent will be converted to dollars to be sent to Gibson. The income tax rate for the joint venture will be 10%. However, the Brazilian government is considering raising the income tax rate to 30%. At the present time, the Brazilian government doe not impose a separate income tax on profits sent out of the country. However, the Brazilian government is considering imposing an additional 10 percent income tax on profits distributed to a foreign company. Assume that there are no other forms of tax. After considering the taxes paid in Brazil, assume an additional seven percent tax imposed by the US government on profits received by Gibson Company.

The expected total profits resulting from the joint venture per year are as follows:

Year	Total Profits from Joint Venture (in BRL)
1	40 million
2	60 million
3	70 million
4	90 million
5	120 million

Gibson's average cost of debt is 6 percent before taxes. Its average cost of equity is 9 percent. Assume that Gibsonï¿½s US income tax rate is 10 percent. Gibsonï¿½s capital structure is 70 percent debt and 30 percent equity. Gibson adds between 2 and 5 percentage points to its cost of capital when deriving its required rate of return on international joint ventures. Gibson plans to account for country and other risks within its cash flow estimates.

Gibson is concerned about country risk in the following two forms:

(1) Will the Brazilian government increase the corporate income tax rate from 10 percent to 30 percent (20 percent probability)? If this occurs, Gibson will receive additional tax credits on its US taxes, resulting in no US taxes on the profits from this joint venture.

(2) Will the Brazilian government impose a separate income tax of 10 percent on the profits distributed to foreign companies such as Gibson (20 percent probability)? If this occurs, Gibson will not receive additional tax credits, and the company will still be subject to US tax on the profits from this joint venture.

Assume that the two types of country risk are mutually exclusive. If it does anything, the Brazilian government will only implement one of these changes in its tax policies (i.e., the increase in the basic income tax on the profits of the joint venture or the additional income tax on profits distributed to foreign companies). The Brazilian government may also choose to leave things as they are.

Assignment

5. Under what circumstances might Gibson shift to more equity financing when considering joint ventures like this? What is the minimum required return that would still make this investment worthwhile?