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initial values of assets, debt and equity are (fill in table on next slide)?
The Debt-Overhang Problem
HM Company (HMC)
• HMC has assets that produce payoffs of either $1.4B or $8B
asset value is 1.4/2 + 8/2 = 4.7B
• HMC has debt with $2B FACE Value (promised repayment)
initial values of debt = 1.7B
Initial value of equity = 3B
What is the NPV of this investment project? NPV = -0.5B + 0.6B = 0.1B
With the investment in maintenance,
financed by issuing $.5B of new equity
In this case, it’s harder to determine the face value that makes the new debt worth $5B
In the bad state, the liquidation value is distributed proportionately to debt holders,
based on face values
Let x be the face value of the new debt, so the new debt gets the proportion x/(2+x)
of the $2B, and the old debt gets the proportion 2/(2+x).
2/(2+x) + x/(2+x) = 0.5 =>Solve for x