Consider the case of Ajax Manufacturing which just completed an R&D project on w

ID: 2804510 • Letter: C

Question

Consider the case of Ajax Manufacturing which just completed an R&D project on widgets

that required a $70 million bond obligation. The R&D effort resulted in an investment

opportunity that will cost $75 million and generate cash flows of $85 million in the event of a

recession ( prob. = 20%) and $150 million if economic conditions are favorable ( prob. =

80%). What is the NPV of the project assuming no taxes, no direct bankruptcy costs, risk

neutrality, and a risk-free interest rate of zero? Can the firm fund the project if the original

debt is a senior obligation that doesn’t allow the firm to issue additional debt?

Assume now that if Ajax Manufacturing uses a more capital-intensive

manufacturing process, it can produce a greater number of widgets at a lower variable cost.

Given the greater fixed costs, the cash flows are only $5 million in an unfavorable economy

with the capital-intensive process but are $170 million in a favorable economy. Hence, equity

holders would receive $100 million in the good state of the economy ($170 million $70

million) and zero in a recession because $5 million is less than the $70 million debt

obligation. Can the firm issue equity to fund the project?

Case 1;

NPV = (expected payoff -existing debt -new debt)

=.2 * 85 + .8 * 150 - 75 - 70 = 17 +120 -145 = - $ 8M

Since NPV is negative cannot fund with debt

Case 2:

In this case the firm can issue equity to fund the project since the shareholders may be optimistic and not worry about a recession happening