Gator Software has just completed an RD project that require

Gator Software has just completed an R&D project that required borrowing senior debt from a bank. The bank has been promised a repayment of $140 million.  This R&D effort has resulted in an investment opportunity that will cost an additional $188.50 million and will result in a cash flow of $180 million with probability .5 and $420 million with probability .5.  The firm has no cash on hand and no other assets except for this investment opportunity.  Assume risk-neutrality, a zero-interest rate, no direct bankruptcy costs, and no taxes.

(a)Could the firm fund the investment opportunity with an equity issue?

(b)Could the firm fund the investment opportunity with an issue of junior debt?

(c) Could the firm fund the investment opportunity with a sale of senior debt to a new investor with a promised repayment of $240 (assuming that this is allowed in the existing bank loan agreement)?  Assume the new senior debt has the same priority in default as the bank loan.

(d) Could the firm fund the investment opportunity with an issue of new senior debt with a promised repayment of greater than $240 (assuming that this is allowed in the bank loan agreement).  What would you predict for the minimum face value (i.e., promised repayment) of the new debt that would be necessary to raise funds for the investment opportunity? Assume the new senior debt has the same priority in default as the bank loan and the debt is sold to a new lender.

Solution

The expected cash flows = [($180*.5) +($420*.5)] - $140

The expected cash flows =(90+210) – 140= $160 million

2. Yes, the firm may fund the investment opportunity with junior debt issue. The expected cash flows are $300 million and the firm has to raise $188.5 million.

3. Yes, the firm may fund the investment opportunity with sale of senior debt to new investor with the promised payment of $240 as the expected cash flows are $300 million.

4. Yes, the firm may fund the investment opportunity with sale of senior debt to new investor with the promised payment of more than $240 as the expected cash flows are $300 million. The amount should not exceed $300 million.