Part 1: Case Background Marcher Industries Is Considering ✓ Solved

Part 1: Case Background MarCher Industries is considering

MarCher Industries is considering undertaking a new project with a one-year life with the following expected return scenarios:

Scenario 1: HIGH-RISK PROJECT

  • Cash flow (boom): $1,500,000
  • Cash flow (bust): $400,000

Scenario 2: LOW-RISK PROJECT

  • Cash flow (boom): $1,000,000
  • Cash flow (bust): $500,000

The company currently has no debt but is considering borrowing $870,000 on a short-term basis to help finance its purchase of the project. The company will owe $900,000, including principal and interest, in one year. There is a 60% chance a boom will occur and only a 40% chance a bust will occur.

1) Calculate the expected value of the high- and low-risk projects to MarCher Industry’s stockholders if the company remains unlevered. Which project would the stockholders prefer?

2) Calculate the expected value of the high- and low-risk projects to MarCher’s stockholders and bondholders, assuming the company does borrow money to partially finance the purchase of the project. Which project would the bondholders prefer? Which project would the stockholders prefer?

3) Explain why a conflict exists between the bondholders and the stockholders.

Paper For Above Instructions

MarCher Industries faces an important decision regarding the undertaking of a new project with two distinct risk profiles—high-risk and low-risk—over a one-year horizon. The difference in cash flow outcomes between these two scenarios is substantial, which has implications for both stockholders and bondholders of the company. This paper will first calculate the expected values for both scenarios under unlevered and levered conditions, and will then explore the dynamics of stakeholder preferences, highlighting the potential conflicts that arise.

1. Expected Values of High-Risk vs. Low-Risk Projects (Unlevered)

The expected value (EV) can be computed using the formula:

EV = (Probability of Boom × Cash Flow in Boom) + (Probability of Bust × Cash Flow in Bust)

For the High-Risk Project:

Probability of Boom = 60% or 0.6

Probability of Bust = 40% or 0.4

Cash Flow (Boom) = $1,500,000

Cash Flow (Bust) = $400,000

Calculating the expected value:

EV (High-Risk) = (0.6 × $1,500,000) + (0.4 × $400,000) = $900,000 + $160,000 = $1,060,000

For the Low-Risk Project:

Cash Flow (Boom) = $1,000,000

Cash Flow (Bust) = $500,000

Calculating the expected value:

EV (Low-Risk) = (0.6 × $1,000,000) + (0.4 × $500,000) = $600,000 + $200,000 = $800,000

Under unlevered conditions, MarCher's stockholders would prefer the high-risk project since it has a higher expected value of $1,060,000 compared to the low-risk project's expected value of $800,000.

2. Expected Values of High-Risk vs. Low-Risk Projects (Levered)

To analyze the impact of the company's decision to borrow $870,000 at an interest resulting in a $900,000 obligation in one year, we need to consider the outcomes under both scenarios again.

High-Risk Project (Levered):

In case of a boom, the cash flow available to equity holders is:

Cash Flow (Boom) = $1,500,000 - $900,000 = $600,000

In case of a bust:

Cash Flow (Bust) = $400,000 - $900,000 = -$500,000 (indicating a loss to stockholders)

Calculating the expected value:

EV (High-Risk, Levered) = (0.6 × $600,000) + (0.4 × -$500,000) = $360,000 - $200,000 = $160,000

Low-Risk Project (Levered):

In case of a boom:

Cash Flow (Boom) = $1,000,000 - $900,000 = $100,000

In case of a bust:

Cash Flow (Bust) = $500,000 - $900,000 = -$400,000 (indicating a loss to stockholders)

Calculating the expected value:

EV (Low-Risk, Levered) = (0.6 × $100,000) + (0.4 × -$400,000) = $60,000 - $160,000 = -$100,000

When leveraged, the expected value of the high-risk project becomes $160,000 while that of the low-risk project becomes -$100,000. Thus, the bondholders would prefer the high-risk project because it provides a positive return, whereas, in the event of a bust, both projects are expected to result in losses for stockholders, but at least the high-risk option does offer potential upside. Conversely, from the stockholders' perspective, they end up preferring the high-risk project as it gives them some possibility of positive cash flow compared to the low-risk project.

3. Conflict Between Bondholders and Stockholders

The conflict between bondholders and stockholders primarily arises from their differing risk appetites and claim priorities. Bondholders prefer projects that are stable and mitigate risk since they are primarily concerned with receiving their interest payments and the return of principal. High-risk projects, while having the potential for high returns in the case of success, increase the risk of bankruptcy and may jeopardize bondholders’ interests. On the contrary, stockholders are inclined to favor high-risk projects because they provide the opportunity for higher returns if successful. This divergence in objectives leads to a classic agency problem where the interests of stockholders might not align with those of bondholders.

In conclusion, MarCher Industries must carefully analyze these expected values and stakeholder preferences when deciding on the project's future financing strategy. Leveraging debt alters the landscape of risk and reward significantly, impacting the overall valuation and risk appetite of the organization.

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