Corporate Finance Task
Hey! Im struggling with an exercise from my book, the question goes like this "Consider the company MXK that generates the following risky cash flow: With probability ½ the company is in a boom next year and free cash flow equals $50. With probability ½ the company is in a recession next year and free cash flow equals $150. MXK has a debt obligation that is due next year with a face value of $100. Suppose that the manager is the sole equity owner of the company. Everyone is risk neutral and there is no discounting.
a. Calculate the present value of MXK’s debt and equity claims.
in the solution they are saying Debt = 75 and Equity = 25. But im struggling to understand how they came up with this solution?
Ah, let's dive into this intriguing corporate finance puzzle, shall we? Based on the most helpful WSO content, let's break down the calculation for MXK's debt and equity claims under the given scenario. Remember, we're in a world where everyone is risk-neutral and there's no discounting involved, making our calculations straightforward.
Given: - Probability of boom = 1/2, Free Cash Flow (FCF) = $50 - Probability of recession = 1/2, FCF = $150 - Debt obligation due next year = $100
Calculating the Present Value of MXK's Debt:
In both scenarios, the debt holders will be paid first, up to the face value of the debt ($100). Let's see how much they get in each scenario:
Now, to calculate the expected payment to debt holders, we take the average of these two outcomes, weighted by their probabilities:
[ \text{Expected Debt Payment} = \frac{1}{2} \times 50 + \frac{1}{2} \times 100 = 25 + 50 = 75 ]
So, the present value of MXK's debt claims is $75.
Calculating the Present Value of MXK's Equity:
Equity holders get whatever is left after debt holders are paid. Let's calculate:
Again, taking the average of these outcomes, weighted by their probabilities:
[ \text{Expected Equity Payment} = \frac{1}{2} \times 0 + \frac{1}{2} \times 50 = 0 + 25 = 25 ]
Thus, the present value of MXK's equity claims is $25.
And there you have it! The debt is valued at $75, and the equity at $25, under the given conditions. It's all about understanding the priority of payments and applying some basic probability-weighted calculations. Keep practicing, and soon these types of questions will feel like second nature!
Sources: DCF Modeling Course ~ Pre-training text.pdf, POPULAR ACCOUNTING/FINANCE QUESTIONS, 20 balance sheet ratios every investor should be aware of, Confused by a Technical Question, Equity is cheaper than debt, isn't it?
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