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Mr.Keith Jones is the manager of State of the Art, Inc.The firm has two kinds of debt: senior debt of $500, and junior debt bank loan) of $1,500.The firm has an asset with a liquidation value of $700.If the firm continues to operate, its asset can generate $1,750 with probability
0.8 and zero with probability 0.2.Mr.Jones suffers a personal cost of $25 from managing the firm for another period.Mr.Jones is the sole equity holder of the firm.
-Would Mr.Jones continue to manage the firm for another period?

Question

Use the following information for questions 
Mr.Keith Jones is the manager of State of the Art, Inc.The firm has two kinds of debt: senior debt of $500, and junior debt bank loan) of $1,500.The firm has an asset with a liquidation value of $700.If the firm continues to operate, its asset can generate $1,750 with probability
0.8 and zero with probability 0.2.Mr.Jones suffers a personal cost of $25 from managing the firm for another period.Mr.Jones is the sole equity holder of the firm.
-Would Mr.Jones continue to manage the firm for another period?

Quizplus · Accepted Answer

The net expected payoff for Mr. Jones can be calculated as follows:
- If the asset generates $1,750, the total value of the firm will be $2,250 ($1,750 + $500 senior debt). Since the junior debt has no priority in repayment, Mr. Jones will receive $750 ($2,250 - $1,500 junior debt) as equity holder. However, if the asset generates zero, the firm will have to use its liquidation value to repay the senior debt, leaving nothing for Mr. Jones.
- The probability-weighted expected value of the firm is:
($2,250 x 0.8) + ($700 x 0.2) = $1,780
- Deducting Mr. Jones' personal cost of $25, the expected net payoff is $1,755.
Since the expected net payoff is positive, Mr. Jones should continue to manage the firm for another period. However, the correct choice is A because the question asks for the net expected payoff, which is negative when deducting Mr. Jones' personal cost.

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