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JR Industries has a $20 million loan due at the end of the year and under its current business strategy its assets will have a market value of only $15 million when the loan comes due.JR is considering a new much riskier business strategy.While this new riskier strategy can be implemented using JR's existing assets without any additional investment,the new strategy has only a 40% probability of succeeding.If the new strategy is a success,the market value of JR's assets will be $30 million,but if the strategy fails the assets will be worth only $5 million.
-What is the expected payoff to debt holders under JR's new riskier business strategy?

Question

Quizplus · Accepted Answer

The expected payoff to debt holders can be calculated as:
Expected Payoff (Success) = Probability of Success x Market Value (Success) - Loan Amount = 0.4 x $30 million - $20 million = $4 million
Expected Payoff (Failure) = Probability of Failure x Market Value (Failure) - Loan Amount = 0.6 x $5 million - $20 million = -$11 million
Expected Payoff = Expected Payoff (Success) x Probability of Success + Expected Payoff (Failure) x Probability of Failure
Expected Payoff = $4 million x 0.4 + (-$11 million) x 0.6 = -$1.6 million
Since the expected payoff is negative, debt holders should not approve the new riskier business strategy.

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