Suppose that USB Corp has $100m invested in 8% risk-free bonds that mature in one-year. The company also has $80m in debt outstanding that will also mature in a year. USB shareholders are considering selling the $100m in debt and investing in a project that has a 60% chance of returning $200m and a 40% chance of returning $2m. Agency costs: What is the expected value of the bonds if the shareholders sell the debt?
A) $100m
B) $88.8m
C) $48.8m
D) None of the above.

Question

Quizplus · Accepted Answer

The expected value of the project is (0.6 * $200m) + (0.4 * $2m) = $120.8m. After paying off the $80m debt, $40.8m remains for bondholders, which is less than the $100m they would have received from the risk-free bonds.

Suppose That USB Corp Has $100m Invested in 8% Risk-Free