LOL * Lucky Octopus Limited is a defense firm that has just concluded a test on the feasibility of a new project * LOL’s management knows that the test was a success and that NPV of this NeW secretive project is 10m * NPV generated by is sine * The new project requires an of 75m, and LOL needs new equity for thatINFORMATION * In the interest of national security, LOL cannot disclose any details about the test, so no one knows whether the test was successful venture captabit — With 50%, the market thinks that LOL is right — With 50%, the market thinks that of the assets is14m and NPV of the project is Market doesn't have data -> 50% not sure u'te right@ PLAN OF ATTACK {how mart ins abou the decison 2) mat mana wo ‘ 5) rm ech heel * Outsider valuation based on their beliefs: — What is right after issuing new the market believes that LOL will use the money for the new project? * Outsider offer: — WhatSBEGUIE do the BREE ERBREHBILER ave to to raise new equity? * Insider valuation of offer based on their beliefs: — Will 01 ste neweguty? Waeaxnkust FINA 3303/LECTURE 15 26 aoe > nk wether hs rae sn Mom Tn perapactveMARKET VALUE —75+50%x(41410)#50%x(1445)= 110 seen * They need to give up: - 75/110= 68% Of shares — mrwdsane * According to LOL: ‘ey tr wath more cu tay tak value: 10475 — Worth 51+75=126 but they would only keep — 32%X126, i.e. 40.09 — smerresrame — If they don’t raise money for new roject, their |. value is 41>40.09 * They prefer not to take new project ##exHKust FINA 3303/LECTURE 15 27RISK TAKING * Remember Fedex casino story and the associated exercise? * Assume a firm with HKD500m one-year bank debt faces two projects, paying next year: — Low risk project gives either HKDS500m or HKD700m with equal probabilities — High risk project gives HKD100m with 70% and HKD1000 with 30% probability * Firm has no other assets — All value next period will result from these projects Waenxnkust FINA 3303/LECTURE 16 26RISK TAKING * Which project does the bank prefer? — Low risk project = 0.5 x 500 + 0.5 x 500 = 500 — High risk project = 0.7 x 100 + 0.3 x 500 = 220 * Which project do the shareholders prefer? — Low risk project = 0.5 x0 + 0.5 x 200 = 100 — High risk project = 0.7 x 0 + 0.3 x 500 = 150 * What if there was no bank debt, only equity? — Low risk project = = 0.5 x 500 + 0.5 x 700 = 600 — High risk project = 0.7 x 100 + 0.3 x 1000 = 370 * Firm value maximized with low risk project Waeaxukust FINA 3303/LECTURE 16 27IMPLICIT TERMS * For example, the firm could offer 3/10 net 30 — Customer gets a 3% discount if paid within 10 days —In any event, it must pay within 30 days Firm is essentially offering their customers a — What is the implicit interest rate?IMPLICIT TERMS * Acustomer that forgoes the 3% discount to pay on day 30 is borrowing $970) for 20) days and paying +$970 ~$1,000 0 10 30 * The discount rate is: 365 swmancens 61 Og $1,000 ) 2° $970 = =lgo70 | > 2 al ° WaetnxHKust FINA 3303/LECTURE 16 18 = 74.35%