Consider a firm with $4000 of principal and
interest payments due at the end of the year (assume $3500 lent at 14.29%
stated).If there is a recession,
it will be pulled into bankruptcy because its cash flows will be only
$2400.Else, it will have cash
flows of $5000.
The firm could avoid bankruptcy in a recession
by raising new equity to invest in a new project (soon after
beginning).The project costs $1000
and brings in $1700 in either state and has an NPV > 0.
Recession and Boom states are equally likely.
Will it do the right thing and raise new equity
Bondholders return = -8.57%; exp. equity payoff
= $500; total return = 7.14%. Bond buyers will have to demand higher yields
to account for the possibility that stockholders will turn down desirable
projects in the future. This might make initial project unprofitable as
well; need 31.43% stated return on bonds and only $200 for stockholders to
obtain even 0% return for bondholders.
If the new project could be financedseparately, say, under
debtor-in-possession financing, or a new issuethat would be senior to the previous issue, then (assuming a
riskfree rate of 10%), the new project would be undertaken; and bondholders
would be better off.