A firm used to have productive assets that generated an income stream with a present value of 3,000. However, fire occurred and most of those assets were destroyed. The remaining, undamaged assets produce an income stream that has a present value of only 1,000. Therefore, the fire has led to reduction in the value of the firm from 3,000 to 1,000. The firm could undertake a reconstruction of the damaged asset for a capital cost of 1,500, which would restore the income stream to its preloss (PV = 3000). The firm has existing debt of 2,000 which is a senior claim.
a. Would the shareholders choose to reinvest by issuing new equity to pay for the loss or are they better off walking away from the firm?
b. Would the decision made by the shareholders be in the best interest of the bondholders?
In answering this question remember that the shareholders have limited liability and therefore the share value cannot be negative.
The market for digital cameras is are relatively new. Ajax Inc. produces what they regard as a high quality digital camera. Knockoff Inc. produces what they regard as a low quality digital camera. However, since the market is so new, reputations for quality have not yet developed and consumers can not dell the difference between an Ajax digital and a Knockoff digital just by looking at them.
If consumers knew the difference, they'd be willing to pay $200 for a high quality camera (i.e. their reservation price for the a high quality camera) and they'd be willing to pay $100 for a low quality camera. It costs Ajax $60 to produce a high quality camera and it costs Knockoff $25 to produce a low quality camera.
A recent MBA hire at Ajax suggest that Ajax could differentiate its camera from Knockoff's by offering a full coverage warranty (i.e. one which would fully cover any defect in their camera at no cost to the customer). The MB estimates that it would cost Ajax $20 per year to offer such a warranty. The MBA also estimates that it would cost Knockoff $40 per year should Knockoff attempt to copy Ajax's warranty strategy. Consumers will feel that the camera with the longest warranty is high quality and that with the shortest warranty is low quality. The camera companies want to maximize the profit per camera.
What's Ajax's profit per camera in the digital camera market?
Book TITLE: MANAGERIAL ECONOMICS, THEORY, APPLICATIONS, AND CASES 6th Ed.
AUTHOR: EDWIN MANSFIELD and etc. hide problem
A case of shareholders' limited liability is presented.