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1. 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 pre-loss level (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.
To help you answer this ...
Economics and shareholders are assessed.