Question

Investment analysis q 3,25

ln a world that is not perfect but risk neutral, assume that the firm has projects worth $100 in the down-state, $500 in the up-state. The cost of capital for projects is 25%. However, if you could finance it with 50-50 debt, the cash flow rights alone are enough to make the cost of capital a lower 20%. Managers are intransigent and do not want to switch to this new capital structure. You only have $60 of capital and cannot borrow more to take over the firm. What can you do?

Answer 1

This question appears to be from a perspective of PE/ VC investor where you are the investor. The projects are worth (NPV) $100 in downstate and $500 in upstate. Assuming a 50-50 probability of each state, the value of the firm is $300. We only have $60 of own capital with no ability of leverage. The best way to proceed is to collaborate with other shareholders or capital providers to replace the existing the existing managers and bring in new management. The managers are clearly not of the aggressive growth mindset. The 50-50 debt stricture could bring down the cost of capital and improve the overall profitability of the projects. This is a situation where the new management could add value quickly and improve the value of the firm. Once the value through recapitalization and restructuring of the firm is materialized, you can sell of your stake. This is the general modus operendi of the leveraged buyout PE firms. They focus on generating For the firm that’s performing the LBO, this is a way to generate high returns while only risking a small amount of capital. Often a financial sponsor is involved and the assets, in this case the cash flows from projects, of the company being acquired are used as collateral for the debt. The success of the strategy will depend on the successful exit at higher valuation. This can be easily achieved in this case through lower cost of capital.