Case Study: Capital Structure

Part 1: Case Background

MarCher Industries is considering undertaking a new project with a one-year life with the following expected return scenarios.

Cash flow (boom)$1,500,000$1,000,000Cash flow (bust)$400,000$500,000

The company currently has no debt, but is considering borrowing $870,000 on a short-term basis to help finance its purchase of the project. The company will owe $900,000, including principal and interest, in one year. There is 60% chance a boom will occur, and only 40% chance a bust will occur.

Part 2: Case Analysis

1)  Calculate the expected value of the high- and low-risk projects to MarCher Industry’s stockholders if the company remains unlevered. Which project would the stockholders prefer?

2)  Calculate the expected value of the high- and low-risk projects to MarCher’s stockholders and bondholders, assuming the company does borrow money to partially finance the purchase of the project. Which project would the bondholders prefer? Which project would the stockholders prefer?

3)  Explain why a conflict exists between the bondholders and the stockholders.