Debt overhang and financial restructuring
Air Utopia (AU) is operating in the airline industry, it flights both domestically and
internationally. As a result of the recent slowdown in air travel, AU is facing a lot of
uncertainty about its future earnings. The Earnings Before Interest and Taxes (EBIT) are
expected to depend considerably upon individual country restrictions to curb the pandemic.
The financial management team is considering three scenarios: a full reopening of borders
(EBIT=100m), a partial reopening (EBIT=30), or the situation as of today (EBIT=5m). The
three states are equiprobable. The firm has debt with face value K=35m which is due one
year from now. AU is located in a country in which it is not paying taxes.
a. Suppose all agents are risk neutral and discount all cash flows at the same (riskfree)
10% discount rate. What is the value of AU’s debt? What is the value of AU’s equity?
b. AU has a project which is to open a new flight route in its home country. Because the
state of Utopia is not planning any restrictions on domestic flights, this project does not
come with much uncertainty: its costs 15m and it will generate 22m one year from now.
However, AU does not have any liquidity to fund the investment. Show that although
the project is valuable, shareholders will not fund it if they have to inject the $15m
themselves into the firm. Explain.
Since the existing shareholders will not add money onto BNC to fund the project, they are
considering funding the $15m with different sources of outside finance.
c. Equity: how much new equity would AU need to issue? Would shareholders agree?
d. Junior debt: the new debt would be junior to the existing debt, i.e. the new debt gets
paid only after the existing debt has been paid in full. How much new debt would AU
need to issue? Would shareholders agree?
e. Senior debt: The existing debt would be junior to the new debt. How much new debt
would AU need to issue? Would shareholders agree?