A firm used to have productive assets that generated an income stream with

a present value (PV) of 3,000. However, a fi re 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 fi re has reduced

the value of the firm from 3,000 to 1,000. The firm could reconstruct the

damaged assets for a capital cost of 1,500, which would restore the income stream to its pre-loss level (PV = 3,000). The firm has existing debt of 2,000, which is a senior claim. 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? Would the decision made by the shareholders be in the best interests

of the bondholders? In answering this question, remember that the shareholders have limited liability, and therefore the share value cannot be negative.


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