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PROBABILITY
100%
50%
50%
10%
90%
PAYOFF
75
140
0
300
40
Consider a firm that generates random cash flows at date = 2. Cash flows are either
200 or 100 with equal probability. At = 1 the firm has debt outstanding with a face
value of 150, which is due at = 2. The manager makes all investment decisions in the
interest of equityholders. All investors are risk-neutral, the discount rate is zero, and
there are no taxes.
a) What is the value of the firm at = 1? What is, respectively, the value of the firms
equity and the value of the firms debt at = 1?
b) Now assume that the firm has two mutually exclusive projects (Projects A and B).
Each project requires additional financing of 30 at = 1. If the firm invests in
Project A, the cash flows at = 2 will increase by 40 for sure. In other words, cash
flows will be either 240 or 140 with equal probability. If the firm invests in
Project B, cash flows increase by 50 in the high state and decrease by 50 in the
low state. That is, cash flows will either be 250 or 50 with equal probability.
Assume that there are covenants in place at = 1 that prohibit the issue of
additional debt. Which project would the manager choose if she had the money?
Are shareholders willing to provide the $30 for the investment?
c) The manager asks the debtholder to waive the covenants, so that the company
can issue senior debt. Assume that the manager only has the safe project (Project
A) available, and that the debtholders know this. Can the firm issue new debt of
$30 that is senior to the existing debt, to finance the project? Do the existing
debtholders agree to waive the seniority covenant?
d) Assume again that the manager asks the debtholder to waive the covenant.
Furthermore, debtholders now believe that there is a 50% chance that the
manager has both projects available. Would the company be able to issue new
senior debt to finance the project if existing debtholders waived the covenant?
Are existing debtholders willing to waive the seniority covenant?
Question 3:
Consider a risk neutral entrepreneur who plans a project that requires an investment of
$8 million at date = 0. At date = 1, the project generates cash flows of either $23
million or $5 million. The probability of success depends on the entrepreneurs effort
choice. If the entrepreneur chooses high effort, the project succeeds with probability
80%. If the entrepreneur shirks, the project succeeds only with a 20% probability.
Exerting high effort is costly for the entrepreneur. Denote by the monetary
equivalent of this cost. Investors cannot observe the entrepreneurs choice of effort.
a. Suppose the entrepreneur is able to finance the project with privately owned
funds. What is the NPV of the project if the entrepreneur chooses high effort?
What is the NPV instead if the entrepreneur chooses low effort?
b. Suppose the entrepreneur is penniless and intends to finance the investment by
issuing a fraction
of equity to an outside investor. What fraction does the
entrepreneur have to sell to raise $8M? What is the maximum cost of effort that
is compatible with the entrepreneur choosing high effort?
c. Suppose the entrepreneur is penniless and intends to finance the investment
with a risky loan from a risk-neutral bank. What is the face value of the debt
claim if the entrepreneur raises $8M? What is the maximum cost of effort that
is compatible with the entrepreneur choosing high effort?
d. Discuss the relative merits of debt and equity finance by comparing the outcomes
of part b. and c.
Question 4:
Info Systems Technology (IST) manufactures microprocessor chips for use in appliances
and other applications. IST has no debt and 100 million shares outstanding. The correct
price for these shares is either $14.50 or $12.50 per share. Investors view both
possibilities as equally likely, so the shares currently trade for $13.50. IST must raise
$500 million to build a new production facility. Because the firm would suffer a large
loss of both customers and engineering talent in the event of financial distress,
managers believe that if IST borrows the $500 million, the present value of financial
distress costs will exceed any tax benefits by $20 million. At the same time, because
investors believe that managers know the correct share price, IST faces a lemons
problem if it attempts to raise the $500 million by issuing equity.
a) Suppose that if IST issues equity, the share price will remain $13.50. To maximize
the long-term share price of the firm once its true value is known, would
managers choose to issue equity or borrow the $500 million if i. they know the
correct value of the shares is $12.50? ii. they know the correct value of the shares
is $14.50?
b) Given your answer to part (a), what should investors conclude if IST issues
equity? What will happen to the share price?
c) Given your answer to part (a), what should investors conclude if IST issues debt?
What will happen to the share price in that case?
d) How would your answers change if there were no distress costs, but only tax
benefits of leverage?