FM212: Principles of Finance

Lent Term: Corporate Finance

Problem Set 6

1. The Bahia Corporation has fallen on hard times. It successfully issued 80 million Reals of
zero-coupon bonds four years ago, but since then its business has gone from bad to worse.
The debt is due one year from now. Its only remaining asset is 20 million Reals in cash. If
Bahia’s managers do nothing, the bondholders will receive all of this cash, which is earning
interest at the risk-free rate of 15 percent. Bahia has the possibility of undertaking one of
the following projects (assume beta is zero for all projects so the opportunity cost of capital
is the risk-free rate):

• Project X: Cost now: 20 million Reals. Payoff one year from now: 160 million Reals
with probability 0.05 and 0 with probability 0.95.
• Project Y: Cost now: 20 million Reals. Payoff one year from now: 30 million Reals with
probability 1.
• Project Z: Cost now: 20 million Reals. Payoff one year from now: 140 million Reals
with probability 0.05 and 50 with probability 0.95.

(a) What are the NPVs of projects X and Y?

(b) What can you say about today’s present value of Bahia’s debt and equity if it:
i. Rejects both projects X and Y and leaves 20 million Reals in the bank at 15 percent?
ii. Accepts project X and rejects Y?
iii. Accepts project Y and rejects X?
(c) If the firm operates strictly in the interests of the shareholders, which strategy will be
chosen?
(d) How do your answers change if Project X is replaced with Project Z?

Solution (a):

For Project X, the expected cash flow in one year is 160 × 0.05 + 0 × 0.95 = 8. Therefore,

8
NPVX = −20 + = −13.04 million reals
1.15

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For Project Y, the expected cash flow in one year is 30. Therefore,

30
NPVY = −20 + = +6.09 million reals
1.15
Solution (b):

i If Bahia rejects both projects X and Y, the 20 million Reals in the bank will grow to
20(1+0.15) = 23 million reals in one year. Bahia will default on its debt, so debtholders
will receive 23 million reals and equity holders will receive nothing.

Therefore, present value of the firm’s debt is 23/1.15 = 20 million reals and the present
value of the equity is zero.

ii If Bahia accepts project X, the present value of the firms assets is:

Vfirm = 20 (cost of the project) −13.04 (the negative NPV of project X) = 6.96 million reals

There is a 5% probability that the payoff for project X will be 160 million reals. There-
fore, there is a 5% probability that the firm’s 80 million real debt will be paid off, leaving
80 million reals as the payoff to equityholders. Therefore, the value of the firm’s equity
is positive:

0.05 × 80
Vequity = = 3.48 million reals
1.15
Hence, the value of the firm’s debt is:

Vdebt = Vfirm − Vequity = 6.96 − 3.48 = 3.48 million reals

iii If Bahia accepts project Y, the present value of the firm’s assets is:

Vfirm = 20 (cost of the project) + 6.09 (the NPV of project Y) = 26.09 million reals

One year from now, the payoff for Project Y will be 30 million reals, so the present
value of the equity is zero and the present value of the firms debt is 26.09 million reals.

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 Solution (c):

If the firm operates strictly in the interest of the shareholders, project X should be accepted
since this is the only strategy that produces a positive value for the firms equity.

Solution (d):

For project Z, the expected cash flow in one year is 140 × 0.05 + 50 × 0.95 = 54.5. Therefore,

54.5
NPVZ = −20 + = 27.39 million reals
1.15
Both the shareholders and the debtholders regard project Z as preferable to project Y.
Debtholders will receive a payoff of at least 50 million reals, with 95% probability, while
shareholders have a 5% probability of receiving a payoff of 60 million reals. In this case, the
higher NPV investment (i.e., project Z) is the preferred alternative.

2. Consider the case of Henrietta Ketchup, a budding entrepreneur with two possible investment
projects that offer the following payoffs (assuming zero discount rate and zero interest):

• Project 1: Investment now: 12. Payoff one year from now: 15 with probability 1.
• Project 2: Investment now: 12. Payoff one year from now: 24 with probability 0.4 and
0 with probability 0.6.

(a) Calculate the expected payoffs to the bank and Ms. Ketchup if the bank lends the
present value of $10. Which project would Ms. Ketchup undertake?
(b) What is the maximum amount the bank could lend that would induce Ms. Ketchup to
take project 1?

Solution (a):

Expected Payoff to Bank Expected Payoff to Ms. Ketchup

Project 1 +10 +5
Project 2 10 × 0.4 + 0 × 0.6 = +4 14 × 0.4 + 0 × 0.6 = +5.6

Project 2 offers a Ms. Ketchup a higher expected payoff, so she would undertake Project 2.

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 Solution (b):

If X is Ms. Ketchup’s payment on the loan, then her payoff from Project 1 is (15 − X) and
her payoff fro Project 2 is: 0.4(24 − X). Ms Ketchup will prefer to take Project 1 if her
expected payoff from Project 1 is larger than from Project 2:

15 − X > 0.4(24 − X)

Solving, we get X < 9. Therefore, the bank would need to lend Ms. Ketchup less than the
present value of 9 in order to induce her to take Project 1.

3. “We R Toys” (WRT) is considering expanding into new geographic markets. The expansion
will have the same business risk as WRT’s existing assets. The expansion will require an
initial investment of $50 million and is expected to generate perpetual EBIT of $20 million
per year. After the initial investment, future capital expenditures are expected to equal
depreciation, and no further additions to net working capital are anticipated. WRT’s existing
capital structure is composed of $500 million in equity and $300 million in debt (market
value), with 10 million equity shares outstanding. The expected return on assets (unlevered
cost of capital) is 10%, and WRT’s debt is risk free with an interest of 4%. The corporate
tax rate is 35%, and there are no personal taxes.

(a) WRT initially proposes to fund the expansion by issuing equity. If investors were not
expecting this expansion, and if they share WRT’s view of the expansion’s profitability,
what will the share price be once the firm announces the expansion plan?
(b) Suppose investors think that the EBIT from WRT’s expansion will be only $4 million.
What will the share price be in this case? How many shares will the firm need to issue?
(c) Suppose WRT issues equity as in part (b). Shortly after the issue, new information
emerges that convinces investors that management was, in fact, correct regarding the
cash flows from the expansion. What will the share price be now? Why does it differ
from that found in part (a)?
(d) Suppose WRT instead finances the expansion with a $50 million issue of permanent
risk-free debt. If WRT undertakes the expansion using debt, what is its new share price
once new information comes out? Comparing your answer with that in part (c), what
are the two advantages of debt financing in this case?

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Solution (a):

The project is expected to generate perpetual annual FCF = 20(1 − 0.35) = 13

The NPV of expansion is NPV = −50 + (13/0.1) = $80 million.

Equity value after announcement = (500 + 80)/10 = $58/share

Solution (b):

If investors think EBIT will only be $4 million, then they will attach a lower NPV to the
expansion plan:

4(1 − 0.35)
NPV = −50 + = −$24 million
0.1
Therefore, the share price on announcement will fall to:

500 − 24
= $47.60/share
10
To raise $50 million, the firm will need to issue (50/47.6) ≈ 1.05 million shares.

Solution (c):

The value of equity will adjust to reflect the new/correct information about the NPV of
expansion. The value of equity will be:

Vequity = 500 (old equity) + 50 (new equity) + 80 (correct NPV) = $630 million

The share price will be:

630
= $57/share
10 + 1.05
The share price is now lower than the answer from part (a), because in part (a), the share
price is fairly valued, while the shares issued in part (b) are undervalued. New shareholders’
gain of (57 − 47.6) × 1.05 = $10 million is equal to old shareholders’ loss of (58 − 57) × 10.
Since, in the case of asymmetric information, there was an over-issue of shares, the final
share price is now lower.

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Solution (d):

Financing the project with $50 million in new permanent risk free debt will generate a in-
terest tax shield with a present value of D × τc = 50 × 0.35 = $17.5 million.

The share price will be:

500 + 80 + 17.5
= $59.75/share
10
That is a gain of $2.75 per share compared to (c): $1 from avoiding the issue of undervalued
equity and $1.75 from the interest tax shield.