EC334 assessment

Instructions: please complete all problems

1. Modigliani-Miller: A leveraged firm is faced with two risky projects. Currently, the firm has
5 of outstanding debt due to be paid back at the end on period 1 (the 5 payment made in
period 1 includes all interest in other words, it is a future value). The riskless rate of
interest is 5%, and you may assume that the risk-adjusted rate of interest is 10% (well
revisit this at the end of the question). The firm currently has 5 cash in hand, which it can
use for new projects or invest at the riskless rate of return.

If the firm undertakes project A, it will have to invest 10 in period 0 and will earn 25 in
period 1 with probability 40% and will get 0 otherwise.

If the firm undertakes project B, it will have to invest 15 in period 0 and will earn 25 in
period 1 with probability 80% and will get 0 otherwise.
a) [6 points] First, suppose that the firms existing debt-holders have a covenant that
prevents the firm from using its cash for investing in the project, and that the firm
decides to finance a project using new debt.
i.

For each project (A or B), how much will the firm owe the new debt-holders if it
borrows the full project cost at the risk-adjusted rate? Simple future value
computation

ii. For each project, how much will holders of existing debt, holders of new debt and
the firms equity owners get in period 1 if the project succeeds?
Standard calculation
i. For each project, how much will holders of existing debt, holders of new debt and
the firms equity owners get in period 1 if the project fails?
Standard calculation
ii.

Using these data, compute for each project the expected present value of the firms
existing debt, new debt and equity. What is the actual rate of return on the new debt?
[Note: you should use the risk-adjusted rate for new debt and for equity, because they
are risky in this part of the problem, old debt is not risky due to the covenant. But
you can also make a case for using the riskless rate to provide a common point of
reference or considering the second part of the question using a different rate. As
long as you make clear assumptions and explain your motivation, you are on solid
ground. The actual rate of return is found by dividing investment by expected NPV
and subtracting 1: when the expected payment to new debt holders is less than the
original borrowing, this could easily be negative.
iii. Which project would be preferred by the existing debt holders, new debt holders
and equity owners?
Compare expected returns.

b) [6 points] Now suppose that the firm does not have a covenant and uses its cash to pay
part of the project cost, financing the rest with new debt at the risk-adjusted rate.
Answer questions i-v as above. Comments as above, except note that now old debt is
risky too but this risk cannot increase the return paid to old debt, as the final payment
is fixed.
c) [6 points] Suppose there is a covenant and the firm finances the project by equity. Hint:
in this case, there is no new debt, but the payoff to equity holders is reduced by the cost
of the project in period t=0. Answer questions i-v as above. Comments as above

d) [6 points] Clearly, the assumed risk-adjusted rate of return is inadequate. A more

appropriate risk-adjusted rate would make the expected value of the new debt
investment in period t=1 equal to the amount that would be earned by investing the
same amount at the riskless rate). Show (by means of an example or otherwise) that this
rate would be different for project A and project B. Why is this? If rs is the safe return
(5%), I0 is the project investment, D0 is the future value of old debt, P the probability of
winning, RW is the winning revenue and R L is the losing revenue, the risk-adjusted rate
r* must satisfy:
I0(1+rs) = P*max{0,min{RW-D0, (1+r*)I0}}
Rates are different because P is different.
2. A building society is in financial distress. It has some shares outstanding and owes the
Treasury 90 million in debt (payable next period to compute the present value, assume
an interest rate of 10%). It has two options: continue to operate or accept nationalisation. If
it soldiers on and business picks up (probability ), it will be worth 150 million; if
business does not pick up the firm is only worth 50 million. If it is liquidated today, it will
realise 75 million, of which current stockholders will get 15 million.
a) [5 points] For what values of would the Treasury prefer nationalisation? (please
explain why)?
Straightforward computation, but note that the liquidation/nationalization payment
comes this period while the return to carrying on comes next period.
b) [5 points] For what values of would the firms stockholders reject nationalisation?
Straightforward computation
c) [5 points] If the Treasury cuts the interest rate, what happens to the critical success
probabilities for the Treasury and the stockholders do they go up or down, and do
they move closer together or further apart? Write probnabilities as functions of the
interest rates.
[5 points] Finally, suppose that the interest rate is again 10% and the probability that
business will pick up is 60%, but the Treasury will experience distress costs of B if it does
not nationalise the building society and business does not pick up. How large does B have
to be for the Treasury to prefer nationalisation? Straightforward computation
3. A manager is hired by a firm with no debt or bank finance outstanding. To produce revenue
she needs to exert effort e, which costs her 50e 2. There are two equally-likely states of the
world:

In state A, the revenue earned by the firm (not including effort cost) is 100e.

In state B, the revenue earned by the firm (not including effort cost) is 50e
a) [6 points] For each state, compute the value of e that maximises the profit (revenue
effort cost) of the firm and the resulting levels of revenue and profit.
A: e* = 1;
B: e* = ;
Now suppose the manager observes the state after signing her contract but before
choosing her effort, but the firm cannot observe the state or her effort (it only observes
revenue) and offers the manager a contract which pays *R, where R is the revenue
earned by the firm.
b) [12 points] What are the optimal and the expected payoffs to the manager and the

firm?
* = .
c) [7 points] If the manager can choose between signing the contract or taking up an
outside opportunity worth 11, how is your answer to b) changed?
Need to check whether optimal contract from b leaves manager with less than 11 (it
does) and see what has to be to match the outside offer.
4. A fund manager at an investment bank is investing the banks money in a risky project the
return depends on the state which belongs to the set {1, 2, 3, 4, 5}- all states are equally
likely. The net return in state is R() = 5 2. The manager is supposed to report the
state to the banks Board and transfer to them an amount h( ). The Board can audit the
state for a cost of 10. The manager has an outside offer worth 10. The fund managers
contract with the Board specifies the repayment scheme h( ) and the set of states E where
the auditors will be called in.
a) [8 points] Assuming that the manager must reject his outside offer when he signs the
contract, write the expected payoffs for both parties, the participation (IR) and
incentive compatibility (IC) constraints for the manager and the Boards contract
design problem.

[ 5 210 ] + h ( )

U ( B )= E

[ 5 2h ( ) ]

U ( M )=

IC constraint(s):

E , ' E ; 0 [ 5 2h ( ' ) ]
E ; 0 [ 5 2h ( ) ]
, ' E ; [ 5 2h ( ) ] [ 5 2h ( ' ) ]
IR constraint: U(M) > 10
b) [17 points] In the optimal contract,
i. How much should the manager pay the Board in each state? Note that as the
trigger rises, the expected audit cost increases more slowly than the Boards
expected revenue! Also note that asking the manager for the maximal payment
(125) would violate IR (participation constraint).
ii. There are effectively 5 levels of the audit trigger (running from never audit to

audit only if maximum revenue is not reports): why do you not need to consider
always audit when computing the optimal contract? Because it is never optimal to
audit when agent reports maximal feasible revenue.
iii. What audit trigger level maximises the Boards expected payoff, ignoring the
managers outside option and what are the associated expected payoffs for the
manager and the Board? Straightforward based on above not much computation
needed.
iv. What is the audit trigger level that maximises the Boards expected payoff taking
the managers outside option into account and what are the associated expected
payoffs for the manager and the investors (net of audit cost)? Straightforward based
on above not much computation needed.
v. Does the managers outside option increase or decrease the total expected value
received by the manager and investors together? Increase think about what this
implies for e.g. the market for managers.