Answers/Solutions to Selected Questions/

Exercises

The first part of this book was focused on the major theories of capi-
tal structure: trade-off theory, pecking-order theory, asset substitu-
tion, credit rationing, and debt overhang. According to most empirical
research, none of these theories are able to fully explain real life decisions
made by companies. However, in most research related to capital struc-
ture, these basic ideas are used either as reference points or intermedi-
ate tools that help develop further ideas. The future of capital structure
theory is still uncertain, in my opinion. Will any theory(ies) emerge as a
clear “winner” (in terms of its ability to explain the reality) or will they
all combine into one “big” theory? Will any of these basic ideas be com-
pletely forgotten because the market imperfections used as a basis will no
longer be relevant in practice, or because empirical research consistently
rejects the results of a theory? In my opinion all of these possibilities are
still on the table. It seems that unlike other areas of finance, research-
ers of capital structure are still far from bridging the gap between its
theory and practical reality. Grahan and Harvey (2001) is a good refer-
ence point.
Part II discussed different topics of capital structure. As was men-
tioned earlier, the objective of the book was not to cover as many topics

© The Editor(s) (if applicable) and The Author(s) 2016 227

A. Miglo, Capital Structure in the Modern World,
DOI 10.1007/978-3-319-30713-8
228  Answers/Solutions to Selected Questions/Exercises

of capital structure as possible but rather to review the major theoretical

concepts and provide basic tools to understand the complicated area of
capital structure. Many advanced theories of capital structure discussed
in this book are still growing areas of research. I think that some areas
are very promising including the links between capital structure and
corporate/national culture, dynamic versions of trade-off theory and
pecking-­order or signaling theories, interactions between capital struc-
ture choices and bargaining strategies (with unions, suppliers or govern-
ments), capital structure of small and start-up companies, links between
capital structure choices and market timing, theoretical foundations of
flexibility and life cycle ideas of capital structure, and capital structure
management of financial institutions and its role in preventing financial
crises.
Educators should spend more time teaching capital structure given
that the topic has seen tremendous growth in recent years. Students are
very excited when they hear the words entrepreneurial finance (young
talent plus money combination!) and are very excited about such profes-
sions as investment banker and corporate treasurer. All of this is directly
related to capital structure knowledge. I have noticed in recent years that
students have stopped being afraid of capital structure topics and courses
and have begun to speak professionally, and with interest, about capital
structure related topics! So I think that new courses specifically dedicated
to capital structure theory and management and new programs preparing
specialists in the area of capital structure analysis and management could
be created at universities. Another reason for the existence of the large
gap between the theory and practice of capital structure is that educators
focus mostly on the positive aspects of the theory and its applications and
not on its normative aspects. As a result, students may be aware of exist-
ing models but are not able to apply them in real life when they become
managers. I feel that this is especially true for asymmetric information
and agency cost theories, which are without a doubt the most technically
complicated. Educators need to find a way to explain the practical appli-
cations of these theories.
   Answers/Solutions to Selected Questions/Exercises  229

Finally, I am a big fan of further integration of universities and

the financial sector. Practitioners should be given the opportunity to
teach more courses and professors should allocate more time to practi-
cal work. Nobel Prize winner Josef Stiglitz is a good example. Theories
have become more and more complicated so if the gap between the
theory and practice is not being constantly reduced, severe conse-
quences will follow. The challenges of this approach are to find prac-
titioners who have deep theoretical knowledge and professors who are
able to work in ­managerial positions. Both combinations are pretty
rare from my experience. Where we stand now, it is hard to imagine
that in the near future a large volume of (constantly growing expo-
nentially) complicated mathematical research will be able to seri-
ously penetrate into the practical sector with satisfactory speed and
intensity.
My book is aimed primarily at those who feel very excited about the
financial sector both theoretically and practically. I tried to make most
of my points in a theoretically rigourous fashion and bridge the deep
theoretical concepts with the practical examples and cases. If you, my
dear reader, feel this way I will be very satisfied. And good luck with your
exciting journey in the world of finance and capital structure!

Part I

Chapter 1

1. False
2. b
3. c
4. False
5. True
230  Answers/Solutions to Selected Questions/Exercises

6. We have V = 20000, D = 50000 and W = 100000. Since D > V , the

firm is in financial distress and the firm’s owner is personally liable for
the firm’s debt because it’s a sole proprietorship. Since W > D − V,
the firm’s owner will likely sell a part of his assets to pay the firm’s
debt.
7. False
8. c
10. True
11. False

Chapter 2

1. True
2. False
3. False.
4. False.
5. True.
6. True
7. True
8. True
9. False
12. Consider an investor holding 10 % of firm U′ s shares. Consider the
following two strategies for this investor:
Strategy 1: To keep 10 % of firm U′s shares
Strategy 2: Sell the shares for 0.1 ∗ 100, 000 = 10, 000 , buy 12.5 % of
company L′S shares (the value is 0.125 ∗ 40, 000 = 5, 000 ) and buy
12.5 % of company L′S bonds (the value is 0.125 ∗ 40, 000 = 5, 000 ).

Strategy 2 provides higher earnings in each scenario and thus is defi-

nitely better than strategy 1.

Investment
Earnings if economy is weak
Earnings if economy is strong
Strategy 1 Strategy 2
0 10, 000 − 5, 000 − 5, 000 = 0
400 = 0.1 * 4, 000 500 = 0.125 * ( 4000 − 0.1 * 40000 ) + 0.1 * 5, 000
15, 000 = 0.1 * 150, 000 18, 750 = 0.125 * (150000 − 0.1 * 40000 ) + 0.1 * 5, 000
  Answers/Solutions to Selected Questions/Exercises 
231
232  Answers/Solutions to Selected Questions/Exercises

13. The value of the unlevered firm can be found as follows:

1000
VU = (1 − 0.2 ) = 400
2

Tax shield:

 1000 − D D D 
TS = 0.2 *  ×D+ × 
 1000 1000 2 

Bankruptcy costs:

D D * 0.2
BC = ×
1000 2

The firm’s value V equals

 1000 − D D D 
V = VU + TS − BC = 400 + 0.2 *  ×D+ × 
 1000 1000 2 
D D * 0.2
− ×
1000 2

The firm’s choice of leverage is determined by maximizing V. The first-­

order condition with respect to D is D = 500.

Chapter 3

1. False
2. True
3. True
4. b
5.
   Answers/Solutions to Selected Questions/Exercises  233

(a) Outside investors know the value of the existing assets (100).
When they buy equity, if they get a fraction α of the firm, their
wealth in period 2 is α190, and of course in a competitive market
(remember no discounting) this will equal the cost, 70. Thus:
α = 70 / 190 = 7 / 19 .
Thus, the new shareholders will ask for 7000000 additional
shares and the share price will be 70 / 7 = 10 per share. The original
equity is worth (1 − α )190 = 120.
(b) Since 120 > 100, the new equity will clearly be issued and the new
project will be undertaken.
(c) The expected intrinsic value of the assets-in-place is
EX = p160 + (1 − p ) 40 = 100. If the project is not undertaken, the
entrepreneur’s wealth WNI is 40 or 160 depending on the firm’s
type.
Suppose now that equity is issued under any value of the asset.
A competitive capital market implies 70 = α (100 + 90 ) where
investors now break even only in expectation. The necessary
equity fraction required by outsiders is then

70 7
α= =
190 19

The wealth of the entrepreneur when he invests is now given (for

a high-value type) by:

12
(160 + 90 ) ≈ 157
19

For a low-value type, it is:

12
( 40 + 90 ) ≈ 82.1
19

So, a low-value type firm will invest because 82 > 40 while the
high-value type will not because 157 < 160.
234  Answers/Solutions to Selected Questions/Exercises

(d) When observing a new issue of shares, investors rationally realize

that the firm which issues shares is of a low-value type. A
­competitive capital market implies 70 = α ( 40 + 90 ). The necessary
equity fraction required by outsiders is then

70 7
α= =
130 13

The wealth of the entrepreneur when he invests is now given by

(for a low-value type)

6
( 40 + 90 ) = 60
13

(e) In
the beginning, the share price is (based on average value of
assets-in-place)

100 1
=8
12 3

After the market knows that the firm has an opportunity to invest
in the new project the share price becomes the average between
the future share values for each type of firm: high-value type is
160/12 and low-­value type is 5. So the price will be 9 and 1/6. The
price of shares sold during the issue is 70 / 14 = 5.
(f ) Lemon problem

6. If the information about the expected profits were public then Firm 1
would be sold for 20 and Firm 2 would be sold for 100.
Consider the case with asymmetric information. Suppose that the
entrepreneurs sell their firms. The price in this case will be 60. The
investors will be ready to buy the firm for an average expected return.
Consider the entrepreneurs’ expected utilities. The entrepreneur of
   Answers/Solutions to Selected Questions/Exercises  235

Firm 1 will obviously benefit from selling the firm for 60. His expected
utility will be 60. If he keeps the firm, his expected utility is less than
20. What about the entrepreneur of Firm 2?
If he does not sell the firm, his expected utility is

1
100 − ρ 50 = 100 − 25ρ
2

If he sells, then it is 60. The entrepreneur is only interested in selling

the firm if ρ > 8 / 5. Otherwise, he will keep his shares.

Partial sale of shares. Firm 1 sells all shares: P1 = 20 . Firm 2 sells

partially. To find α, we need to solve the following equation:

α2 2 (100 – 20 )
=
1−α ρ 50

Suppose that ρ = 1. The condition becomes:

α2 16
=
1−α 5

Solving for α, given that 0 < α < 1, gives: α = 0.8. Therefore, the entre-
preneur of Firm 2 should keep approximately 80 % of the shares and
sell 20 %.
236  Answers/Solutions to Selected Questions/Exercises

Chapter 4

1. (a) 40 and 35 (expected earnings minus cost)

Earnings
b g Expected
(Pr=0.5) (Pr=0.5) earnings
Project F 60 60 60
Project S 20 90 55

(b) Project S
Payoff to shareholders
b g Expected
(Pr=0.5) (Pr=0.5) value
Project F 10 10 10
Project S 0 40 20

Payoff to creditors
b g Expected
(Pr=0.5) (Pr=0.5) value
Project F 50 50 $50
Project S 20 50 $35

In this case, the shareholders will make the firm choose project S
because it has a higher NPV of 20; it, however, leaves the creditors
with a payoff worth 35.
(c) Still S.
Shareholder payoff
b g Expected
(Pr=0.5) Pr=0.5) value
Project F 0 0 0
Project S 0 10 5
   Answers/Solutions to Selected Questions/Exercises  237

Payoff to creditors
b (Pr=0.5) g (Pr=0.5) EV
Project F 60 60 60
Project S 20 80 50

Earnings
b g Expected
2. (Pr=1/2) (Pr=1/2) earnings
Project 1 10 10 10
Project 2 3 15 9

(a) It depends on D.

1. D$15. Both projects give 0 to shareholders.

2. 10 # D < 15. Then only Project 2 may provide some payment to
shareholders (only in the good state). So Project 2 is chosen.
3. 3 < D < 10.

The shareholders’ payoff:

b g Expected
(Pr=1/2) (Pr=1/2) payoff
Project 1 10-D 10-D 10-D
Project 2 0 15-D ½(15-D)

Comparing the payoffs we find that if D > 5 project 2 will be cho-

sen and Project 1 otherwise.

3. (a) D < 3. Project 1 will be chosen since it has higher expected earn-
ings and debt is risk-free.

(b) Project 2 is riskier. So when D is large enough there will be an

asset substitution.
(c) Asset substitution. Higher debt is worse for the asset substitution
problem.
(d) There is no FOD so asset substitution may take place. There is no
IR so sometimes there will be no substitution.
238  Answers/Solutions to Selected Questions/Exercises

(e) D > 6 . In this case Project 2 will be chosen. For creditors, the fol-
lowing should hold: ½ * D + 1 / 2 * 3 = 6. Since D = 9.
(f ) 1 / 2 * (15 − 9 ) + 1 / 2 * 0 = 3
(g) The shareholders’ expected payoff with the additional project is 3.
With the new project (assuming a new senior debt with face value
2 is issued): 1 / 2 * (15 + 3 − 2 − 9 ) + 1 / 2 * 0 = 3.5. The shareholders
will take the new project, which has a negative NPV:
3 * 1 / 2 − 2 = −0.5. The problem illustrated here is overinvestment.

4. D

7. In this question, we have to compare the payoff to the shareholders.

In both scenarios, whichever is greater will be the option they will
choose.
Liquidation:
Year 1
CF 1100
Senior debt payments –1100
Shareholders’ profit 0

Continuation (bank will accept a promise to pay 330 next year because
it will get 165 on average which will give the bank an average rate of
return of 10 %):
Year 1 Year 2
Good state Bad state
CF 0 1500 500
Senior debt payments –150 –1000 –500
Bank 150 –330 0
Shareholders’ profit 0 170 0

The shareholders would prefer to continue operations. The senior

debtholders are made worse off.
8. First let us compare the projects’ NPVs.
   Answers/Solutions to Selected Questions/Exercises  239

NPV ( F ) = 0.5* 60 + 0.5 * 60 − 20 = 40.

NPV ( S ) = 0.5 * 20 + 0.5 * 90 − 20 = 35.

Since F has a higher NPV than S, the shareholders will choose F. For
example, the firm can issue a risk-free debt with face value 20.
Now suppose that the cost of the project is 50. Now the projects’
NPVs are: NPV ( F ) = 10; NPV ( S ) = 5. Project F still has a higher NPV
than S. Which project will be chosen by the shareholders?
Suppose the firm can raise the 50 by issuing a bond with a
face value of 50. The shareholders earnings from taking proj-
ect F are: 1 / 2 ( 60 − 50 ) + 1 / 2 ( 60 − 50 ) = 10. And those from S are:
1 / 2 ( 90 − 50 ) + 1 / 2 ( 0 ) = 20. Shareholders will prefer project S which leads
to an asset substitution problem. Note also that the lender’s expected cash
flow from project S is 1 / 2 ( 20 ) + 1 / 2 ( 50 ) = 35 which is less than 50 if the
shareholders choose project S.
What should the face value of debt D be in order for creditors to have
an incentive to invest in the project?
Suppose that D > 50. If F is chosen, the shareholders’ payoff is
1 / 2 ( 60 − D ) + 1 / 2 ( 60 − D ) = 60 − D if D < 60 . Otherwise, it is 0. If S is
chosen, the shareholders’ payoff is 1 / 2 ( 90 − D ) + 1 / 2 * 0 = 45 − 1 / 2 D.
Comparing F and S we find that, since D > 30, S will be chosen.
How do we find the minimal acceptable value of D for credi-
tors? Their expected cash flow should cover the initial investment 50:
1 / 2 * D + 1 / 2 * 20 = 50. This gives D = 80. So the equilibrium scenario in
this seemingly very simple problem is that the firm will borrow an amount
50 by promising to return 80 and the shareholders will undertake project
S which has a smaller value compared to project F. If the creditors miscal-
culate the shareholders’ incentives it may lead to their loss in equilibrium.

9. (a) Project A’s NPV is 40 (expected earnings minus cost) and Project
B’s is 15.

(b) Considering a debt with face value 40, the shareholders’ payoffs
are:
240  Answers/Solutions to Selected Questions/Exercises

If A: 1 / 2 * 40 + 1 / 2 * 40 = 40.
If B: 1 / 2 (110 − 40 ) + 1 / 2 * 0 = 35.

Therefore, project A will be chosen. The creditors will be inter-

ested in providing the firm with the needed funds because debt is
essentially risk-free when the firm takes project A.
(c) In order to be able to raise debt, the firm needs to convince the
potential creditors that they can earn at least 50 % (on average).
Otherwise the creditors would prefer to invest in risk-free govern-
ment bonds. If the debt face value is 60 (= 40 * (1 + 0.5 )), the
shareholders’ expected payoffs will be as follows. If A:
0.5 ( 20 ) + 0.5 ( 20 ) = 20. If B: 0.5 ( 0 ) + 0.5 ( 50 ) = 25. Therefore, proj-
ect B will be chosen. In this case, the creditors’ expected payoff is
0.5 * 60 + 0.5 * 0 = 30, which is less than the cost of the investment.
As a result, they will not be willing to lend the money.
(d) The maximal possible face value of the debt is 110 (otherwise the
shareholders do not receive any profit). Therefore the maximal
expected payoff to the creditors is 0.5 * 110 = 55 < 60 . So there is
no equilibrium where creditors can count on earning at least at a
minimal acceptable interest rate of 50 %.

Chapter 5

1. (a) The firm’s expected earnings increase by 100, 000 * 0.4 = 40, 000
which is greater than the 30000 investment cost. So the NPV of
the project for the firm equals 100, 000 * 0.4 − 30, 000 = 10, 000.

(b) Without the new project, the shareholders’ earnings are:
(100, 000 − D ) * 0.4. If D = 20, 000, the shareholders’ expected earn-
ings are (10, 000 − 20, 000 ) * 0.4 = 32, 000 . If the firm undertakes
the new project the shareholders’ expected payoff will be
(100, 000 − 20, 000 ) * 0.8 − 30, 000 = 34, 000 > 32, 000 so the project
will be undertaken.
(c) Consider D = 60, 000. Without the new project the shareholders’
expected earnings are (100, 000 − 60, 000 ) * 0.4 = 16, 000. If the firm
undertakes the new project the shareholders’ expected payoff will
   Answers/Solutions to Selected Questions/Exercises  241

be (100, 000 − 60, 000 ) * 0.8 − 30, 000 = 2, 000 < 16, 000 so the proj-
ect will not be undertaken.
(d) Debt overhang; higher debt increases the likelihood of debt

overhang.

2. (a) The NPV = 3000 − 2000 = 1000 > 0.

(b) Without the new project, the shareholders’ expected payoff is:
1 / 2 (10000 − 6000 ) = 2000. Now consider the new investment
opportunity. Let F be the face value of the new debt. The expected
payoff to the new debtholders: 1 / 2 * F = 2000 , thus F = 4000. The
1
shareholders’ payoff is * (13000 − 6000 − 4000 ) = 1500. This is less
2
than the shareholders’ payoff without the new project. Thus, the
project will not be undertaken.
(c) Now suppose the initial debt is junior and the firm can issue a
senior debt to finance the new project. The face value of the new
senior debt is 2000 (since the total earnings are at least 2000 in
both states). So the shareholders’ expected payoff, if the new proj-
1
ect is undertaken, is: * (13000 − 6000 − 2000 ) = 2500. This is
2
greater than 2000. So the new project will be undertaken.
(d) Suppose the incumbent debtholders agree to finance the new proj-
ect with a new (junior) debt with a face value (including principal
and interests) of 2200. Suppose the shareholders accept financing
from the incumbent creditors. The shareholders’ payoffs with the
new project will be 0.5 * (13, 000 − 6, 000 − 2, 200 ) = 2400.
This is greater than 2, 000 and hence the shareholders will be inter-
ested in having a deal with the incumbent creditors. Now consider
the incentive for the creditors. Without the new project their
expected payoff is 0.5 * 6, 000 + 0.5 * 4, 000 = 5, 000 . With the proj-
ect it is: 0.5 * ( 6, 000 + 2, 200 ) + 0.5 * ( 7,000 ) − 2, 000 = 5, 600 .
So the deal is beneficial for both the shareholders and the creditors.
(e) Minimal for creditors: 1000. Maximal for shareholders: 3000.
Use the proof of Propositions 5.3 and 5.4.
(f ) Free rider-problem.
242  Answers/Solutions to Selected Questions/Exercises

3. Debtholders will sell the debt for 5000. To see this, note that in the
current situation debtholders will receive: 1 / 2 * 10000 + 1 / 2 * 0 = 5000 .
Will shareholders repurchase the debt? Currently, the shareholders’
expected payoff (given that corporate tax is 40  %) is:
1 / 2 (18000 − 10000 ) * (1 − 0.4 ) + 1 / 2 ( 0 ) = 2400. The new shareholders
will be able to pay 5000 for the newly issued shares if they get 25/27
of the firm’s equity. To see this note that the firm’s net income after the
debt repurchase in the bad state will still be 0 and that in the good
state it will be 18000 * 0.6 = 10800. Since this occurs with a 50 % prob-
ability, new shareholders will need 10000 in that state. So their frac-
tion should be equal to 25/27. The initial shareholders’ fraction of
equity is then 2/27 and their expected payoff is 2 / 27 * 10800 = 800,
which is less than 2400.

Part II
Chapter 6

1. True
2. True
3. True
4. Consider first financing for stage 2. We have 0.25 * D = 0.1. Hence
D = 2 / 5. In stage 1 investors require a fraction of equity s1 such that:
s1 * 0.7 + s1 * 0.25 * (1 − 2 / 5 ) = 0.1. Therefore s1 = 2 / 17. Now consider
the payoff of shareholders of b in case b decides to mimic g. This
equals 15 * 0.1 + 15 * 0.8 *  1 − 2  = 29 . If a signaling equilibrium
17 17  5 50
exists, the shareholders’ payoff for type b is pb1 + pb 2 − C1 − C2 = 0.7
(the present value of b). Thus, a separating equilibrium exists because
29 / 50 < 0.7.
5. Consider pooling equilibrium where both firms issue equity. We have
0.1 0.1
αe = =
0.3 * 0.3 + 0.7 * 0.1 + m + 0.12 0.28 + m
   Answers/Solutions to Selected Questions/Exercises  243

Consider the incentives for type 2. It’s optimal choice depends on

0.1( 0.42 + m ) . It holds if
0.12 > m > 0.42.
0.28 + m

Chapter 7

1. The expected earnings of project 1 equal 2.5 and they are greater than
that of project 2. So from the firm’s point of view, the manager should
choose project 1. The manager’s expected payoff if project 1 is chosen
equals 0.2 and 0.5 for project 2. If D = 0 the probability of bankruptcy
equals zero and the manager chooses project 2 since 0.5 > 0.2.
If D > 0, the manager’s expected payoff under project 1 is
0.2 * ( 5 − D ) / 5 and for project 2 it is 0.5 * ( 3 − D ) / 3. The manager will
choose project 1 if D > 45 / 19.
If D = 45 / 19, the real value of debt equals
45 / 19 * ( 5 − D ) / 5 + 45 / 38 * ( D / 5 ) = 6525 / 3610. This amount can be
provided by debtholders and in this case the rest should be raised by
selling equity.
2. (a) The first-best effort maximizes the firm’s value: 2e − 2e2. Socially
optimal e* = 1 / 2.

(b) E will maximize 2ke − 2e2 , where k is the fraction of equity that
belongs to E. Optimal e′ = k / 2 . For any k < 1, e′ < e*. If the man-
ager owns less than 100 % of the equity, the level of effort is below
the first-best level. The manager’s profit is then k2/2. To find the
optimal contract, we have to find the value of k that will maximize
the entrepreneur’s profit under the condition that the investor’s
expected profit is not less than b. This condition is
2e (1 − k ) = k (1 − k ) ≥ 1 / 8. The left side of this inequality reaches
its maximum when k = 1 / 2. In this case I′s expected payoff is 1/4.
E′s expected payoff is k2/2. It is increasing in k. Hence the optimal
k is the largest value of k that satisfies I’s budget constraint, i.e.
1/2. Optimal e = 1 / 4 and E′s expected payoff is 1/8.
(c) Two cases are possible. (1) 2e < D. In this case the manager maxi-
mizes 1 / 3 ( 4e − D ) − 2e2 . So optimal e = 1 / 3. The manager’s pay-
244  Answers/Solutions to Selected Questions/Exercises

off is 2 / 9 − D / 3. (2) 2e > D . In this case the manager maximizes

1 / 3 ( 2e − D ) + 1 / 3 ( 4e − D ) − 2e2. So optimal e = 1 / 2 . The manag-
er’s payoff is 1 / 2 − 2 D / 3. By comparing the manager’s payoffs in
each case we find that if D < 5 / 6 the optimal e = 1 / 2 and other-
wise e = 1 / 3. Now to find D note that the investor’s payoff should
be greater than b. So in the second case D = 3 / 2b . It is possible
only if b < 15 / 18. That is our case. So the firm can be financed
with debt with face value 3/8 and the manager’s profit is 1/4 in
this case.
(d) The manager’s payoff is higher under debt financing.

3. Equity financing. As was shown, earnings will not be manipulated in

this case. E will maximize ke + 2k − e2 , where k is the fraction of equity
that belongs to E. Optimal e′ = k / 2 . To find the optimal contract, we
have to find k that will maximize the entrepreneur’s profit under the
condition that the investor’s expected profit is not less than 19/32.
This condition is

(1 − k ) ( e + 2 ) = (1 − k )  
k
+ 2  ≥ 19 / 32
2 

The left side of this inequality is decreasing in k and equals 19/32

when k = 3 / 4 . In this case I′s expected payoff is 19/32. E′s expected
k 
payoff is k  + 2  . It’s increasing in k. Hence the optimal k is the larg-
 2 
est value of k that satisfies I′s budget constraint. E′s expected net pay-
off when k = 3 / 4 is 57 / 32 − 9 / 64 = 105 / 64.
Debt financing
E will use EM if R10 = 0. Otherwise, E loses control of the firm and
gets nothing in the second period. Optimal e equals e′ = (1 + c ) / 2 = 9 / 16.
Since R = 1 regardless the value of r, I′s payoff is D. Optimal D= b= 19 / 32.
E′s payoff is then 245/128. This is better than E′s payoff in the case of
equity financing without EM.
   Answers/Solutions to Selected Questions/Exercises  245

Chapter 8

1. (a) Period 1. The first-best effort maximizes the firm’s value: 2e − 2e2.
Socially optimal e* = 1 / 2.

(b) In the case of equity financing E will maximize 2ke − 2e2 , where k
is the fraction of equity that belongs to E. Optimal e′ = k / 2 . For
any k < 1, e′ < e* .
E′s profit is then k2/2. To find the optimal contract, we have to
find k that will maximize E′s profit under the condition that the
investor’s expected profit is not less than b. This condition is
2e (1 − k ) = 2 k (1 − k ) / 2 ≥ 1 / 8. The left side of the inequality
reaches its maximum when k = 1 / 2. In this case, I′s expected pay-
off is 1/4. E′s expected payoff is k2/2. It is increasing on k. Hence
the optimal k is the largest value of k that satisfies I′s budget con-
straint, i.e. 1/2. Optimal e = 1 / 4 and E′s expected payoff is 1/8.
(c) Now consider debt financing. Two cases are possible. (1) e < D. In
this case the manager maximizes 1 / 3 ( 4e − D ) − 2e2 . So optimal
e = 1 / 3. E′s payoff is 2 / 9 − 1 / 3D. (2) e > D. In this case the man-
ager maximizes 1 / 3 ( 2e − D ) + 1 / 3 ( 4e − D ) − 2e2. So optimal
e = 1 / 2 . E′s payoff is 1 / 2 − 2 / 3 D. By comparing the manager’s
payoffs in each case we find that if D < 5 / 6 optimal e = 1 / 2 and
otherwise e = 1 / 3. Now to find D, note that the investor’s payoff
should be greater than b. So in the second case D = 3 / 2b . It is pos-
sible only if b < 3 / 8, which is our case. So the firm can be financed
with debt with face value 3/8 and the manager’s profit is 1/4 in
this case.
(d) Debt is better because E′s payoff is higher in this case.
(e) Period 2. The first-best effort maximizes the firm’s value:
2e1 + 2e2 − 2e12 − 2e2 2 . Hence e= 1 e=
2 1 / 2.
(f ) Under equity financing, E has a fraction k of the firm’s equity. So
E will maximize k ( 2e1 + 2e2 ) − 2e12 . Optimal e1′ = k / 2 . Similarly
we find e ′2 = (1 − k ) / 2. I′s payoff equals
246  Answers/Solutions to Selected Questions/Exercises

(1 − k ) . If
2

(1 − k ) ( 2e1 + 2e2 ) − 2e22 = 1 − k − k = 1 / 2, it equals

2
3/8. E′s payoff also equals 3/8.
(g) Now consider debt financing. Two cases are possible. (1)
2 ( e1 + e2 ) < D. In this case E maximizes 1 / 3 ( 4 ( e1 + e2 ) − D ) − 2e12 .
So the optimal e1 = 1 / 3. (2) 2 ( e1 + e2 ) > D . In this case E maxi-
mizes 1 / 3 ( 2e1 + 2e2 − D ) + 1 / 3 ( 4 ( e1 + e2 ) − D ) − 2e12. So optimal
e1 = 1 / 2 . In this case I′s payoff is 2/3D. So D equals 9/16. e2 = 0
so 2 ( e1 + e2 ) > D . Similarly to the way we did it in period 1 one
can show that the second case is better for E and it works for I. So
the firm can be financed with debt with a face value of 9/16. E’s
profit is 2e1 + 2e2 − 2e12 − 3 / 8 = 1 / 8.
(h) So one can see that in period 2, equity is a better financing
structure.
(j) An optimal capital structure in this case is debt financing in period
1 and equity financing in period 2. It can also be interpreted as a
convertible debt or convertible preferred equity that are converted
into common equity in period 2.

2. The choice between the ID and IE is given by:

−0.3
pj =
0.2 Fj − D

It can be rewritten as:

−0.3
pj = .
0.2 Fj − D

The choice between the ID and the OD is given by:

p j ( 0.5Fj − D ) = p j ( Fj − D′ ) − 0.3 (1 − p j )
   Answers/Solutions to Selected Questions/Exercises  247

This equation can be rewritten as:

−0.3
pj =
− D + D′ − 0.3 − 0.5Fj

Finally, the choice between the OD and IE is given by:

p j ( Fj − D′ ) − 0.3 (1 − p j ) = 0.3 p j Fj − 0.3

This equation can be rewritten as:

D′ − 0.3
Fj =
0.7

The marginal entrepreneur with Fj = F * and p j = p* is indifferent

between all types of financing where

D′ − 0.3
F* =
0.7

and

0.21
p* =
0.7 D + 0.2 D′ − 0.06

Chapter 9

1. True.
2. True
3. (a) The new project has a positive net present value (NPV) because
1 / 2 * 2, 000 + 1 / 2 * 5000 > 3500.
248  Answers/Solutions to Selected Questions/Exercises

(b) The face value, d′, of this debt can be found from the following
equation: 3000 = d ′ * 1 / 2 + 1 / 2 * 0. Therefore d ′ = 6000.
The shareholders’ expected payoff without the new investment
is 1 / 2 * ( 20000 − D ) = 6000. With the new project, it will be
1 / 2 ( 20000 + 5000 − D − d ′ ) = 5500. Since the expected payoff
without the new project is more than that with the project, it will
not be undertaken.
(c) The face value d can be found from: 3000 = d * 1 / 2 + 1 / 2 * 2, 000 .
Here d = 4000 .
The shareholders’ expected payoff is (note that the shareholders
get nothing if B is realized): 1 / 2 * ( 20000 − D + 5000 − d ) = 6500 .
This is greater than 6000 (the shareholders’ expected payoff with-
out new investment), and thus the project will be undertaken and
it will be financed with non-recourse debt.
(d) The new project has a negative net present value (NPV) because
0.4 * 4, 000 − 0.1 * 20000 + 0.1 * 2000 < 0.
(e) The face value, d ′, of this debt can be found from the following
equation: 1000 = d ’* 0.4 + 0.6 * 0. This means that if G is realized,
the new debtholders will receive the face value of the debt; if,
however, B is realized, the firm’s cash flow is 2000, which is less
than the face value of the senior debt, leaving the new creditors
with nothing. Therefore, d' = 2500. The shareholders’ expected
payoff without the new investment is 0.5 * ( 20000 − 15000 ) = 2500.
With the new project, it will be 0.4 * ( 24000 − 15000 − 2500 ) = 2600.
Since the expected payoff with the new project is more than it is
without the project, it will be undertaken.
(f ) In this case, the debtholders’ payoffs depend only on the returns
from the new project and not on the returns from the assets
already in place. Since the NPV is negative, the firm will not able
to finance the project.

4. (a) It is impossible because the face value of debt will be lower for
type 1 than it is for type 2 if the latter were to use it. It’s because
   Answers/Solutions to Selected Questions/Exercises  249

the profit equals 2 with probability 0.75 * 0.25 and it equals 1

with probability 0.75 * 0.75 + 0.25 * 0.25. Both numbers are lower
for type 2. Therefore type 2 will mimic type 1.

(b) Suppose that both firms use project financing. We have:

0.2 0.2 0.2 0.2

=d11 = , d12 = , d21 = , d22
0.75 0.25 0.25 0.6
The shareholders’ expected payoff for type 2 is:

EE = 0.6 * 0.25 * (1 + 1 − 0.2 / 0.6 − 0.2 / 0.25 ) + 0.6 * (1 − 0.25 ) *

 0.2   0.2 
1 −  + 0.4 * 0.25 *  1 −  + 0.4 * 0.75 * 0 = 0.45
 0.6   0.25 

Type 1 firms will not mimic type 2. Indeed, if they do, their pay-
off will be
E = 0.6 * 0.25 * (1 + 1 − 0.2 / 0.75 − 0.2 / 0.25 )
+ 0.6 * (1 − 0.25 ) * (1 − 0.2 / 0.25 ) + 0.4 * 0.25 * (1 − 0.2 / 0.75 )
+ 0.4 * 0.75 * 0 ≈ 0.31

Calculations are similar for type 1.

 Index

A Berglöf, E., 139, 143

Abhyankar, A., 93
Antweiler, W., 61
asset substitution, viii, 69–94, 97,
139, 146, 163, 164, 223, 224,
237–9
B Chemmanur, T., 202
Baker, M., viii, 125, 126, 128
bank, ix, 4, 29, 34, 61–3, 70, 78–80,
82–5, 89, 90, 106, 108–10,
164, 172, 177, 185, 193, 202,
205, 238
bankruptcy
direct bankruptcy costs, 29, 34,
40, 139
indirect bankruptcy costs, 29, 30,
34, 40
Berkovitch, E., 146, 187
Brealey, R., 193, 201, 204
Brennan, M., 122, 194, 196
C
Chang, C., 153
control, 15–16, 69, 72, 83, 86, 135,
140, 144, 151, 168, 186,
203–5, 218–19, 244
Cooper, I., 193, 201, 204
corporate governance, viii, 135–56,
193
correlation, 37–9, 54, 55, 60, 61, 79,
115, 124, 130, 218
coupon, 17, 89
credit rationing, viii, 69–94, 164, 165

© The Editor(s) (if applicable) and The Author(s) 2016 251

A. Miglo, Capital Structure in the Modern World,
DOI 10.1007/978-3-319-30713-8
252 Index
D H
debtor-in-possession, 106
debt overhang, 97–111, 139,
187, 189, 190, 205, 223,
224
Degeorge, F., 147, 150
Dewatripont, M., 140, 143, 147
dividend policy, 105, 106
“double taxation”, 31
E Innes, R., 144, 146, 151
Eckbo, B.E., 61
“empire-building”, 136, 138,
139
Esty, B., 184, 186, 193, 201
Ewert, R., 14
exchange, 27, 49, 56, 104, 118, 166,
177, 215
F 183, 184, 187, 189–94,
Fama, E., 37
Fisher, I., 6
Frank, M., 5, 32, 36, 37, 54, 55,
61
Franks, J.R., 139
“free cash-flow”, 116, 135, 137–40,
190, 222
French, K., 37
G
Gatti, S., 185, 204, 205
Goyal, V., 5, 32, 36, 37, 54, 55
Graham, J., 5, 32, 34, 37–9, 79,
107
Green, R., 73, 75, 78
Grossman, S., 137, 140
Habib, M.A., 193, 201, 203, 204
Hart, O., 137, 140
Harvey, C., 5, 79, 107
Hennessy, C., 6, 39, 118
Ho, K., 93
Horvath, M., 14
I
incumbent debtholders, 241
insiders, 46–7, 64, 119, 131, 147,
148, 150, 194, 197
investment, vii, 4, 6, 10, 12, 23–6,
47–52, 61, 64, 69, 71–7, 80,
84, 86–8, 97–102, 105, 107,
110, 111, 115, 116, 118, 119,
122, 126, 127, 130–1, 135,
137, 145, 146, 148, 150,
154–6, 166, 171, 172, 176–8,
197–200, 203–6, 215, 216,
228, 239, 240
J
Jaramillo, F., 9
Jensen, M., 71, 137, 139, 144
John, K., 192, 202
Johnsen, D.B., 203
K
Kaplan, S., 141, 169
Kaufman, M., 82
Kensinger, J., 193
Kim, E., 187
Kleimeier, S., 185, 186, 193, 205
 Index 253

Korteweg, A., 30
Kraus, A., 32, 122, 194, 196
L overinvestment, 77–9, 140, 175,
Leary, M.T., 5, 32, 39, 55
Lee, Z., 211, 214, 217, 218
Leland, H.E., 56, 61, 118
“lemon” problem, 53
Levi, H., 93
limited liability, 13–14, 16, 30–1,
71, 172, 176
Lindhe, T., 14
Litzenberger, R., 32
Low, A., 154
M stock, 169
Majluf, N., 117, 176, 197, 198, 199
Martin, G., viii, 193
Meckling, W., 71, 144
Megginson, W.L., 186
Miglo, A., 3, 5, 14, 31, 32, 55, 61,
117, 119, 121, 126, 143, 150,
176, 197, 199, 211, 214, 217
Miller, M., vii, 6, 22, 40
Modigliani, F., vii, viii, 6, 22
Myers, S.C., 5, 32, 47, 51, 55, 97,
117, 176, 187, 192, 197, 198,
199
N 169, 184, 190, 193, 199,
Nachman, D., 51, 61
Niemann, R., 14
Noe, T., 51, 61, 122
non-recourse debt, 183, 186,
189–93, 196, 199, 201–3,
205, 206, 248
O
Oberg, A., 14
outsiders, 46–7, 53, 64, 150, 177,
194, 219, 233, 234
186, 190, 238
P
Patel, F., 147, 150
pecking-order theory, viii, 5, 47–56,
64, 107, 115, 117, 130, 175,
218, 222, 227
preferred stock
convertible preferred stock,
169
participating convertible preferred
present value, 32, 52, 120, 123, 203,
242
project, 3, 47, 69, 97, 117, 137, 170,
183, 224
project financing, 183–206
Pyle, D., 56, 61, 118
R
Rajan, R., 37, 106
Rajgopal, S., 149
risk, 8, 36, 47, 55, 57, 60, 61, 64,
71–4, 77, 79, 88, 93, 99, 106,
116, 139, 140, 146, 154, 166,
201–5, 214, 217, 219, 224
“risk-bearing” signaling, 56
Roberts, M., 55, 154
Rosenthal, H., 139
Ross, S.A., 56
Roychowdhury, S., 149
254 Index

S U
Schiantarelli, F., 9 underinvestment problem, 100–2,
Shah, K., 118 105, 106, 186, 187, 192–3, 199
Shah, S., 201 underpricing, 46, 56, 115, 198, 214
Shyam-Sunders, L., 5, 55 unlimited liability, 13–16, 172, 176
Sodersten, J., 14
Stiglitz, J., vii, 45–6, 70, 80, 164,
176, 229 V
stochastic dominance von Thadden, E.-L., 143
first-order stochastic dominance,
91
increasing risk, 93 W
second-order stochastic Weiss, A., 45, 70, 80, 164, 176
dominance, 88, 92 Wessels, R., 37
Strebulaev, I., 37, 39 Whited, T., 37–9
Sussman, O., 139 Woywode, M., 14
Wright, J., 185
Wright, S., 37
T
Thakor, A., 201
Tirole, J., vii, 140, 141, 143, Z
148 Zeckhauser, R., 147, 150
Titman, S., 37, 47, 84, 86, 99, Zender, J., 5, 143, 154, 168
106 Zhao, H., 93
Zingales, L., 37