Problem Set 2

Advanced Corporate Finance

Due date: October 20
Submit via Moodle before class starts!!!

Problem 1

You are the sole shareholder and CEO of your own local newspaper. The company’s only assets
are $25,000 in cash. In one year the company’s only bank loan is due. The principal together
with the last interest payment amounts to $25,000. If the newspaper is unable to sell enough ads
to repay, all its assets will be taken over by the bank. There are three investment opportunities
available: (1) do nothing; (2) use the $25,000 to buy lottery tickets that will pay $2,500,000 in
one year with probability 0.01 and $0 otherwise; and (3) investing the $25,000 in an
advertisement salesperson training program that lasts one year and returns $50,000 with
probability 0.50, and $25,000 otherwise. The discount rate for valuing the cash flows is 10%.
Answer the following questions.

a) Which of the 3 investment opportunities would you prefer?

P1: In this case you go bankrupt and get nothing.

P2: (0.01max(2,500,000-25,000;0) + 0.99max(0-25,000;0))/1.1 = 22,500
P3: (0.50max(50,000-25,000;0) + 0.50max(25,000-25,000;0))/1.1 = 11,364
Shareholders prefer P2.

b) Which of the 3 investments would the bank prefer?

P1: 25,000/1.1 = 22,727

P2: (0.01min(2,500,000;25,000) + 0.99min(25,000;0))/1.1 = 227
P3: (0.50min(50,000;25,000) + 0.50min(25,000;25,000))/1.1 = 22,727
The bank is indifferent between P1 and P3.

c) How much would the bank have to pay you to make you choose the investment project
that it prefers? Hint: The payment has to make both the bank and the shareholder (you)
at least as well off as compared to the choice from part a).

At a minimum the bank must pay 22,500-11,364 = 11,136. You are now indifferent
between P2 and P3.

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Problem 2

According to the managerial entrenchment theory, managers choose capital structure so as to

preserve their control of the firm. On the one hand, debt is costly for managers because they risk
losing control in the event of default. On the other hand, if they do not take advantage of the tax
shield provided by debt, they risk losing control through a hostile takeover.

Suppose a firm expects to generate free cash flows of $90 million per year, and the discount rate
for these cash flows is 10%. The firm pays a tax rate of 40%. A raider is poised to take over the
firm and finance it with $750 million in permanent debt. The raider will generate the same free
cash flows, and the takeover attempt will be successful if the raider can offer a premium of 20%
over the current value of the firm. What level of permanent debt will the firm choose, according
to the managerial entrenchment hypothesis?

90
Unlevered Value   $900 .
0.10
Levered Value with Raider = 900 + 40%(750) = $1.2 billion
To prevent successful raid, current management must have a levered value of at least
$1.2 billion
 $1 billion.
1.20
100
Thus, the minimum tax shield is $1 billion – 900 million = $100 million, which requires  $250
0.40
million in debt.

Question 3

Zymase is a biotechnology start-up firm. Researchers at Zymase must choose one of three
different research strategies. The payoffs (after-tax) and their likelihood for each strategy are
shown below. The risk of each project is diversifiable.

Strategy Probability Payoff ($ million)

A 100% 75

B 50% 140

50% 0

C 10% 300

90% 40

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 a) Which project has the highest expected payoff?

b) Suppose Zymase has debt of $40 million due at the time of the project’s payoff. Which
project has the highest expected payoff for equity holders?

c) Suppose Zymase has debt of $110 million due at the time of the project’s payoff. Which
project has the highest expected payoff for equity holders?

d) If management chooses the strategy that maximizes the payoff to equity holders, what is
the expected agency cost to the firm from having $40 million in debt due? What is the
expected agency cost to the firm from having $110 million in debt due?

a. E(A) = $75 million

E(B) = 0.5 × 140 = $70 million
E(C) = 0.1 × 300 + 0.9 × 40 = $66 million
Project A has the highest expected payoff.
b. E(A) = 75 – 40 = $35 million
E(B) = 0.5 × (140 – 40) = $50 million
E(C) = 0.1 × (300 –40) + 0.9 × (40 – 40) = $26 million
Project B has the highest expected payoff for equity holders.
c. E(A) =$0 million
E(B) = 0.5 × (140 – 110) = $15 million
E(C) = 0.1 × (300 –110) = $19 million
Project C has the highest expected payoff for equity holders.
d. With $40 million in debt, management will choose project B, which has an expected
payoff for the firm that is 75 – 70 = $5 million less than project A. Thus, the expected
agency cost is $5 million.
With $110 million in debt, management will choose project C, resulting in an
expected agency cost of 75 – 66 = $9 million.

Question 4

On May 14, 2008, General Motors paid a dividend of $0.25 per share. During the same quarter
GM lost a staggering $15.5 billion or $27.33 per share. Seven months later the company asked

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for billions of dollars of government aid and ultimately declared bankruptcy just over a year
later, on June 1, 2009. At that point a share of GM was worth only a little more than a dollar.

a) If you ignore the possibility of a government bailout, the decision to pay a dividend given
how close the company was to financial distress is an example of what kind of cost?

Agency cost—cashing out.

b) What would your answer be if GM executives anticipated that there was a possibility of a
government bailout should the firm be forced to declare bankruptcy?

By paying a dividend, executives increased the probability of bankruptcy and therefore

the probability of receiving government funds. Since these government funds are funds
that investors would not otherwise be entitled to, the payment of a dividend could
actually raise firm value in this case.

Question 5

If managed effectively, Rearden Metal will have assets with a market value of $200 million,
$300 million, or $400 million next year, with each outcome being equally likely. Managers,
however, may decide to engage in wasteful empire building, which will reduce Rearden's market
value by $20 million in all cases. Managers may also increase the risk of the firm, changing the
probability of each outcome to 50%, 5%, and 45% respectively.

a) What is the expected value of Rearden's assets if it were run efficiently?

A) $265 million
B) $280 million
C) $295 million
D) $300 million
Answer: D
Explanation: The expected value is just the weighted average of the possible outcomes.
E[assets] = ($200 million) + ($300 million) + ($400 million) = $300 million

b) Suppose that the managers at Rearden Metal will engage in empire building unless that
behavior increases the likelihood of bankruptcy. If Rearden has $180 million in debt due
in one year, then what is the expected value of Rearden's assets?

A) $265 million.
B) $280 million.
C) $295 million.
D) $300 million.
Answer: B
Explanation: In all cases Rearden will be able to pay off its debt and avoid bankruptcy if

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 it engages in empire building, even in the worst case they will have $200 million - $20
million = $180 million in assets.
The expected value is just the weighted average of the possible outcomes.
E[assets] = ($200 million - $20 million) + ($300 million - $20 million) + ($400

million - $20 million) = $280 million

c) Suppose that the managers at Rearden Metal will engage in empire building unless that
behavior increases the likelihood of bankruptcy. If Rearden has $190 million in debt due
in one year, then what is the expected value of Rearden's assets?

A) $265 million.
B) $280 million.
C) $295 million.
D) $300 million.
Answer: D
Explanation: In this case the probability of bankruptcy is increased, since in the event of
the worse outcome with empire building Rearden's assets would only be worth $200
million - $20 million = $180 million which will not cover the repayment of debt.
Therefore, the management team will not engage in empire building.
The expected value is just the weighted average of the possible outcomes.
E[assets] = ($200 million) + ($300 million) + ($400 million) = $300 million

d) Suppose that the managers at Rearden Metal will increase risk to maximize the expected
payoff to equity holders. If Rearden has $180 million in debt due in one year, then what
is the expected value of Rearden's assets?

A) $280 million.
B) $295 million.
C) $300 million.
D) $900 million.
Answer: C
Explanation: Expected payoff to equity holders w/o increase in risk:
E[equity] = ($200M - $180M) + ($300M - $180M) + ($400M - $180M) = $120

million
Expected Payoff to equity holders w/increase in risk:
E[equity] = (50%)($200M - $180M) + (5%)($300M - $180M) + (45%)($400M - $180M)
= $115 million

Therefore, Rearden's managers will not increase the risk and the expected value of
Rearden's assets is:
E[assets] = ($200M) + ($300M) + ($400M) = $300 million

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e) Suppose that the managers at Rearden Metal will increase risk to maximize the expected
payoff to equity holders. If Rearden has $230 million in debt due in one year, then what
is the expected value of Rearden's assets?

A) $280 million.
B) $295 million.
C) $300 million.
D) $900 million.
Answer: BC
Explanation: Expected Payoff to equity holders w/o increase in risk:
E[equity] = ($0) + ($300M - $230M) + ($400M - $230M) = $80 million

Expected Payoff to equity holders w/increase in risk:

E[equity] = (50%)($0) + (5%)($300M - $230M) + (45%)($400M - $230M) = $80 million

Therefore, Rearden's managers will be indifferent and the expected value of Rearden's
assets is:
E[assets] = ($200M) + ($300M) + ($400M) = $300 million

OR
E[assets] = (50%)($200M) + (5%)($300M) + (45%)($400M) = $295 million