Problem Set 2
Advanced Corporate Finance
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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.
1
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 .1 0
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 b illio n
$ 1 b illio n .
1 .2 0
100
Thus, the minimum tax shield is $1 billion – 900 million = $100 million, which requires $250
0 .4 0
million in debt.
Question 3
Zymase is a biotechnology start-up firm. Researchers at Zymase must choose one of three
different research strategies. The payoffs (after-tax) and their likelihood for each strategy are
shown below. The risk of each project is diversifiable.
Strategy Probability Payoff ($ million)
A 100% 75
B 50% 140
50% 0
C 10% 300
90% 40
2
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.