Sample Questions

These questions are representative of the type of questions that you will find in the
final exam. (Note: Please do not interpret these set of questions as representative
of the content of the exam but of the type of questions that you should expect.)

Please review the sample questions for the midterm and the midterm itself. They should
help you to prepare for the final as well.

Sample short questions

Question 1. Give two reasons (referring to issues discussed in class) why issuing senior debt can create
shareholder value (i.e., why they might choose to issue senior debt over junior debt).

1. Helps to protect debtholders against further more senior debt issuances that would transfer wealth from
debtholders to equityholders. (And hence might make borrowing possible at all)

2. Helps to avoid excessive managerial growth by limiting free cash flow

Question 2. A CFO says: “In our company shareholder value comes first. Therefore for each project we
calculate NPV, i.e., the present value of future cash flows minus the current cost of taking on the project,
and choose not to invest if the NPV is negative.” Do you agree with this CFO that maximizing shareholder
value implies passing up negative NPV projects in all circumstances? If you agree justify your answer, if
you don’t please build a specific numerical example that proves your point.

False. A firm that has outstanding debt can increase equity value at the expense of bondholders by investing
in negative NPV but high risk projects. The upside potential of the project accrues to equity holders, whereas
downside risk hurts bondholders.

Question 3. A real estate development company is considering purchasing litigation insurance against the
risk of being sued for an office building it constructs. The company is public, and is planning to increase its
leverage to 60% right after the insurance purchase. The CFO is against purchasing insurance.
He says: “The risk of being sued is completely idiosyncratic, and we are a public company, which means
our shareholders are not worried about idiosyncratic risks. Therefore insuring against idiosyncratic risks is
redundant”. Do you agree with the CFO? Explain.

False. Idiosyncratic risk affects the likelihood of bankruptcy. Even if the risk factor is completely
independent of macroeconomic events, a negative realization of such a risk factor can lead to bankruptcy.
The firm is about to increase its leverage. If it does so without first hedging against the litigation risk, the
debt issue will be priced given the relatively higher bankruptcy risk and the resulting costs of bankruptcy
(both direct and indirect), and the firm will have to pay an accordingly high interest rate. This high interest
rate can be avoided or lowered if the firm reduces its bankruptcy risk by buying insurance.
 SAMPLE PROBLEMS
Question A
A diversified firm consists of two divisions, industrial equipment and beer production. A year from now,
the industrial equipment division will produce either $150 if the economy is in expansion, or $50 if the
economy is in a recession. The beer division will make $30 if the economy is in expansion, but $170 if the
economy is in recession. Each state of the economy is equally likely. The firm has outstanding bonds with
face value $120 to be repaid a year from now, and 100 outstanding shares.

Assume that the risk-free rate is zero, investors are risk-neutral, there are no taxes, and no bankruptcy costs.
a) What is the current market value of the debt? What is the current share price?

The total firm cash flows are $180 in expansion and $220 in recession. Since both figures exceed $120, the
bonds will be paid in full in either state of the world, which makes the current
market value of debt $120. The share price is then
[(0.5)*(180 – 120) + (0.5)*(220 – 120)]/100 = $0.8

b) Now suppose that the firm decides to sell the beer division, and pay the proceeds to its shareholders as a
dividend. How much will the beer division sell for? Immediately after this decision is announced, but
before the actual sale and the dividend takes place, what is the market value of the bonds?
What is the per share price? Compare the share price with the one obtained in a) and explain the difference
(if any).

The beer division will sell for (0.5)*(30) + (0.5)*(170) = $100

The market value of bonds immediately after the announcement is (0.5)*(120) + (0.5)*(50) = $85
Per share price immediately after the announcement is [100 + (0.5)*(150 - 120) + (0.5)*(0)]/100 = $1.15

c) Suppose now that rather than directly selling the beer division, the firm spins it off.
Specifically, for each outstanding share of the original company, one new share representing an ownership
claim in the newly created beer firm is issued and is given to shareholders. The new beer company assumes
half of the face value of the outstanding debt. After the spin-off, the original shares keep trading (now
representing a claim only on the industrial equipment business), while the newly issued beer shares start
trading separately. Immediately after this spin-off takes place, what is the market value of the debt of the
industrial equipment firm? What is the market value of the debt of the beer production firm? What are the
per share prices of each company? Compare the share price with part a) and explain the difference (if any).

Immediately after the spin-off, the market value of the debt of the industrial equipments firm is
(0.5)*(60) + (0.5)*(50) = $55
The market value of the debt of the beer firm is
(0.5)*(30) + (0.5)*(60) = $45
Per share price of the industrial equipment firm is
[(0.5)*(150 - 60) + (0.5)*(0)]/100 = $0.45
Per share price of the beer firm is
[(0.5)*(0) + (0.5)*(170 - 60)]/100 = $0.55

d) Does the Modigliani-Miller Proposition hold? (i.e., is the total firm value is independent of the capital
structure decisions of the firm in parts a, b, and c.?) Explain.
a) Firm value = Debt value + Equity value
= 120 + 100*(0.8) = $200
b) Firm value = Debt value + Equity value
= 85 + 100*(1.15) = $200
c) Firm value = Debt value(Industrial) + Debt value(beer) +
+ Equity value(Industrial) + Equity value (beer)
= 55 + 45 + 100*(0.45) + 100*(0.55) = $200

Question B

Suppose that a company has an opportunity to build a steel mill. The company can build either a mill to
produce common steel or a mill to produce specialty steel, but not both. If it builds a common steel mill, it
can produce up to 200 tons of common steel next year. If it builds a specialty steel mill, it can produce up to
200 tons of specialty steel next year. Neither type of mill costs anything to build, and neither has any value
after next year.

Producing 1 ton of either type of steel requires using 1 ton of iron ore as an input. All production and sales
take place one year from today. Next year, the economy can be in either a recession or an expansion. In an
expansion, the price of iron ore is $2,000 per ton. In a recession, the price of iron ore is $1,000 per ton. The
one year forward price of iron ore is $1,400 per ton.

If the company produces common steel, it can sell it one year from today for $3,000 per ton in an expansion
and $1,500 per ton in a recession. If the company produces specialty steel, it can sell it one year from today
for $3,500 per ton in an expansion and $500 per unit in a recession. The company will find out the state of the
economy before it has to decide how much steel to produce. The risk-free rate is 10%.

a) (5 points) What is the value of building a mill to produce common steel today?

Payoff: 200 × (3,000 – 2,000) = $200,000 in expansion and 200 × (1,500 – 1,000) = $100,000 in recession.

Tracking portfolio:

Y forward contracts on iron ore and Z dollars invested in the risk-free asset, which satisfy the following
equations:

Y × ($2,000 - $1,400) + Z × 1.1 = $200,000

Y × ($1,000 - $1,400) + Z × 1.1 = $100,000

Solving the two equations, we get Y = 100 forward contracts and Z = $127,272.73 invested in the risk-free
asset.

Since the forward contracts cost nothing, the value of tracking portfolio = $127,272.73.

b) (10 points) What is the value of building a mill to produce specialty steel today? Should the company
build a common steel mill or a specialty steel mill?

Payoff is 200 x (3,500 – 2,000) = $300,000 in an expansion and 0 in a recession because the firm will not
produce.

Tracking portfolio:

Y forward contracts on iron ore and Z dollars invested in the risk-free asset, which satisfy the following
equations:

Y × ($2,000 - $1,400) + Z × 1.1 = $300,000

Y × ($1,000 - $1,400) + Z × 1.1 = $0

Solving the two equations, we get Y = 300 forward contracts and Z = $109,090.91 invested in the risk-free
asset.

Since the forward contracts cost nothing, the value of tracking portfolio = $109,090.91.

So, we should build a common steel mill.

c) (15 points) Now suppose that a technology is available that allows a mill built to produce specialty steel to
be converted to produce common steel instead (but not the other way around). The company can wait until it
finds out the state of the economy in one year to decide whether or not to convert, and if it decides to convert,
this conversion takes place immediately. Converting a specialty steel mill to a common steel mill costs
$50,000, which is paid at the time of conversion if the company converts. Which type of mill should the
company build today? What is the value of the company today?

Payoff from building common steel mill is same as in part a.

If the company builds a specialty steel mill, it will convert to a common steel mill in a recession. This
changes its recession payoff to 200 x ($1,500 - $1,000) - $50,000 = $50,000.

The tracking portfolio that replicates the cash flow from building a specialty steel mill now be:

Y × ($2,000 - $1,400) + Z × 1.1 = $300,000

Y × ($1,000 - $1,400) + Z × 1.1 = $50,000

Solving the two equations, we get Y = 250 forward contracts and Z = $136,363.63 invested in the risk-free
asset.

Since the forward contracts cost nothing, the value of tracking portfolio = $136,363.63.

So, we should build a specialty steel mill.

Question C

A firm consists of assets that will produce at t = 2 cash flows of $100 if the economy is good and $30 if the
economy is bad. (Both states are equally likely). The firm has 100 shares outstanding and debt with a face
value of $20, due at the end of t = 2. Assume no taxes. Both the risk-free rate and the risk premium are zero;
therefore the discount rate is 0%.

a) (7 points) Suppose that at t=1 the firm unexpectedly announces that it will issue additional debt with a face
value of $20 more junior than the existing debt. The firm will use the entire proceeds to repurchase some of
its outstanding shares. What is the market price of the new debt? Before the announcement, what is the share
price? Just after the announcement, what will the price of a share be?

Market price of the new debt is 0.5 x $20 + 0.5 x $10 = $15.

Share price before announcement:

Good state: 100-20=80

Bad state: 30-20=10

Share Price = [(80+10)/2]/100 = $0.45

Share price after announcement still $0.45.

b) (7 points) Suppose instead that at t=1 the new debt issued above is more senior than the existing debt (and
also has a face value of $20). The firm will use the entire proceeds to repurchase some of its outstanding
shares. What is the market price of the new debt? Just after the announcement, what will the price of a share
jump to?

Market price of new debt = $20

Equity value after announcement = 20 + (60 + 0)/2 = $50

Share Price will jump to $0.50

c) (8 points) Suppose that before the financial transactions described in (a), a shareholder owned 20% of the
firm’s equity. Assume that when the firm buys back the shares this shareholder is unable to sell any of her
shares directly in the share repurchase program. Show how the shareholder can costlessly undo the effects of
the firm’s transaction to get back to the same future cash flows in both states that she would have had in the
absence of the firm’s transaction. Be specific about the exact transactions that the shareholder needs to
undertake (i.e., what should the shareholder buy and/or sell in the market) and what her cash flows are in each
state after she undoes the effects of the firm’s transaction.

The shareholder should sell equity to retain 20% of ownership and buy 20% of the new debt issued by the
firm. Doing so, the shareholder will guarantee herself at t=2 a cash-flow of either $16 or $2, which is what
she got before the transaction.

d) (8 points) Suppose that before the financial transactions described in (b), a shareholder owned 20% of the
firm’s equity. Assume that when the firm buys back the shares this shareholder is unable to sell any of her
shares directly in the share repurchase program. Show how the shareholder can costlessly undo the effects of
the transaction in such a way that she ends up with at least as much cash flow in both states as she would have
received in the absence of the firm’s transactions, and more cash flow in at least one of the two states. Be
specific about the exact transactions that the shareholder needs to undertake (i.e., what should the shareholder
buy and/or sell in the market) and what her cash flows are in each state after she undoes the effects of the
firm’s transaction.

The shareholder should sell equity to retain 20% of ownership and buy 20% of the new debt issued by the
firm. After the transaction, there will be 100 - 20/0.50 = 60 shares outstanding. 20% of this is 12 shares. So
the shareholder needs to sell 20 - 12 = 8 shares. This nets 8 * $0.50 = $4, which she uses to buy the new debt.
Her payoff is 0.2 * 60 + $4 = $16 in the good state, which is what she got before the transaction, and $4 in the
bad state, which is greater than the $2 she got before the transaction. So she is better off.

Question D
(Make the usual assumptions of zero risk-free rate, zero risk premium, and no taxes)
A firm has the following debt outstanding:

a) Senior bond obligation (Bond X) of $100 due immediately

b) Senior bond obligation (Bond Y) of $300 due in one year
c) Subordinated bank loan of $200 due to Longhorn Bank in one year. This debt is subordinated to
bonds X and Y, but not to subsequent debt issues.
Unless the firm gets a new loan of $100 (to pay off Bond X) immediately, it must liquidate. The current
liquidation value of the firm is $400.

If the firm liquidates, its debts are paid off according to the absolute priority rule. (Bonds X and Y will be paid
first. Afterwards, assuming that there is any cash flow left, the loan to Longhorn Bank will be repaid. Then if
there is anything left equityholders would be paid.)

If the firm does not liquidate, it can take one of the following two projects with no additional investment:

Project A: Next period, it will produce cash flows of $450 for sure.

Project B: Next period, it will produce cash flows of $200 or $650 with equal probability.

a) (5 points) Suppose (contrary to what is stated above) that the firm is all equity financed: Will the firm
liquidate? If it doesn’t liquidate, which project will it choose?

Liquidate: $400

Operate, project A: $450

Operate, project B: (650+200)/2 = $425

 Operate, choose project A

b) (15 points) Now suppose that the financing is as described above. Would Longhorn Bank be willing to
offer the firm a $100 loan with a face value of $110 due in one year that will allow the firm to pay off bond X
and avoid liquidation? Explain. (Hint: Start by figuring out which project the firm will choose if it raises the
additional capital). What is the minimum face value that Longhorn Bank would accept for the new loan?

For the firm:

If the firm chooses project A: 450 – 300 – 200 – 110 < 0  Firm doesn’t get anything

650 – 300 – 200=

– 110 $40

If it chooses project B:

200 – 300 – 200 – 110 < 0

Then firm will choose project B, accepting the loan from Longhorn Bank

For Longhorn Bank:

Do nothing  Firm will liquidate, Longhorn Bank gets nothing

Issue the new loan  200 =
+ 110 310

Firm will choose project B 0

That is the bank gets $155

Then, Longhorn Bank will give the loan with face value of 110.

The minimum face value that Longhorn Bank would accept is: 100 = (200 + F)/2

 F = $0. That is, Longhorn Bank would be willing to loans the company $100 in exchange for debt
with face value zero.

c) (10 points) Can the firm borrow the $100 it needs to pay off bond X and avoid liquidation from an
alternative financier (i.e., from someone other than Longhorn Bank and the existing bondholders)?

No, because if another financier provides $100, it can only recover an expected value of, at most, $75. The
reason for the difference is that Longhorn Bank already has money invested in the firm.