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Corporate Finance Exercises & Solutions

The document contains a series of corporate finance exercises focused on key concepts such as risk-shifting, adjusted present value, and the impact of payout choices on shareholder wealth. Each exercise presents a scenario with specific calculations and solutions, illustrating the principles of firm value, debt, equity, and taxes. The exercises also explore the informational effects of share repurchases and cash management models.

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Al iibrahim
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4 views2 pages

Corporate Finance Exercises & Solutions

The document contains a series of corporate finance exercises focused on key concepts such as risk-shifting, adjusted present value, and the impact of payout choices on shareholder wealth. Each exercise presents a scenario with specific calculations and solutions, illustrating the principles of firm value, debt, equity, and taxes. The exercises also explore the informational effects of share repurchases and cash management models.

Uploaded by

Al iibrahim
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd

Corporate Finance Exercises with Integrated Solutions

Exercise 1 – Shareholders’ Selfish Risk-Shifting (Asset Substitution)


A levered firm has one-year zero-coupon debt outstanding with face value F = 60.
Management (acting for equity) must choose one of two mutually exclusive projects, each
requiring no new investment and each paying off in one year:
• Safe project S: pays 100 for sure.
• Risky project R: pays 150 with probability 0.5, and 50 with probability 0.5.
Assume limited liability and perfect markets otherwise.
Questions: (a) Compute expected payoffs to debt and equity under S and under R. (b) Which
project maximizes equity value? (c) Comment on total firm value and the conflict.

Solution 1

Debt F = 60.
Safe S: Firm payoff = 100 ⇒ Debt = min(100,60)=60; Equity = 100−60=40.
Risky R: 150 (p=0.5) ⇒ Equity = 90; 50 (p=0.5) ⇒ Equity = 0.
E[Equity|R] = 0.5×90 + 0.5×0 = 45 (vs 40 under S) ⇒ Equity prefers R; E[Debt|R] = 0.5×60 +
0.5×50 = 55 (vs 60 under S).
Total E[V] = 100 in both cases ⇒ conflict arises from fixed debt payoff.

Exercise 2 – Adjusted Present Value (APV)


I0 = 500; CF = 150 for 5 years; r_u = 10%; D0 = 300; r_d = 6%; T_c = 30%; Tasks: (a)
NPV_unlevered (b) PV tax shield (c) subtract costs (d) APV.

Solution 2

PVAF(r_u,5)=3.79079 ⇒ PV(CFs)=568.62; NPV_unlevered=68.62.


Interest=300×6%=18.00 ⇒ Tax shield/yr=30%×18.00=5.40;

PVAF(r_d,5)=4.21236 ⇒ PV(TS)=22.75.

Exercise 3 – MM Irrelevance: Dividend vs Buyback (No Taxes)


Firm value=100m; shares=10m; P0=10; excess cash=10m. Policies: (A) Dividend 1/share;
(B) Buyback at 10. Holder has 100 shares.

Solution 3

A) Ex-div P≈9; Wealth=100×9 + 100×1 = 1,000.


B) Repurchase 1m shares ⇒ shares=9m; V=90m; P=10; Non-seller wealth=100×10=1,000.
⇒ Identical wealth.
Exercise 4 – Taxes in Payout Choice
Introduce taxes: T_d=30%, T_g=15%. Compute after-tax wealth for a 100-shareholder
under dividend; buyback (sell vs no-sell).

Solution 4

Dividend: after-tax cash=0.70/share ⇒ Wealth=100×9 + 100×0.70 = 970.


Buyback (no sale): Wealth=100×10 = 1000 (tax deferred).
Buyback (sell 10): Cash=100, tax=15%×100=15; Shares left=90 ⇒ Equity=900; Total wealth
= 900 + 85 = 985.

Exercise 5 – Informational Effect of Share Repurchase


Values: 12 (G) or 8 (B); P(G)=0.5, P(B)=0.5; pre-announcement price=10. P(announce|G)=1,
P(announce|B)=0.2.

Solution 5

P(G|announce) = (0.5×1) / (0.5×1 + 0.5×0.2) = 0.8333; Price after = 12×0.8333 + 8×0.1667 =


11.3333; Announcement return = 13.33%.

Exercise 6 – Baumol Cash Management Model


T=1,200,000; b=50; i=6%. Compute: (a) C* = sqrt(2bT/i), (b) T/C*, (c) C*/2, (d) TC =
b(T/C*) + i(C*/2).

Solution 6

C* = 44,721; Transactions/year = 26.8; Average cash = 22,360.7; Total cost = 2,683.28.

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