DMBA: Corporate Finance & Financial Markets, Fall 2021

Problem Set 2 Solution

Each question is worth 20 points. The maximum number of points for this assignment is 120.

Question 1

Two firms, U and L, generate exactly the same cash flows as each other every year. Each will
earn $350 in a boom year and $100 in a slump year. In each year, there is a 50% chance of a boom
and a 50% chance of a slump. U is entirely equity financed, and shareholders receive the entire
income of the company as a dividend every year. Its shares are currently valued at $1,000. L has
$800 of perpetual risk-free bonds paying an interest rate of 10%, and therefore $80 of L's income
is paid out as interest every year. There are no taxes, and investors can borrow at the risk-free rate.

1a) (5 points) What should the value of L's stock be if there are no arbitrage opportunities?

Because the firms are identical except for the financial structure, no arbitrage requires that the total
value of these companies must be the same. Thus, L's stock is worth $1,000 - $800 = $200.

1b) (5 points) Suppose that you invest $40 in U's stock. Is there an alternative involving an
investment in L’s securities that would give identical payoffs to those from owning $40 of U’s
stock in both a boom and a slump? What is the expected annual payoff from such a strategy?

If you own $40 of U's common stock, you own 4% of the outstanding shares and thus are entitled
to 0.04 x $350 = $14 if there is a boom and 0.04 x $100 = $4 if there is a slump. The equivalent
investment is to purchase 4% of L’s outstanding stock for 0.04 x $200 = $8 and 4% of L’s
outstanding debt for 0.04 x $800 = $32, or $8 + $32 = $40 altogether. In a boom, you are entitled
to 0.04 x ($350 - $80) + 0.04 x $80 = $14 if there is a boom and 0.04 x ($100 - $80) + 0.04 x $80
= $4 if there is a slump.

1c) (5 points) Now, suppose that you invest $40 in L's stock. Is there an alternative portfolio
involving an investment in U that would give identical payoffs to those from owning $40 of L’s
stock in both a boom and a slump? What is the expected annual payoff from such a strategy?

If you own $40 of L's common stock, you own 20% of the outstanding shares and thus are entitled
to 0.20 x ($350 - $80) = $54 if there is a boom and 0.20 x ($100 - $80) = $4 if there is a slump.
The equivalent is to purchase 20% of U's outstanding stock, which costs 0.20 x $1,000 = $200,
and borrow $160 at the risk-free rate. The total investment is $200 - $160 = $40. You will need
to pay interest of $160 x 0.10 = $16 on the loan. In a boom, you receive 0.20 x $350 - $16 = $54,
and in a slump, you receive 0.20 x $100 - $16 = $4.

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 1d) (5 points) Show that the expected return of the alternative portfolio you constructed in part c
is the same as the formula for the cost of equity on slide 38 of the Unit 3 – Financing Fundamentals
slides predicts that it should be. Note that the equity (E in the formula on the slide) here is the
amount of capital that you invest out of pocket, while the debt (D in the formula on the slide) is
the amount that you borrow to finance the transaction.

Expected return on alternative portfolio = (0.5 x $54 + 0.05 x $4) / $40 = 72.5%

Since U is unlevered, use it to find expected return on assets = (0.5 x $350 + 0.5 x $100) / $1,000
= 22.5%. $200 of stock, financed with $160 debt and $40 equity ($ out of your own pocket).
Formula on slide 25: Expected return on equity = 22.5% + ($160 / $40) (22.5% - 10%) = 72.5%.

Question 2

Companies X and Y are identical in all respects except for their financing. Current data on the
financial structure of the two companies is as follows:

Company X:
1 million shares outstanding with a current market price of $10 per share
100,000 bonds outstanding with a current market price of $100 per bond

Company Y:
2 million shares outstanding with a current market price of $8 per share
50,000 bonds outstanding with a current market price of $100 per bond

The bonds of both companies are risk-free zero-coupon bonds that will pay the holder principal
and interest due one year from today. The risk-free interest rate is 10%. All of the securities listed
above can be sold short at no cost. There are no taxes, and investors can borrow at the risk-free
rate.

2a) (10 points) Use the four securities described above (Company X’s stocks and bonds and
Company Y’s stocks and bonds) to construct an arbitrage portfolio (i.e., one that generates a
positive profit today with no future risk) that includes exactly 50,000 shares of stock in Company
X. How large are the arbitrage profits from this portfolio? Construction of this arbitrage portfolio
will require short-selling some of the securities. Note: There are actually infinitely many arbitrage
portfolios that differ only in their scale. I am asking you to construct one with exactly 50,000
shares of Company X’s stock in order to pin down the specific arbitrage portfolio.

Since the companies have identical cash flows, they should have identical total (equity + debt)
values. However,

Value of X = (1,000,000 x $10) + (100,000 x $100) = $20,000,000

Value of Y = (2,000,000 x $8) + (50,000 x $100) = $21,000,000

Company X is undervalued relative to firm Y. Buying 100% of both the equity and debt of
Company X and short-selling 100% of both the equity and debt of Company Y would generate an

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 arbitrage (risk-free) profit of $1,000,000 today. Similarly, buying Z% of both the equity and debt
of Company X and short-selling Z% of both the equity and debt of Company Y would generate an
arbitrage (risk-free) profit of Z% x $1,000,000 today for any value of Z. In this case, we are buying
50,000 shares of Company X’s stock – or 5% of Company X’s equity – in our arbitrage portfolio.
We therefore need to also buy 5% of Company X’s debt and short-sell 5% of both the equity and
debt of Company Y. Thus, our arbitrage portfolio should be:

Long 5% of the equity of X ➔ purchase 50,000 shares for $500,000

Long 5% of the bonds in X ➔ purchase 5,000 bonds for $500,000
Short 5% of the equity of Y ➔ short-sell 100,000 shares for $800,000
Short 5% of the bonds in Y ➔ short-sell 2,500 bonds for $250,000

This portfolio generates a net cash inflow today of –500,000 – 500,000 + 800,000 + 250,000 =
$50,000.

The net cash flow from this portfolio in the future (i.e., in all subsequent periods) will be exactly
zero. Thus the arbitrage profits are $50,000.

2b) (10 points) Suppose that Company Y is planning to issue $2,000,000 worth of new stock and
use the proceeds to repurchase some of its existing bonds. You currently own 40,000 shares of
stock in Company Y and are concerned that the stock will offer a lower return after the financial
restructuring because you (correctly) anticipate that the stock will be less risky if the company has
lower leverage. You want to counteract Company Y’s financial restructuring so that your payoffs
are exactly the same as they would have been absent the restructuring. What financial transactions
do you need to make after the restructuring in order to restore the payoffs you would have received
in the absence of the restructuring?

You originally hold 40,000/2,000,000 = 2% of Company Y’s equity. This entitles you to an annual
cash flow equal to 2% of the firm’s pre-interest cash flows less the principal and interest payment
of $5,500,000 – let’s call this 0.02 x (C – $5,500,000). If Company Y issues stock and repurchases
bonds, there will be 250,000 new shares outstanding, and the new principal plus interest for the
company will be only $3,300,000. Thus, since 40,000/2,250,000 = 0.017778, your position will
now entitle you to 0.017778 x (C – $3,300,000). Since Company Y has lowered its leverage, you
must increase the leverage of your investment if you want to offset the effect of the company’s
leverage change and get back to your original payoffs. Since your original position entailed
owning 2% of the cash flows, you borrow $40,000 and use the proceeds to purchase 5,000 shares
for $40,000. You will then own 45,000/2,250,000 = 2% of Company Y’s shares, entitling you to
0.02 x (C – $3,300,000) next year from your equity position. Your will need to pay back $40,000
x 0.10 = $4,000 of interest plus $40,000 of principal. Your total annual cash flow will be [0.02 x
(C –$3,300,000)] - $44,000 = 0.02 x (C – $5,500,000) = your original payoff before Company Y
changed financial structure.

Question 3

A company has zero-coupon bonds outstanding that mature one year from today and have a face
value of $500. The bonds do not include any covenants that restrict the company from issuing

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 additional debt, even if this additional debt is of higher seniority than the existing bonds. The
company will realize all of its cash flow next year. This cash flow will be $200 with probability
1/3, $600 with probability 1/3, and $1,000 with probability 1/3. The company is planning to issue
new bonds with a face value of $200 that will be senior to the old debt and that will also be due in
one year. Assume for simplicity that the risk-free rate and market risk premium are zero (so there
is no discounting, and thus the value of a claim today is equal to the expected payoff to the
claimholder one year from today) and that there are no taxes.

3a) (10 points) How much money will the company receive from selling its new bonds?

Since the new debt is senior to the old debt, and the company will have at least $200 to repay next
year for sure, the new debt is risk-free. Since interest rates are zero, a risk-free promise to pay
back $200 next year has a present value of $200 today. Therefore, the company will receive $200
from selling its new bonds.

3b) (10 points) Suppose that the proceeds from the new bonds are used to pay a one-time dividend
to shareholders. After the company issues the new bonds, what will the market value of (i) the old
debt, (ii) the new debt, and (iii) the company’s equity be? Has total firm value changed? Who is
made better off or worse off from the transaction?

High CF Medium CF Low CF Expected value

Before change
Asset value $1,000 $600 $200 $600
Old debt $500 $500 $200 $400
Equity $500 $100 $0 $200

After change
Asset value $1,000 $600 $200 $600
New debt $200 $200 $200 $200
Old debt $500 $400 $0 $300
Equity $300 $0 $0 $100

Total company value is constant at $600, as Modigliani and Miller say it should since total cash
flows are unchanged. Old debt value goes down in value by $400 – $300 = $100 (old creditors
are worse off). Equity decreases in value by $200 – $100 = $100. However, shareholders also get
the special dividend payment of $200, so they end up with $100 + $200 = $300 in value. Thus,
they profit in the amount of $300 – $200 = $100 (shareholders are better off). Note that it is not a
coincidence that the value of equity goes up by the same amount that the value of debt goes down.

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 Question 4

A company consists of a machine that will produce cash flows of $450 one year from today if the
economy is good and $150 if the economy is bad. The economy is good or bad each with 50%
probability. Assume for simplicity that the risk-free rate and market risk premium are zero (so
that there is no discounting, and thus the value of a claim today is equal to the expected payoff to
the claimholder one year from today) and that there are no taxes. The company has 100 shares
outstanding and debt with a face value of $200 due at the end of the year.

4a) (6 points) What is the company’s share price (i.e., the market value of each of its shares)?

Initially, the expected payoff to equity is: 0.5($450-$200) + 0.5 x $0 = $125 so the price per share
is $125/100 = $1.25.

4b) (7 points) Suppose that the company unexpectedly announces that it will issue additional debt
with the same seniority as existing debt (i.e., pari passu) and a face value of $100. The company
will use the entire proceeds to repurchase some of its outstanding shares. What is the market price
of the new debt?

In a good economy, both the new debt and old debt are paid in full. In a bad economy, the new
debtholders get 1/3 of the $150 that is available while the old debtholders get 2/3 of the $150.
Thus, the new debt has a value of 0.5($100)+ 0.5(1/3)($150) = $75.

4c) (7 points) Just after the announcement described in part b, what will the price of a share of the
company’s stock be?

After the capital structure change, the expected value of the remaining equity is 0.5($450-$300) +
0.5($0) = $75. The value of the equity after the announcement (but before the repurchase takes
place) is $75 cash flow from the future repurchase plus $75 equity value that will be left after the
repurchase. Hence the total value for equity holders is $150 and the value per share $1.50.

Question 5

Company X has $10M of excess cash (i.e., cash that is not used in the company’s operations) and
operating assets that will generate risky (i.e., uncertain) future cash flows with a present value
today of $25M. It has no other assets. The company has risky zero-coupon bonds outstanding
with a face value of $20M, and no other debt. Who is likely to gain and who is likely to lose from
the following maneuvers? Justify your answers.

5a) (10 points) Company X pays a cash dividend of $10M to its shareholders.

This transaction benefits shareholders at the expense of bondholders. Creditors’ payoffs are more
likely to be lower after the dividend than before. As an example, suppose that the debt were due
in one year and the firm’s operations also generated all of their cash flow in one year. Before the
dividend, if the firm’s operations generated $10M of cash flow, creditors would receive $20M.
After the dividend, creditors would only receive $10M if operations generate $10M of cash flow.

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 So the value of the debt should fall. No value is being destroyed here. The cash is simply going
from the company’s balance sheet to the shareholders. So, if creditors are being harmed, then
shareholders must be better off.

5b) (10 points) Company X halts operations and sells all of its operating assets for $15M. It
invests the proceeds from this sale along with its $10M of existing cash in Treasury Bills (i.e., risk-
free bonds).

Bondholders gain out of this move at the expense of shareholders. Ceasing operations and
investing $15M in Treasury bills eliminates risk from the viewpoint of bondholders. In particular
bondholders are certain now that there will be at least $25M of cash available to repay them (and
they are only owed $20M). This increases the current market value of the bonds. Shareholders lose
for two reasons here. First, there is a wealth transfer from shareholders to bondholders since the
debt value increases. Second, the decision to cease operations shrinks the size of the pie by $10M
(the operating assets would produce a PV of $25M if kept operating, but are now sold for only
$15M). This cost is also borne by shareholders.

Question 6

Ace Manufacturing is an all-equity financed firm with a current market value of $500 million and
10 million shares outstanding. Ace plans to announce that it will issue $100 million of perpetual
bonds and use these funds to repurchase equity. The bonds will have a 6-percent coupon rate. After
the sale of the bonds and the share repurchase, Ace will maintain the new capital structure
indefinitely. The corporate tax rate for Ace is 35%, and there are no personal taxes.

6a) (7 points) Immediately after Ace announces its plan to issue bonds and repurchase equity,
what will the market value of its equity be? What will its stock price be?

The initial share price is 500M/10M = $50. The tax shield from the debt is worth $100M x 0.35
= $35M. Thus, the market value of equity should increase from $500M to $535M on the news of
the repurchase, and the shares should increase in value to $535M/10M = $53.50.

6b) (6 points) How many shares will Ace repurchase?

If they plan to repurchase $100M of stock at a price of $53.50, then they will repurchase 1,869,159
shares.

6c) (7 points) After the bond issue and share repurchase are completed, what will be the market
value of Ace’s equity?

When they repurchase the equity, their equity value will go down to $535M - $100M = $435M.

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