Corporate Finance Assignment 4

Question 1
The year 2012 is crucial for the future of Computec. (Assume that we are on 1/1/2012) At the end of the
year, EBIT will be either $1,000M or $700M, with equal probability. The growth rate of EBIT from then on
is expected to be 3% in perpetuity. The company has debt with a face value of $6 billion, maturing in one
year. Creditors have been promised an interest payment of $600M to be paid at the end of the year. The
company will then be sold debt free (i.e. with no debt) at its fair value. Assume that potential bidders for the
company will operate it unlevered. The proceeds from this sale will be paid to creditors and shareholders
according to absolute priority rule (i.e. face value of debt must be repaid in full before shareholders are
paid anything).
You can make the following assumptions:
Depreciation equals capital expenses and net working capital is constant.
Comparable companies indicate an asset beta = 0.8.
Risk-free rate is 6%; Equity risk premium = 6%.
The marginal tax rate is 40%.

a. How much do debtholders and shareholders receive at the end of the year in each state? Show details
of your calculations.

b. There is an opportunity to increase the expected EBIT by $100M per year in perpetuity if the company
undertakes an investment today at a cost equal to $400M. Is this a positive NPV investment? Will
shareholders provide the needed capital? Why or why not? Assume that the new project’s cash flows
should be discounted at 12%. Show details of your calculations.

Question 2
ABC Inc. currently has $2,000 in cash. The firm is considering one of the three alternatives: Project A,
Project B or liquidate (and hence, return the $2,000 to the investors). Below is a summary of the payoffs of
the three alternatives:

Project A Project B Liquidate

$4,000 $2,500 $2,000
CF at t=1 if demand is high
(Demand is high with prob. 0.1)

$500 $2,500 $2,000

CF at t=1 if demand is low
(Demand is low with prob. 0.9)

Both projects A and B require an initial investment of $2,000 so there is no need to raise external finance
(the firm has $2,000 in cash).
Assume that there are no taxes, investors are risk-neutral and that the risk-free rate is zero.

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 i Assume the firm has no debt. Which project would the firm take?

ii Now assume instead that from past unsuccessful investments the firm has debt with face value of
$1,000 due at t=1. Which project would the firm take?

iii Now assume instead that from past unsuccessful investments the firm has debt with face value of
$2,450 due at t=1. Which project would the firm take?

iv In question iii, assume that the debt holders can get together and agree to reduce the face value of
debt. What is the reduced face value of debt that would maximize the value of debt?

Question 3
If it is managed efficiently, Remel Inc. will have assets with a market value of $50 million, $100 million,
or $150 million next year, with each outcome being equally likely. However, managers may engage in
wasteful empire building, which will reduce the firm’s market value by $5 million in all cases. Managers
may also increase the risk of the firm, changing the probability of each outcome to 50%, 10%, and 40%,
respectively. The firm’s cost of capital is zero.

i. What is the expected value of Remel’s assets if it is run efficiently?

ii. Suppose Remel has debt due in one year as shown below. For each case, indicate whether managers
will engage in empire building, and whether they will increase risk. What is the expected value of
Remel’s assets in each case?

a. $44 million
b. $49 million
c. $90 million
d. $99 million

iii. Suppose the tax savings from the debt, after including investor taxes, is equal to 10% of the expected
payoff of the debt. The proceeds from the debt, as well as the value of any tax savings, will be paid
out to shareholders immediately as a dividend when the debt is issued. Which debt level in part (ii.)
is optimal for Remel?

Question 4
Andrea Edmunds graduated recently from MIT’s PhD program in Physics. He is setting up a high-tech
firm that aims to produce a patent on a new super-conductive material. He needs $100 thousand to start
up the firm. Having no money of his own to invest, he turns to TeXplore, a venture capitalist firm, which
specializes in financing high-tech start-ups. The two parties negotiate on a contract, that will split the equity
of the new firm between them. Assume both parties are risk neutral, and that the interest rate is 2%. Andrea
has also been working on a paper with his supervisor, that requires his attention. If he finishes that paper
in a year, his supervisor will be able to secure for him a Post-Doc, which will earn him $10,000 per year.
Unfortunately, there are too many demands from Andrea. Either he works hard on his new startup, and
produces a patent worth $153 thousand and does not finish the paper, or works on his paper, and sees the
value of his patent reduced to $137.7 thousand.

1. Suppose Andrea can commit credibly to work exclusively in his start-up. Is it optimal for him to do
so? What share of the equity should TeXplore require in exchange for the funds they provide? What
is Andrea’s benefit from the project?

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 2. Suppose that once TeXplore has paid in their capital contribution, and received their shares, they
cannot monitor whether Andrea is working exclusively for the start-up. Will it now be incentive
compatible for Andrea to quit working on the paper? How much will Andrea’s wealth increase now,
net of the foregone Post-Doc contract? What is the cost of moral hazard to Andrea?

Question 5
At the boardroom of the pharmaceutical firm’s Zipfer, the head of the R&D department presents for
investment two mutually exclusive projects, PromoX and GeneStar. Assume that management works on
behalf of shareholders, all parties are risk neutral and the discount rate is zero. Both projects require an
investment of 100, to be financed by issuing debt. The payoffs on the two projects have the following
distribution:

State Prob. PromoX GeneStar

1 1/3 370 350
2 1/3 200 200
3 1/3 0 110

1. Which project has the higher NPV, and what is it?

2. If the Zipfer’s investment choices are observable to outsiders, and it can costlessly pre-commit to
follow the optimal investment policy, what will the promised payment on the debt be?

3. If the firm issues debt on the terms you found in part b), and it cannot pre-commit in its investment
policy, will the NPV maximizing choice be incentive compatible?

4. If Zipfer cannot pre-commit, what will the promised payment on the debt be?

5. In same case, what is the cost of moral hazard to the firm?

Question 6
Consider a firm that consists of an entrepreneur and an investment project. The firm also has existing assets
that pay either 400 or 0. The entrepreneur has no funds available and must finance the project by issuing
outside equity. All parties are risk neutral. The interest rate is zero. There is one period. At date 0 the
entrepreneur sells securities to the outsiders, and at date 1 payoffs on the project and the firm’s existing
assets are realized, and outsiders receive payment on their claims.
The project requires the entrepreneur to invest 100 today. The project will pay 130 in one period. These
values are common knowledge. The entrepreneur knows whether his firm’s existing assets will pay 400 or
0. The market does not, but assigns equal probability to the two possibilities.

a. Show that it is not an equilibrium for both types of firms to issue equity and invest in the project.
What is the cost of asymmetric information in this setting, and who bears this cost?

b. Assume now that the existing assets of the firm pay either 200 or 180. All other assumptions remain
the same as before. Is it now an equilibrium for both types of firms to issue equity and invest in the
project? What is the cost of asymmetric information in this case, and who bears this cost?

Question 7
Jamaican Exotic Resorts (JER) is a subsidiary of a real estate company. This subsidiary aims to construct
hotels in Jamaica and sell them to hotel management companies in 5 years. After that the subsidiary will
dissolve and stop existing. The cost of construction, which is known for sure to be 500 million euros, will
be paid immediately at the start of the project. To finance this project, the company has filed an application

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for a loan at VCB Bank. This loan will be the sole source of capital for JER. The trouble is that the price at
which the hotels will be sold is unknown today. It is expected that the first cash flow of the hotels, in five
year’s time will be 20 million, that the cash flows will grow at a perpetual rate g after year 5 and can be
discounted back to year 5 at the WACC of 10%. The level of g will be known by everyone in year 5, but
it is unknown today. On the one hand, the management assigns probability P that the growth rate g will
be 8% and probability (1 − P) that the growth rate will be 0%. VCB on the other hand, does not know P.
From prior experience on loans in this market, it assigns a probability π = 50% that JER is a high quality
client and has a P of 70%; and a 1 − π = 50% probability that JER is a low quality client and has a P equal
to q < 70%. In the negotiations, JER can obtain the loan, provided it allows VCB to break even on the loan
extended, i.e if the expected value of repayment is at least as high as the amount of the loan extended. The
loan will need to be repaid in 5 years time, after the hotels are sold. The covenants of the loan stipulate that
if JER defaults on the loan, the hotels will become possesion of VCB and that JER is protected by limited
liability.

i. What is the debt repayment (i.e. principal+interest) that JER needs to promise VCB in 5 years time, if
q = 50%? What promised yield to maturity does that correspond to? What is the cost of asymmetric
information for JER if it knows it is a high quality client?

ii. What happens if q = 0%? What is the cost of asymmetric information for JER if it knows it is a high
quality client?