Corporate Finance

Assignment 3
Suggested Answers

1. Consider a firm with an initial value V = $400, an original pure-discount debt that
pays X = $400 in three years, and for which

V u = $650 with probability p = 0.7,
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V3 =
V d = $250 with probability 1 p = 0.3.
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The risk-free rate is rf = 5%.

(a) Compute the current values of debt (D) and equity (E).
Answer: The value of equity in three years is either E3u = 650 400 = $250 or
E3d = $0. Since debt is not risk-free, the current value of debt and equity must be
determined by constructing a risk-free portfolio, which will be long on the firms
total assets and short on the firms equity. Let denote the fraction of the firms
equity being sold short for each unit of V purchased. Then is such that

V3u E3u = V3d E3d ,

which gives us
V3u V3d 600 250
= u d
= = 1.6.
E3 E3 250 0
Since this risk-free portfolio pays off V3d = 250 in three years, its present value is
given by
V3d
V E = .
(1 + rf )3

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 The current value of equity, E, is then

V3d
   
1 1 250
E = V = 400 = $115.03,
(1 + rf )3 1.6 (1.05)3

and the current value of debt is

D = V E = 400 115.03 = $284.97.

(b) Compute updated parameter values after the following actions. Management
issues additional pure-discount debt that has a promised payment of $605.30 in
three years and with the same priority over the firms assets as the original debt.
This new debt is sold at its market value and management uses the proceeds to
double the firms operations (i.e. V , V3u and V3d all double in value). What is the
effect of this expansion on the current values of original debt and equity?
Answer: We now have V n = $800, V3u,n = $1, 300 and V3d,n = $500. Note that
debt is still subject to default since V3d,n < 400 + 605.3. Let E n , E3u,n and E3d,n
denote the new values for the firms equity for the current period, the up state in
three years and the down state in three years, respectively. That is,

E3u,n = V3u,n (400 + 605.3) = $294.70 and E3d,n = 0.

Let Dn denote the new current value of total debt and let Do denote the current
value of the original debt issue. Using the risk-free portfolio method, we find

V3u,n V3d,n 1, 300 500

= = = 2.7146 ,
E3u,n E3d,n 294.7 0

and thus
!
V3d,n
 
n 1 n 1 500
E = V = 800 = $135.59.
(1 + rf )3 2.7146 (1.05)3

The current value of total debt is then

Dn = V n E n = 800 $664.41.

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 Both debt issues having the same priority on the firms assets, the current value
of the original debt is now

400
Do = 664.41 = $264.36.
400 + 605.30

Note that the market value of the new debt issue is $664.41 264.36 = $400.05,
and thus enough money has been raised through this new issue to increase the
firms initial value from $400 to $800. (Somehow, $0.05 has been lost in the
process.)

In this example, the market value of equity has increased by $20.56 whereas the
market value of the original debt has decreased by $20.61 (the $0.05 discrepancy
comes from the loss mentioned above). Increasing the total value of the firm has
increased shareholders wealth in this example.

Try to see what would have happened had the firm doubled its value by raising
$400 in equity.

2. Consider a firm with the same parameter values as in Problem 1. Assume now that
the firm has $142.50 of idle cash invested in a risk-free security.

(a) Compute updated parameter values after management uses all the idle cash to
pay a dividend to shareholders. What is the effect of this action on the current
values of debt and equity?
Answer: Using this $142.50 to pay a dividend to shareholders reduces the current
value of the firm by $142.50 and the future value of the firm by

$142.50 (1.05)3 = $164.96.

That is,
V n = 400 142.5 = $257.50,
V3u,n = 650 164.96 = $485.04, and
V3u,n = 250 164.96 = $85.04.

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 This gives us E3u,n = $85.04 and E3d,n = 0, and thus

V3u,n V3d,n 485.04 85.04

= = = 4.7031,
E3u,n E3d,n 85.04 0

and
!
V3d,n
 
n 1 n 1 85.04
E = V = 257.5 = $39.13.
(1 + rf )3 4.7031 (1.05)3

The new market value of debt is then

Dn = V n E n = 257.5 39.13 = $218.37,

a reduction of $66.60 (one tenth of a beast). To calculate shareholders wealth,

we need to add the value of the dividend to the value of equity. This yields

E n + 142.5 = 39.13 + 142.5 = $181.63,

which exceeds the initial value of equity by $66.60. Note that shareholders gain
is equal to bondholders loss.

(b) Compute updated parameter values after management uses the idle cash to retire
half the firms debt at the price of $142.5. What is the effect of this action on the
current values of debt and equity?
Answer: If half the debt is retired today, the amount due in three years is
X n = $200. The value of the firm, currently and in three years, is the same as in
(a). Equity, however, is now

E3u,n = 485.04 200 = $285.04 and E3d,n = 0.

So
V3u,n V3d,n 485.04 85.04
= = = 1.4033,
E3u,n E3d,n 285.04 0
and
!
V3d,n
 
n 1 n 1 85.04
E = V = 257.5 = $131.15.
(1 + rf )3 1.4033 (1.05)3

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 The current value of debt is now

Dn = V n E n = 257.5 131.15 = $126.35.

Here the market value of equity has increased by $16.12 whereas the change in
bondholders wealth is

Dn + 142.5 D = 126.35 + 142.5 284.97 = $16.12.

(c) Compute updated parameter values after management uses the idle cash to finance
a project that pays $200 with probability one in three years. What is the effect
of this action on the current values of debt and equity?
Answer: As in (a) and (b), the $142.50 wont earn the risk-free rate but there is
now an extra $200 cash flow in year three. The firms future value is then

V3u,n = 485.04 + 200 = $685.04 or V3d,n = 85.04 + 200 = $285.04.

Future equity is then either

E3u,n = 685.04 400 = 285.04 or E3d,n = 0,

and the current value of the firm now includes the net present value of the project.
The latter being risk free, its future payoff can be discounted at the risk -free rate,
and thus
200
V n = 400 142.5 + = $430.27.
(1.05)3
This gives us

V3u,n V3d,n 685.04 285.04

= = = 1.4033,
E3u,n E3d,n 285.04 0

and
!
V3d,n
 
n 1 n 1 285.04
E = V = 430.27 = $131.15.
(1 + rf )3 1.4033 (1.05)3

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 Current value of debt is therefore

Dn = 430.27 131.15 = $299.12.

In this example, the present value of equity increases by $16.12 and the present
value of debt increases by $14.15, for a total of $30.27, the net present value of
the project.

(d) Which case do shareholders prefer? (a), (b) or (c)? Explain.

Answer: The greatest increase in shareholders wealth occurs when the $142.50
is paid out as a dividend, i.e. case (a).

3. Consider a firm with the same parameter values as in Problem 1. Suppose now that
projects can be undertaken by the firm only if shareholders contribute the initial outlay
out of their own pockets.

(a) Consider first a risk-free project that pays $200 with probability one after three
years and that requires an initial outlay of $142.5. Will shareholders accept to
finance this project?
Answer: Here the value of the firm in three years is either V3u,n = $850 or
V3d,n = $450, and its current value is

V n = 400 + 30.27 + 142.5 = $572.77,

200
where 30.27 = (1.05)3
142.5 is the net present value of the project. Debt is now
risk free so its present value is

400
Dn = = $345.54,
(1.05)3

an increase of $60.57.

The present value of equity is, on the other hand,

E n = V n Dn = 572.77 345.54 = $227.23,

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 and thus the change in shareholders wealth is

E n E 142.5 = 227.23 115.03 142.5 = $30.30.

Note that 60.57 30.3 = 30.27, the NPV of the project.

(b) Suppose now that the firm has identified another project that pays off either
P3u = $328.5 in the up state or P3d = $0 in the down state. This project also
requires an initial outlay of $142.5. Using a rate of return of 10%, management
has determined that the net present value of this project is
.7 328.5 + .3 0
142.5 = $30.26.
(1.1)3
Note that this projects NPV is almost the same as the risk-free project described
in (a). Will shareholders accept to finance this project? Is your answer different
from what you found in (a)? Why?
Answer: In this case, using the above NPV, we have

V n = 400 + 30.26 + 142.5 = $572.76,

V u,n = 650 + 328.5 = $978.50,
V d,n = 250.

Proceeding as before, we find

V3u,n V3d,n 978.5 250
= = = 1.2593,
E3u,n E3d,n 578.5 0
and thus
!
V3d,n
 
n 1 n 1 250
E = V = 572.76 = $283.33.
(1 + rf )3 1.2593 (1.05)3

In this case, the increase in shareholders wealth is

E n E 142.5 = 283.33 115.03 142.5 = $25.80,

and the current value of debt becomes

Dn = V n E n = 572.76 283.33 = $289.43,

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an increase of $4.46.

Note that the value of debt has increased even though bondholders expected
payoff has not changed: Whether or not the project is undertaken, bondholders
receive $400 in the up state and $250 in the down state. Thus the value of debt
should not change once the project is undertaken. We must therefore conclude
that the rate of return of 10% used by management is not appropriate here, i.e.
the NPV of this project is not $30.26.

Why 10% as the rate of return? Using the initial parameter values, the annual
return on the firms assets, rA , is such that

.7 V3u + .3 V3d
V = ,
(1 + rA )3

which gives us
1/3 1/3
.7V3u + .3V3d
 
.7 650 + .3 250
rA = 1 = 1 = 9.8%.
V 400

We could use this figure as the firms cost of capital given its initial capital struc-
ture. Note that we obtain approximately the same return by calculating the
firms weighted average cost of capital (WACC) under its initial capital structure.
That is, let rE and rD denote the return on equity and debt, respectively. Using
E = 115.03 and D = 284.97, we find
1/3 1/3
.7E3u + .3E3d
 
.7 250 + .3 0
rE = 1 = 1 = 15.0%
E 115.03
1/3 1/3
.7D3u + .3D3d
 
.7 400 + .3 250
rD = 1 = 1 = 7.6%.
D 284.97

The WACC is therefore

284.97 115.03
WACC = 7.6% + 15.0% = 9.7%,
400 400

Which is pretty close to 9.8%. This might be an excuse to use 10% to discount
future cash flows.

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But 10% cannot be the right discount rate since the project is entirely funded by
shareholders. The right discount rate is the firms initial return on equity. That
is, if we discount the expected payoff of the project with the return on equity, we
should not observe any change in the market value of debt. To show this carefully,
we will keep four decimals for each number. That is, we will use E = $115.0254
for the initial value of equity and D = $284.9746 for the initial value of debt. The
return on equity is then
 1/3
.7 250 + .3 0
rE = 1 = 15.0133%,
115.0254
and thus the net present value of the project is
.7 328.5 + .3 0
142.5 = $8.6433.
(1.150133)3
Let VrnE denote the firms present when when rE is used to discount the projects
expected payoff. Then

VrnE = 400 + 8.6433 + 142.5 = $551.1433,

and thus the present value of equity under rE , ErnE , is given by

!
d,n
1 V 3
ErnE = VrnE
(1 + rf )3
 
1 250
= 551.1433
1.2593 (1.05)3
= $266.1687.

Note that is as above since V3u,n and V3d,n are not affected by the discount rate.
In this case, the increase in shareholders wealth is

ErnE E 142.5 = 266.1687 115.0254 142.5 = $8.6433,

exactly the net present value of the project. Note that the present value of debt
has not changed here:

DrnE = VrnE ErnE = $284.9746.

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 Hence a project entirely funded with external equity will create shareholder value
only if its return is greater than the return on equity. In the case of the risk-free
project paying $200 with certainty, the return is
 1/3
200
1 = 11.96% < rE = 15.01%,
142.5

and thus this project cannot increase shareholders wealth if bondholders do not
contribute to its financing.

4. Consider a firm with the same parameter values as in Problem 1. Suppose now that
the firms management, fearing that they will lose their jobs if the firm goes bankrupt,
immediately sell all of the firms assets for a fair price of $400, and invest the proceeds
in a risk-free security. How does this action affect current values of debt and equity?
Answer: In this case, the value of the firm in three years is

400(1.05)3 = $463.05

with certainty. Debt is now risk free and thus its present value is Dn = $345.54, as in
Problem 3 (a). The present value of equity is therefore

400 345.54 = $54.46.

Hence the value of equity has decreased by $60.57 and the value of debt has increased
by $60.57.

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