Exercise 1 (Capital Structure I)

Consider two projects. A and B. Both projects last for one period and have the same
expected return but project B is riskier (the variance σ2 is returns is higher). More
specifically, at t = 1, project A yields either 40 or 60 with probability ½ each whereas project
B yields either 10 or 90 with probability ½. Also. assume that investors are risk neutral (they
care only about expected returns) and the risk-free interest rate is zero.
a) Suppose that both projects have issued (risky) straight debt with face value50. What is the
market value of debt issued by each project? Are they different? Explain briefly why.

b) Suppose now that bah projects have instead issued convertible debt with face value 50
which allows debtholders to convert it into equity if they wish. If they decide to do so
they will obtain 70% of the project's equity. What is the mar1(et value of convertible debt
issued by each project? Are they different? Explain briefly why.

c) Compare your result in Part (a) with that in Part (b). Which difference is larger?
Explain briefly why.

PV =FV/(1+r)
Risk Free r 0
tenure t 1

Project A

Expected FV =40*(1/2) + 50*(1/2)

=45

PV 45

Project B

Expected FV =(10*0.5)+(50*0.5)
30

PV 30

Page 1 of 6
 Answer a Since risk free rate is 0, and risk premium =0
Market Value = PV for both assets.

Riskier aster has less PV.

Answer
b Project A

Expected FV = 40*.5+50*.5, since .7*60= 42 <50

PV = 45

Project B

Expected FV =10*.5+ (90*.7)*.5

36.5
PV = 36.5

Answer c In Project A, conversion rate does not get investor better off.
Sticks to debt. In case the scenario is Project B, and profitable,
Investor converts his debt to equity, exercising the option.
Convertible equity gets investor weakly better off than straight debt
with same FV.

Exercise 2
A firm is expected to generate annual free cash flows of £10 million in perpetuity. The firm has issued both
risk-free debt and equity. The market value d the firm's debt is£20 million. The risk-free interest rate is 5%
and the required expected rate of return on its assets is 100%. Assume that capital markets are perfect and
there are no taxes.
a) What is the market value of the firm's equity? What is its cost of equity (the required expected rate of
return on equity)?
b) Suppose the firm issues additional debt with market value of £10 million and uses the proceeds to
repurchase equity. What is the firm value after the share repurchase? What is its cost of equity? (Assume
that the change in the capital structure does not affect the risk of debt). Explain why the rate of return on
equity has or has not changed.
c) How is your answer in Part (b) affected if the issue of additional debt makes current debt risky?
Page 2 of 6
Answer 2.

answer a
Long term growth rate of capital =0
Market value of Firm's equity
=Cash flow / RoR - Debt
= (10/0.1) -20 M
80 M ￡
r= 0.1 (given)

answer b

Firm issues Debt of 10 M, writes of equity worth 10M at PV.

Cash flow
∵ MV of Stock+ MV of Debt=
r
Cost of Equity, r
= Cash Flow / (MV of New Equity +Debt)
=Cash Flow/ ((Old Equity -Buyback) + (Old Debt + New Debt))
= 10/ (80-10 +20+10)
= 0.1

answer c

Case a: Debt issued is senior to current debt. No changes.

Case b: Debt issued makes the additional debt riskier. The cost of debt increases.
MV of equity would fall compensating a rise in debt.

Page 3 of 6
 Answer 3

a. PV of equity before debt

= (1-.35)*50/.2
= 162.5 M￡

Price per share

= 1.625 ￡
New Equity = Old Equity -40 M

= 122.5 M￡

Add Debt 40

RoR = ((1-.35)*50))/(122.5+40)
0.2
Firm Value = Net Equity = Cash Flow / RoR – Debt
As debt increases, Net Equity decreases. Effectively firm buys shares at market
prices offsetting the increase in value through debt. The total outstanding liabilities
Equity + Debt remains constant.
So does the Price per share = Reduced Equity / Reduced number of shares.

=122.5/ (100-(40*100/162.5))
= 1.625 ￡
Personal taxes do not
change equity valuation
and thus number of
b. shares.

Exercise 5
Consider an economy in which there are two types of projects, risky (R) and safe (S). with respective
proportions A and 1-A. Alt= 0, each project requires an investment of 1. Alt = 1, a project of two i. {i =
R,S} generates a cash flow either X, with probability p; or O with probability 1 - p; where XR > Xs > 0,
Ps > PR. PRXR> PsXs.Both types of projects have positive NPVs.
NPVi = ∑ipiXi - I > 0. Entrepreneurs have no funds available and so they need to raise I from
the capital market. Entrepreneurs can borrow by issuing either debt or equity and a combination of debt
and equity. Debt claims are zero coupon bonds that are senior to equity. All agents are risk neutral and
there is zero discounting. At date 0, when securities are issued, only the entrepreneur knows the type
of his project. The financiers do, however. know the proportion of each type in the population of projects
and the nature of the investor, their technology·.

Page 4 of 6
Show that there exist many (a continuum of) reasonable separating equilibria as well as a pooling
equilibrium where both debt and equity are issued and they are fairly priced.
Answer 5.

Expected return from equity, Expected NPV = λ pr XR + (1− λ ¿ps Xs – I = λ ( p r X R−I )+(1−λ)( p s X s−I ) > 0, Since
NPV = p i X i−I > 0

Assume R is minimum expected return .

Payoff ∈risky type∈case of returns=X r −RPayoff ∈risky type∈case of losses=0Expected pay off =
pr ( X r−R)

Payoff of safe type∈case of returns=X s−R Payoff ∈safe type∈case of losses=0

Expected pay off = ps( X s−R)

For debt, assume the assured return is Ḱ .

Payoff ∈risky type∈case of returns=X r − Ḱ . Payoff ∈risky type∈case of losses=−ω ,ω is a penalty, a signal
that makes markets of debt feasible.

Expected pay off = pr ( X r− Ḱ ) −( 1− pr )∗ω

Payoff of safe type∈case of returns=X s− K´ . Payoff ∈safe type∈case of losses=−ωExpected pay off =
ps( X s− Ḱ )−( 1− ps )∗ω
Sufficient to choose R∧ Ḱ . :.
Risky types don’t do debt,
pr
pr ( X r−R ) > pr ( X r− Ḱ ) −( 1− pr )∗ω →ω ≥ ( R− Ḱ ) …(1)
1− pr
ps
Safe types ‘prefer’ debt ps ( X s− Ḱ )−( 1− ps )∗ω > ps ( X s−R ) → ω ≤ ( R− Ḱ ) … (2)
1− ps

1 1
Since by definition, ps> pr ( one is safe ! ) 1− pr >1− ps → > ,
1− ps 1−pr
ps pr
Then > , thusthere exist inifinitely many w , such that Best response of risky typeis ¿ choose R ,
1− ps 1−pr
debt
Best response of Safetype is ¿ choose .
Risk

For risk indifferent lenders, payoff

λ ( p r R )+ ( 1−λ ) Ps Ḱ−I
= λ ( p r R )+ ( 1−λ ) ( p s Ḱ±( 1− ps )∗ω ) > I → ω> .
(1− ps )∗ (1−λ )

Page 5 of 6
 λ ( p r R )+ ( 1−λ ) Ps Ḱ−I pr ps
ω> max ( ( 1− ps )∗( 1−λ )
, ( R− Ḱ ) )
1− pr
, ω< ( R− Ḱ )
1− ps

Aninteresting property is ω , penalty is irrelavant of I , loaned amounts , but only dependant

on fund rate differential , ( how cheap the loan looks ) multiplied by a risk ratio .

Page 6 of 6