Seminar assignments - Problem set 3 - Problem Set 3 Corporate Finance 3 – Fall 2015 Question 1: - Studeersnel (2024)

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Problem Set 3

Corporate Finance 3 – Fall 2015

Question 1:

Zymase is a biotechnology start-up firm. Researchers at Zymase must choose one ofthree different research strategies. The payoffs (after-tax) and their likelihood for eachstrategy are shown below. The risk of each project is diversifiable.

STRATEGY PROBABILITY PAYOFF A 100% 75 B 50% 14050% 0C 10% 30090% 40

a) Which project has the highest expected payoff?b) Suppose Zymase has debt of $40 million due at the time of the project's payoff. Which project has the highest expected payoff for equity holders?c) Suppose Zymase has debt of $110 million due at the time of the project's payoff. Which project has the highest expected payoff for equity holders?d) If management chooses the strategy that maximizes the payoff to equity holders, what is the expected agency cost to the firm from having $40 million in debt due? What is the expected agency cost to the firm from having $110 million in debt due?

Question 2:

Consider a firm that generates random cash flows at date ݐ = 2. Cash flows are either200 or 100 with equal probability. At ݐ = 1 the firm has debt outstanding with a facevalue of 150, which is due at ݐ = 2. The manager makes all investment decisions in theinterest of equityholders. All investors are risk-neutral, the discount rate is zero, andthere are no taxes. a) What is the value of the firm at ݐ = 1? What is, respectively, the value of the firm’s equity and the value of the firm’s debt at ݐ = 1? b) Now assume that the firm has two mutually exclusive projects (Projects A and B). Each project requires additional financing of 30 at ݐ = 1. If the firm invests in Project A, the cash flows at ݐ = 2 will increase by 40 for sure. In other words, cash flows will be either 240 or 140 with equal probability. If the firm invests in Project B, cash flows increase by 50 in the high state and decrease by 50 in the low state. That is, cash flows will either be 250 or 50 with equal probability. Assume that there are covenants in place at ݐ = 1 that prohibit the issue of additional debt. Which project would the manager choose if she had the money? Are shareholders willing to provide the $30 for the investment? c) The manager asks the debtholder to waive the covenants, so that the company can issue senior debt. Assume that the manager only has the safe project (Project A) available, and that the debtholders know this. Can the firm issue new debt of $30 that is senior to the existing debt, to finance the project? Do the existing debtholders agree to waive the seniority covenant?

d) Assume again that the manager asks the debtholder to waive the covenant. Furthermore, debtholders now believe that there is a 50% chance that the manager has both projects available. Would the company be able to issue new senior debt to finance the project if existing debtholders waived the covenant? Are existing debtholders willing to waive the seniority covenant?

Question 3:

Consider a risk neutral entrepreneur who plans a project that requires an investment of$8 million at date ݐ = 0. At date ݐ = 1, the project generates cash flows of either $million or $5 million. The probability of success depends on the entrepreneur’s effortchoice. If the entrepreneur chooses “high effort”, the project succeeds with probability80%. If the entrepreneur shirks, the project succeeds only with a 20% probability.Exerting “high effort” is costly for the entrepreneur. Denote by ܥ the monetaryequivalent of this cost. Investors cannot observe the entrepreneur’s choice of effort. a. Suppose the entrepreneur is able to finance the project with privately owned funds. What is the NPV of the project if the entrepreneur chooses “high effort”? What is the NPV instead if the entrepreneur chooses “low effort”? b. Suppose the entrepreneur is penniless and intends to finance the investment by issuing a fraction ߙ of equity to an outside investor. What fraction does the entrepreneur have to sell to raise $8M? What is the maximum cost of effort ܥ that is compatible with the entrepreneur choosing high effort? c. Suppose the entrepreneur is penniless and intends to finance the investment with a risky loan from a risk-neutral bank. What is the face value ܭ of the debt claim if the entrepreneur raises $8M? What is the maximum cost of effort ܥ that is compatible with the entrepreneur choosing high effort? d. Discuss the relative merits of debt and equity finance by comparing the outcomes of part b. and c.

Question 4:

Info Systems Technology (IST) manufactures microprocessor chips for use in appliancesand other applications. IST has no debt and 100 million shares outstanding. The correctprice for these shares is either $14 or $12 per share. Investors view bothpossibilities as equally likely, so the shares currently trade for $13. IST must raise$500 million to build a new production facility. Because the firm would suffer a largeloss of both customers and engineering talent in the event of financial distress,managers believe that if IST borrows the $500 million, the present value of financialdistress costs will exceed any tax benefits by $20 million. At the same time, becauseinvestors believe that managers know the correct share price, IST faces a lemonsproblem if it attempts to raise the $500 million by issuing equity. a) Suppose that if IST issues equity, the share price will remain $13. To maximize the long-term share price of the firm once its true value is known, would managers choose to issue equity or borrow the $500 million if i. they know the correct value of the shares is $12? ii. they know the correct value of the shares is $14? b) Given your answer to part (a), what should investors conclude if IST issues equity? What will happen to the share price? c) Given your answer to part (a), what should investors conclude if IST issues debt? What will happen to the share price in that case?