PROBLEM 1

A. Which of the 3 investment opportunities would you prefer?

1. First investment opportunity = do nothing → so in this case, we will go

bankrupt and get $0.

2. Second investment opportunity = use $25’000 to buy lottery tickets →

so in this case, we will have 99% chance to loss $25’000, get nothing and
go into bankruptcy or 1% chance to win $2’500’00 in one year:

- 1st outcome: Probability of failure = 99% → $0

- 2nd outcome: Probability of success = 1% → $2’500’000 in one year

0.99 × 0 + 0.01 × (2’500’000 − 25’000)

= //’011
1.1

3. Third investment opportunity = investing $25’000 in an ad

salesperson training program → so in this case, we can generate a
return of $50’000 with a 50% chance, and $25’000 otherwise:

- 1st outcome: Probability = 50% → $50’000 in one year

- 2nd outcome: Probability = 50% → $25’000 in one year

0.5 × (50’000 − 25’000) + 0.5 × (25’000 − 25’000)

= 22’345
1.1

Ø The second investment opportunity has a higher outcome, so we will prefer to

buy lottery tickets.
B. Which of the 3 investments would the bank prefer?

1. In the first opportunity, the bank will receive:

25’000
= //′7/7
1.1

2. In the second opportunity, in the case of success, the bank will receive:

0.01 × 25′000
= 227
1.1

3. In the third opportunity, the bank will receive:

0.5 × (50’000 − 25’000) + 0.5 × 25’000

= //′7/7
1.1

Ø The Bank will be indifferent between opportunity 1 and 3 as both investments

will provide the same potentially return.

C. How much would the bank have to pay you to make you choose the
investment project that it prefers? Hint: The payment has to make both
the bank and the shareholder (you) at least as well off as compared to the
choice from part a).

The bank, which is indifferent between opportunity 1 and 3, will need to pay us
at least 11’136 corresponding to the difference between the second and third
investment (22’500 – 11’364 = 11’136). Therefore, we are indifferent between
the second and third investment opportunity.
 PROBLEM 2

● FCF = $90 million

● Debt = $750 million
● premium = 20%
● r = 10%
● Tax Rate (t) = 40%

First, we need to calculate the value of the firm, and here, the FCF are permanent, so
we need to compute the unlevered value of the firm:

#$# 90
!! = = = $900 ,-..-/0
% 0.1

In the case that the raider would take over the firm with debt, the levered value would
be:

:;: 90
9! = +=×>= + 0.4 × 750 = $1′200 ABCCBDE
< 0.1

The takeover will be successful only with a premium of 20%, so the firm should have
at least a levered value of $1’000m.

9! 2′/11
= = $2′111 HIKKILM
2 + F<GHIJH 2. /

The firm requires a minimum tax shield of $100m (difference between the unlevered
value of the firm which is equal to $900, and the levered value of the firm which is equal
"###
to $1’000). Managers need a capital structure with debt = #.% = $250 million.
 PROBLEM 3

A. Which project has the highest expected payoff?

- E(A) = $75 million

- E(B) = 0.5 × 140 + 0.5 × 0 = $70 million

- E(C) = 0.1 × 300 + 0.9 × 40 = $66 million

Ø Among all projects, project A 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?

- E(A) = 75 - 40 = $35 million

- E(B) = 0.5 × (140 - 40) = $50 million

- E(C) = 0.1 × (300 - 40) + 0.9 × (40 - 40) = $26 million

Ø Among all projects, project B 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?

- E(A) = $0

- E(B) = 0.5 × (140 - 110) = $15 million

- E(C) = 0.1 × (300 - 110) = $19 million

Ø Among all projects, project C 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?

- With a due debt of $40 million, the company will choose project B and
the expected agency cost would be: 75 - 70 = $5 million

- With a due debt of 110 million, the company will choose project C and
the expected agency cost would be: 75 - 66 = $9 million
 PROBLEM 4

A. If you ignore the possibility of a government bailout, the decision to pay a

dividend given how close the company was to financial distress is an
example of what kind of cost?

Even though the strategy of paying dividends might be an attempt to attract new
investors, this way of spending keeps diminishing the funds and threatens even
more the stability of the GM, leading the company towards bankruptcy. The
firm’s decision is an example of agency costs of debt. There is a conflict of
interest between the firm’s stakeholders as the firm makes decisions that benefit
shareholders but harm debtholders. Indeed, in case of default, financial distress
costs will lower payment to debtholders. And instead of retaining the cash and
investing in positive NPV projects, the firm decides to take cash out by paying
dividends which is a wasteful spending.

B. What would your answer be if GM executives anticipated that there was a

possibility of a government bailout should the firm be forced to declare
bankruptcy?

Despite the possible government bailout anticipated by GM’s executives, the

answer to whether or not the company should declare bankruptcy is mitigated.
Bankruptcy is the signal that something is malfunctioning and that it should be
reorganized. Therefore, simply adding money to a failing firm won’t fix anything.
If the firm doesn’t rethink its financial structure, it is better off declaring
bankruptcy, with and without the bailout. On the other hand, by keeping on
paying dividends the firm’s resources will be lowered resulting in an increased
probability of bankruptcy, and therefore, in a higher probability of receiving
governmental funds as firms facing financial distress may be eligible for them.
And if this additional cash is well managed, it may increase the firm’s value and
prevent bankruptcy.
 PROBLEM 5

A. What is the expected value of Rearden's assets if it were run efficiently?

If Rearden’s assets were run efficiently, the expected value of the firm will be:

Ø E[value] = ⅓ × 200 + ⅓ × 300 + ⅓ × 400 = $300m

B. Suppose that the managers at Rearden Metal will engage in empire

building unless that behavior increases the likelihood of bankruptcy. If
Rearden has $180 million in debt due in one year, then what is the
expected value of Rearden's assets?

In all cases, the market value of Rearden will be lowered by $20 million if
managers decide to engage in empire building. However, to take such decision
the firm should be able to pay off its debt to prevent going into bankruptcy.
Indeed, in this case, even in the worst scenario ($200 million - $20 million =
$180 million which is the same amount of the due debt) the firm will be able to
pay off its debts. Therefore, managers will engage in it and the expected value
of Rearden’s assets will be:

Ø E[assets] = ⅓ × (200 - 20) + ⅓ × (300 - 20) + ⅓ × (400 - 20) = $280m

C. Suppose that the managers at Rearden Metal will engage in empire

building unless that behavior increases the likelihood of bankruptcy. If
Rearden has $190 million in debt due in one year, then what is the
expected value of Rearden's assets?

In the worst scenario of this case ($200 million - $20 million = $180 million which
is smaller from the due debt of $190 million) the firm won’t be able to pay off its
debts meaning that the probability of going into bankruptcy will increase.
Therefore, managers won’t engage in it and the expected value of Rearden’s
assets will be:

Ø E[assets] = ⅓ × 200 + ⅓ × 300 + ⅓ × 400 = $300m

D. Suppose that the managers at Rearden Metal will increase risk to
maximize the expected payoff to equity holders. If Rearden has $180
million in debt due in one year, then what is the expected value of
Rearden's assets?

• E[equity] = ⅓ × (200 - 180) + ⅓ × (300 - 180) + ⅓ × (400 - 180) = $120m

• By increasing risk, the expected payoff to equity holders would be:

E[equity] = 50% × (200 - 180) + 5% × (300 - 180) + 45% × (400 - 180) = $115m

As 120 > 115, which means that the expected equity is worsen off when
increasing risk, managers at Rearden Metal will take the decision to not increase
the risk, thus, the expected value of Rearden's assets will be:

Ø E[assets] = ⅓ × 200 + ⅓ × 300 + ⅓ × 400 = $300m

E. Suppose that the managers at Rearden Metal will increase risk to

maximize the expected payoff to equity holders. If Rearden has $230
million in debt due in one year, then what is the expected value of
Rearden's assets?

• E[equity] = ⅓ × (200 - 200) + ⅓ × (300 - 230) + ⅓ × (400 - 230) = $80m

• By increasing risk, the expected payoff to equity holders would be:

E[equity] = 50% × (200 - 200) + 5% × (300 - 230) + 45% × (400 - 230) = $80m

As the expected equity is the same ($80m), managers at Rearden Metal will
increase the risk, thus, the expected value of Rearden's assets will be:

Ø E[assets] = 50% × 200 + 5% × 300 + 45% × 400 = $295m