1FIN 534B
Advanced Corporate Finance 2 ‐ Financing
Practice Problems (Comprehensive)
Professor Yaron Leitner
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Explain under which conditions an increase in the dividend payment can be interpreted
as a signal of the following:
a. Good news
Signals that managers believe that future earnings will be high enough to maintain the
new dividend payment.
b. Bad news
Signals that the firm does not have any positive NPV investment opportunities..
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Why an announcement of a share repurchase is considered a
positive signal
Management credibly signals that they believe the stock is
undervalued.
Problem 4 from Group Assignment 2
(With Some Added Numbers)
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3Dynron’s assets currently have a market value of $150 million.
The firm is exploring the possibility of raising $50 million by selling part of its
pipeline network and investing the $50 million in a fiber‐optic network to generate
revenues by selling high‐speed network bandwidth.
While this new investment is expected to increase profits, it will also substantially
increase Dynron’s risk.
If Dynron is levered, would this investment be more or less attractive to equity
holders than if Dynron had no debt
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Existing New Investment
Bad Good Bad Good Expected
Current Assets 150 150 100 100 100
New Asset 0 140 70
Total Asset Value 150 150 100 240 170
Debt
Equity
Table shows market values next year.
Bad and good state are equally likely
All risk is idiosyncratic and = 0%
NPV(new investment)
= . . % ‐ 50 = 20
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Existing New Investment
Bad Good Bad Good Expected
Current Assets 150 150 100 100 100
New Asset 0 140 70
Total Asset Value 150 150 100 240 170
Debt (face value 120) 120 120 100 120 110
Equity
Table shows market values next year.
Bad and good state are equally likely
All risk is idiosyncratic and = 0%
NPV(new investment) = 20
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Existing New Investment
Bad Good Bad Good Expected
Current Assets 150 150 100 100 100
New Asset 0 140 70
Total Asset Value 150 150 100 240 170
Debt (face value 120) 120 120 100 120 110
Equity 30 30 0 120 60
Table shows market values next year.
Bad and good state are equally likely
All risk is idiosyncratic and = 0%
NPV(new investment) = 20
Equity value increased by 30.
Why Because debt value fell by 10.
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Existing New Investment
Bad Good Bad Good Expected
Current Assets 150 150 100 100 100
New Asset 0 140 70
Total Asset Value 150 150 100 240 170
Debt (face value 80) 80 80 80 80 80
Equity 70 70 20 160 90
Table shows market values next year.
Bad and good state are equally likely
All risk is idiosyncratic and = 0%
NPV(new investment) = 20
Now equity value increased by 20.
The new investment did not affect the market value of debt…
Bottom line:
In a highly levered firm, equity holders decide based on
Project’s NPV + Gain from increased risk
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Everything else equal, increased risk reduces
the market value of existing debt, and hence
increases the market value of equity.
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6Practice Problem 1
Agency Cost of Debt
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ABC, Inc. is about to launch a new product (the new product is their only asset).
The firm can use either a proven technology or a new (experimental) method.
The proven technology will produce a certain (after‐tax) cash flow of $24.
But the cash flows from the new technology are uncertain. If the new
technology works, it will produce an (after‐tax) cash flow of $28 next year. If
it is unsuccessful, it will produce a zero cash flow next year. The probability of
success is 0.8, and whether the new technology succeeds represents
idiosyncratic (diversifiable) risk.
Both methods require a $20 investment today, and there are no cash flows after
next year. The risk‐free rate is 10%.
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7 Which technology has the highest NPV
NPV (old) = ‐20 + . = 1.82
NPV (new) = ‐20 + . . . = 0.36
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The cashflow to the old technology is risk free. So we use the risk‐free rate.
The cashflows to the new technology are risky, but the risk is diversifiable. So
we also use the risk‐free rate.
ABC decided to raise the $20 by issuing zero‐coupon debt due next
year. What should be the face value (x) of the debt
If bondholders expect ABC to choose the old technology:20 . x = 22
But will ABC choose the old technology
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815
Old
Technology
New
Technology
Success Failure
Cash Flow 24 28 0
Debt 22
Equity 2
If managers act on behalf of shareholders, they will choose the new technology. . . .
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If face value = 22
4.80
022
6 0.8(6)+0.2(0)
Expected
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New
Technology
Success Failure
Cash Flow 28 0
Debt
Equity
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What if bondholders expect ABC to use the new technology
0X =
20 . . . X = 27.5
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New
Technology
Success Failure
Cash Flow 28 0
Debt
Equity
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What if bondholders expect ABC to use the new technology
0
24
0.5 0 0.4 0.8(0.5)+0.2(0)
Old
Technology
27.5 24
0
ABC will indeed choose the new technology.
Expected
Conclusion:
Bondholders should (correctly) expect ABC to use the new technology.
The face value will be $27.5
The new technology does not have the highest NPV.
But once they issue debt, the new technology has the highest NPV from the
perspective of equity holders.
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Which agency cost of debt is illustrated here
What’s the reduction in firm value because of this cost
If debt holders are rational, who ends up paying the cost
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NPV(old) – NPV(new) = 1.82 – 0.36 = 1.46
Equity holders end up with
0.4/1.1=0.36 instead of 1.82
a) Risk shifting
b) Debt overhang
c) Free cash flow problem
a) Equity holders
b) Debt holders
c) Both equity holders and debt holders
Practice Problem 2
Mini Case
Raising Capital With Asymmetric Information
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“We R Toys” (WRT) has a capital structure that is composed of $500M in equity
and $300M in debt (market values).
There are 10M equity shares outstanding.
The unlevered cost of capital is 10%
WRT’s debt is risk free with an interest rate of 4%.
The corporate tax rate is 25%, and there are no personal taxes.
10%
4%
25%
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share price = $50
WRT is considering expanding into new geographic markets.
The expansion will have the same business risk as WRT’s existing assets.
The expansion will require an initial investment of $50M and is expected to
generate perpetual EBIT of $20M per year.
After the initial investment, future capital expenditures are expected to equal
depreciation, and no further additions to net working capital are anticipated.
NPV (new expansion) =
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NPV = . – 50 = $100M
FCF = EBIT ‐ Tax + Depreciation – CapEx + Change in NWC
FCF = 20 × (1‐0.25) = $15M
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Part a
WRT initially proposes to fund the expansion by issuing equity.
If investors were not expecting this expansion, and if they share WRT’s view of
the expansion’s profitability, what will be the share price once the firm
announces the expansion plan
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50 + $
# initial share price
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Before
Announcement
After
Announcement
Existing assets
NPV(expansion)
Total
Equity 500
Debt 300
Number of shares 10
Share price
800
800 800
900
600
300
100
10
6050
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Part b
Suppose investors think that the EBIT from WRT’s expansion will be only $4M.
i. What will the share price be in this case
ii. How many shares will the firm need to issue
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FCF = 4 (1‐0.25) = $3M
NPV = 3/0.1 – 50 = ‐$20M
50 + = $48