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FNCE30002 Lecture Notes - Lecture 3: Agency Cost, Net Present Value, Credit Risk

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School
University of Melbourne
Department
Finance
Course
FNCE30002
Professor
C O L E

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Document Summary

Discussion questions 3: capital structure decisions: m&m and beyond - The box below provides an example of a imaginary company. Expected value of the firm (a) expected value of firm in low-risk project: 0. 5*100 + 0. 5*200 = 150 (b) expected value of firm in high-risk project: 0. 5*50 + 0. 5*240 = 145. Expected payoff to shareholders (c) expected value of the stock in low risk-project: 0. 5*0 + 05*100 = 50 (d) expected value of the stock in high risk-project: 0. 5*0 + 0. 5*140 = 70. ==> firm value increases by investing in the low-risk project but the high-risk project provides a higher payoff to shareholders (at the expense of debtholders). ==> if a firm is so highly indebted, that it will be bankrupt in a future recession no matter what, it becomes lucrative for shareholders to start to gamble: they substitute their investment from low risk to high risk.

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Related Questions

Fountain Corporation’s economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of Fountain must choose between two mutually exclusive projects. Assume that the project Fountain chooses will be the firm’s only activity and that the firm will close one year from today. Fountain is obligated to make a $3,700 payment to bondholders at the end of the year. The projects have the same systematic risk but different volatilities. Consider the following information pertaining to the two projects:
Economy Probability Low-Volatility
Project Payoff		 High-Volatility
Project Payoff
Bad .50 $ 3,700 $ 3,100
Good .50 4,000

4,600

a. What is the expected value of the firm if the low-volatility and high-volatility project is undertaken?

b. What is the expected value of the firm’s equity if the low-volatility and high-volatility project is undertaken?

c. Which project would Fountain’s stockholders prefer?

d. Suppose bondholders are fully aware that stockholders might choose to maximize equity value rather than total firm value and opt for the high-volatility project. To minimize this agency cost, the firm's bondholders decide to use a bond covenant to stipulate that the bondholders can demand a higher payment if Fountain chooses to take on the high-volatility project. What payment to bondholders would make stockholders indifferent between the two projects?

Fountain Corporation’s economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of Fountain must choose between two mutually exclusive projects. Assume that the project Fountain chooses will be the firm’s only activity and that the firm will close one year from today. Fountain is obligated to make a $5,400 payment to bondholders at the end of the year. The projects have the same systematic risk but different volatilities. Consider the following information pertaining to the two projects:

Economy Probability Low Volatility Project Payoff High Volatility Project Payoff
Bad .5 $ 5,400 $ 4,800
Good .5 $ 6,550 $ 7,150

What is the expected value of the firm if the low-volatility and high-volatility project is undertaken?

What is the expected value of the firm’s equity if the low-volatility and high-volatility project is undertaken?

Consider a firm F that generates a single cash flow in one year which depends on the state of the economy:

-Boom (probability 1/2) 5m -Recession (probability 1/2) 1m

-F has 2,000 bonds outstanding with a face value of $1,000 and a 6% coupon, one-year maturity.
-There are no taxes, and the risk-free rate is 3%
-F has 1m cash at the beginning of year 1.

-F’s cost of debt is 4% regardless of the payout policy they choose.

-F can distribute at the beginning of year 1 either 70% of its cash or 30% of its cash. The cash retained by the firm is invested at a risk-free rate.

-Stockholders invest the dividend they receive at the beginning of year 1 at the risk-free rate as well.

Question:

Suppose that the market value of the bonds are 2m regardless of the payout policy chosen. The required return on the firm’s assets is 10%, and the required return on equity if the firm had zero cash is 12%. Which of the two payout policies will the firm’s shareholders optimally undertake and why?