Solution
• a. Using M&M Proposition I with taxes, the value of a levered firm is:
VL = [EBIT(1 – TC)/R0] + TCB
VL = [$725,000(1 – .24)/.11] + .24($1,600,000)
VL = $5,393,090.91
• b. The CFO may be correct. The value calculated in part a does not include the costs
of any nonmarketed claims, such as bankruptcy or agency costs.
Solution
• a. Debt issue:
• The company needs a cash infusion of $1.2 million. If the company issues debt,
the annual interest payments will be:
Interest = $1,200,000(.08)
Interest = $96,000
• The cash flow to the owner will be the EBIT minus the interest payments, or:
40-hour week cash flow = $455,000 – 96,000
40-hour week cash flow = $359,000
50-hour week cash flow = $560,000 – 96,000
50-hour week cash flow = $464,000
Solution
• Equity issue:
• If the company issues equity, the company value will increase by the amount of the
issue. So, the current owner’s equity interest in the company will decrease to:
Tom’s ownership percentage = $2,900,000/($2,900,000 + 1,200,000)
Tom’s ownership percentage = .71
• So, Tom’s cash flow under an equity issue will be 71 percent of EBIT, or:
40-hour week cash flow = .71($455,000)
40-hour week cash flow = $321,829
50-hour week cash flow = .71($560,000)
50-hour week cash flow = $396,098
Solution
• b. Tom will work harder under the debt issue since his cash flows will be higher. Tom
will gain more under this form of financing since the payments to bondholders are
fixed. Under an equity issue, new investors share proportionally in his hard work,
which will reduce his propensity for this additional work.
• c. The direct costs of both issues are the payments made to new investors. The
indirect costs to the debt issue include potential bankruptcy and financial distress
costs. The indirect costs of an equity issue include shirking and perquisites.
Solution
• a. The total value of a firm’s equity is the discounted expected cash flow to the firm’s
stockholders. If the expansion continues, each firm will generate earnings before interest and
taxes of $2,900,000. If there is a recession, each firm will generate earnings before interest and
taxes of only $1,300,000. Since Steinberg owes its bondholders $925,000 at the end of the
year, its stockholders will receive $1,975,000 (= $2,900,000 – 925,000) if the expansion
continues. If there is a recession, its stockholders will only receive $375,000 (= $1,300,000 –
925,000). So, assuming a discount rate of 13 percent, the market value of Steinberg’s equity is:
SSteinberg = [.80($1,975,000) + .20($375,000)]/1.13
SSteinberg = $1,464,602
• Steinberg’s bondholders will receive $925,000 whether there is a recession or a continuation of
the expansion. So, the market value of Steinberg’s debt is:
BSteinberg = [.80($925,000) + .20($925,000)]/1.13
BSteinberg = $818,584
Solution
• Since Dietrich owes its bondholders $1,350,000 at the end of the year, its
stockholders will receive $1,550,000 (= $2,900,000 – 1,350,000) if the expansion
continues. If there is a recession, its stockholders will receive nothing since the firm’s
bondholders have a more senior claim on all $1,300,000 of the firm’s earnings. So,
the market value of Dietrich’s equity is:
SDietrich = [.80($1,550,000) + .20($0)]/1.13
SDietrich = $1,097,345
• Dietrich’s bondholders will receive $1,350,000 if the expansion continues and
$1,300,000 if there is a recession. So, the market value of Dietrich’s debt is:
BDietrich = [.80($1,350,000) + .20($1,300,000)]/1.13
BDietrich = $1,185,841
Solution
• b. The value of the company is the sum of the value of the firm’s debt and equity. So,
the value of Steinberg is:
VSteinberg = B + S
VSteinberg = $818,584 + 1,464,602
VSteinberg = $2,283,186
• And value of Dietrich is:
VDietrich = B + S
VDietrich = $1,185,841 + 1,097,345
VDietrich = $2,283,186
• You should disagree with the CEO’s statement. The risk of bankruptcy per se does not
affect a firm’s value. It is the actual costs of bankruptcy that decrease the value of a
firm. Note that this problem assumes that there are no bankruptcy costs.
Solution
• a. The expected value of each project is the sum of the probability of each state of the
economy times the value in that state of the economy. Since this is the only project for
the company, the company value will be the same as the project value, so:
Low-volatility project value = .50($4,200) + .50($4,600)
Low-volatility project value = $4,400
High-volatility project value = .50($3,400) + .50($4,900)
High-volatility project value = $4,150
Since the low-volatility project has a higher value, choosing this low-volatility project
will maximize the expected value of firm.
Solution
• b. The value of the equity is the residual value of the company after the bondholders
are paid off. If the low-volatility project is undertaken, the firm’s equity will be worth
$0 if the economy is bad and $400 if the economy is good. Since each of these two
scenarios is equally probable, the expected value of the firm’s equity is:
Expected value of equity with low-volatility project = .50($0) + .50($400)
Expected value of equity with low-volatility project = $200
• And the value of the company if the high-volatility project is undertaken will be:
Expected value of equity with high-volatility project = .50($0) + .50($700)
Expected value of equity with high-volatility project = $350
Solution
• c. Risk-neutral investors prefer the strategy with the highest expected value. Thus, the
company’s stockholders prefer the high-volatility project since it maximizes the
expected value of the company’s equity.
• d. In order to make stockholders indifferent between the low-volatility project and the
high-volatility project, the bondholders will need to raise their required debt payment
so that the expected value of equity if the high-volatility project is undertaken is equal
to the expected value of equity if the low-volatility project is undertaken. As shown in
part b, the expected value of equity if the low-volatility project is undertaken is $200.
If the high-volatility project is undertaken, the value of the firm will be $3,400 if the
economy is bad and $4,900 if the economy is good. If the economy is bad, the entire
$3,400 will go to the bondholders and stockholders will receive nothing. If the
economy is good, stockholders will receive the difference between $4,900, the total
value of the firm, and the required debt payment. Let X be the debt payment that
bondholders will require if the high-volatility project is undertaken. In order for
stockholders to be indifferent between the two projects, the expected value of equity
if the high-volatility project is undertaken must be equal to $200, so:
Expected value of equity = $200 = .50($0) + .50($4,900 – X)
X = $4,500
Solution
• a. The expected payoff to bondholders is the face value of debt or the value of the
company, whichever is less. Since the cash flows in a recession are $43,000,000 and
the required debt payment in one year is $65,000,000, bondholders will receive the
lesser amount, or $43,000,000.
• b. The promised return on debt is:
Promised return = (Face value of debt/Market value of debt) – 1
Promised return = ($65,000,000/$49,000,000) – 1
Promised return = .3265, or 32.65%
Solution
• c. In part a, we determined bondholders will receive $43,000,000 in a recession. In a
boom, the bondholders will receive the entire $65,000,000 promised payment since
the market value of the company is greater than the payment. So, the expected value
of debt is:
Expected payment to bondholders = .60($65,000,000) + .40($43,000,000)
Expected payment to bondholders = $56,200,000
• So, the expected return on debt is:
Expected return = (Expected value of debt/Market value of debt) – 1
Expected return = ($56,200,000/$49,000,000) – 1
Expected return = .1469, or 14.69%
