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Business 3019

Winter 2006

• Risky Project

• Leverage-Increasing Recap

2

The Binomial Pricing Model

V u with probability p,

T

VT =

V d with probability 1 − p,

T

with VTu > VTd , where u stands for “up” and d stands for “down”.

Let

D ≡ Current value of the firm’s debt

E ≡ Current value of the firm’s equity

X ≡ Payment promised to debtholders at time T

r f ≡ Risk-free rate of interest

4

The Binomial Pricing Model

At time T , the value of the firm’s debt is

X if V ≥ X,

T

DT =

VT if VT < X.

Risk-free assets are discounted at the risk-free rate, and thus

X

D = ,

(1 + r f )T

which gives

X

E = V −D = V − .

(1 + r f )T

6

The Binomial Pricing Model: Risk-Free Debt

D = Xe−r f T

E = V − Xe−r f T .

Example

Consider a firm with present value V = $400, future value

V u = $650 with probability p = 0.7,

3

V3 =

V d = $250 with probability 1 − p = 0.3.

3

in three years.

The risk-free interest rate is r f = 5%.

8

The Binomial Pricing Model: Risk-Free Debt

Example

Note that the above values give us a return on assets of

Ã !1/3

u

pV3 + (1 − p)V3 d

rA = −1

V

µ ¶

.7 × 650 + .3 × 250 1/3

= −1

400

= 9.83%.

Note that rA ≡ ρ.

Example

What is the current value of debt?

Debt is risk-free and thus X can be discounted at the risk-free

rate to find D:

X 200

D = = = 173.

(1.05)3 (1.05)3

The current value of equity is then

10

The Binomial Pricing Model: Risk-Free Debt

Example

The return on equity in this case is

µ ¶

.7 × 450 + .3 × 50 1/3

rLE = − 1 = 13.28%.

227

11

Example

What happens to rLE if X increases to 250?

Debt is still risk-free and thus

250

D = = 216.

(1.05)3

12

The Binomial Pricing Model: Risk-Free Debt

Example

The value of the firm has a whole remains V = 400 (M&M

Proposition I), we have

which gives

µ ¶1/3

.7 × 400 + .3 × 0

rLE = − 1 = 15.02%.

184

13

Suppose now that debt is not risk-free. That is, suppose that

X if V = V u ,

T T

DT =

V d if VT = V d .

T T

14

The Binomial Pricing Model: Risky Debt

V u − X if V = V u ,

T T T

ET =

0 if VT = VTd .

15

We have the risk-free discount rate and thus we can find the

present value of any risk-free asset.

Can we form a risk-free portfolio with V , D and E?

16

The Binomial Pricing Model: Risky Debt

in each state of the world u and d.

How to make a portfolio that pays K, say, whether VT = VTu or

VT = VTd ?

What can K be?

What payoff can we guarantee with certainty?

17

firm’s assets and the short sale of a fraction δ of the firm’s equity.

The payoff of portfolio P at time T is then

VTd − δETd in state d.

18

The Binomial Pricing Model: Risky Debt

VTu −VTd

VTu − δETu = VTd − δETd ⇒ δ = u .

ET − ETd

VT − δET

V − δE = .

(1 + r f )T

19

VTu −VTd

With δ = ETu −ETd

, we have

= VTd − δETd = VTd

and thus

VTd

V − δE = .

(1 + r f )T

20

The Binomial Pricing Model: Risky Debt

µ ¶

1 VTd

E = V −

δ (1 + r f )T

and the current market value of debt is

D = V − E.

21

Example

Consider a firm with present value V = $400, future value

V u = $650 with probability p = 0.7,

3

V3 =

V d = $250 with probability 1 − p = 0.3.

3

in three years.

The risk-free interest rate is r f = 5%.

22

The Binomial Pricing Model: Risky Debt

Example

Same firm as before, except that X = 400.

Debt is not default-free anymore.

What is the current value of debt and equity?

First thing to do: find δ in the portfolio V − δE such that the

latter be risk-free.

23

Example

To have V3u − δE3u = V3d − δE3d , we need

V3u −V3d

δ = u ,

E3 − E3d

where

© ª © ª

E3u = max 0 , V3u − X = max 0 , 650 − 400 = 250

© ª © ª

E3d = max 0 , V3u − X = max 0 , 250 − 400 = 0.

24

The Binomial Pricing Model: Risky Debt

Example

This gives

δ = u = = 1.6

E3 − E3d 250 − 0

and thus

Ã ! µ ¶

1 V3d 1 250

E = V − = 400 − = 184

δ (1 + r f )3 1.6 (1.05)3

25

Example

Note that the expected return to bondholders is

µ ¶

.7 × 400 + .3 × 250 1/3

rD = − 1 = 18.0%.

216

26

The Goal of Management

the value of the firm?

Does maximizing the value of the firm imply maximizing the

market value of equity?

Can maximizing the market value of equity hurt other

stakeholders?

27

with:

projects.

28

Risky Project such that V ↓ and E ↑

V u = $650 with probability p = 0.7,

3

V3 =

V d = $250 with probability 1 − p = 0.3.

3

in three years.

The risk-free rate is r f = 5%.

29

The firm has identified a project that pays off P3u = $200 in the

“up” state or P3d = $0 in the “down” state.

This project also requires an initial outlay of $142.5.

Present value of the project at the firm’s cost fo capital of 9.7% is

.7 × 200 + .3 × 0

− 142.5 = − $36.45

(1.097)3

30

Risky Project such that V ↓ and E ↑

V u,n = 650 − 142.5(1.05)3 + 200 = $685.04

V d,n = 250 − 142.5(1.05)3 = $85.04.

This gives

∆E = $22.79, ∆D = −$59.24, ∆E + ∆D = −$36.45.

31

risky project be to prevent shareholders from investing in the

risky project?

32

Shareholders and Bankruptcy Costs

bankruptcy.

interest rates.

expropriate wealth from bondholders.

33

V u = $200 if boom (p = .7),

5

V5 =

V d = $50 if recession (1 − p = .3).

5

¡ .7×200+.3×50 ¢1/5

Note that 100 − 1 = 9.16%.

Do ≡ original issue of pure discount debt paying $50 in five

50

years. If r f = 5%, then Do = 1.05 o

5 = $39.18 and E = $60.82.

34

A Leverage-Increasing Recap, no Bankruptcy Costs

five years, same priority as the old debt on firm’s assets.

The proceeds from the issue are distributed to shareholders.

issuing more debt does not affect the value of the firm:

35

This gives

4

× 55.40 = $24.62.

9

Increase in shareholders’ wealth:

36

A Leverage-Increasing Recap with Bankruptcy Costs

Present value of bankruptcy costs:

10

= $6.45 ⇒ V n = 100 − 6.45 = $93.55

(1.0916)5

We now have

µ ¶

1 40

δ = 1.4545 ⇒ En = 93.55 − = $42.77.

1.4545 (1.05)5

37

4 4

× (V n − E n ) = × (93.55 − 42.77) = $22.57.

9 9

38

A Leverage-Increasing Recap with Bankruptcy Costs

shareholders from issuing debt to pay themselves a dividend?

39

Protective covenants:

• The firm may not issue long-term debt with equal or higher

seniority

40

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