Professional Documents
Culture Documents
Business 3019
Winter 2006
• Risky Project
• Leverage-Increasing Recap
2
The Binomial Pricing Model
with VTu > VTd , where u stands for “up” and d stands for “down”.
Let
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The Binomial Pricing Model
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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
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The Binomial Pricing Model: Risk-Free Debt
Example
Note that the above values give us a return on assets of
à !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
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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
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Example
What happens to rLE if X increases to 250?
Debt is still risk-free and thus
250
D = = 216.
(1.05)3
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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
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Suppose now that debt is not risk-free. That is, suppose that
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The Binomial Pricing Model: Risky Debt
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The Binomial Pricing Model: Risky Debt
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The Binomial Pricing Model: Risky Debt
VTu −VTd
VTu − δETu = VTd − δETd ⇒ δ = u .
ET − ETd
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VTu −VTd
With δ = ETu −ETd
, we have
and thus
VTd
V − δE = .
(1 + r f )T
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The Binomial Pricing Model: Risky Debt
D = V − E.
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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
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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.
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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.
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The Binomial Pricing Model: Risky Debt
Example
This gives
and thus
à ! µ ¶
1 V3d 1 250
E = V − = 400 − = 184
δ (1 + r f )3 1.6 (1.05)3
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Example
Note that the expected return to bondholders is
µ ¶
.7 × 400 + .3 × 250 1/3
rD = − 1 = 18.0%.
216
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The Goal of Management
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Risky Project such that V ↓ and E ↑
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
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Risky Project such that V ↓ and E ↑
This gives
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Shareholders and Bankruptcy Costs
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¡ .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.
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A Leverage-Increasing Recap, no Bankruptcy Costs
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This gives
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A Leverage-Increasing Recap with Bankruptcy Costs
We now have
µ ¶
1 40
δ = 1.4545 ⇒ En = 93.55 − = $42.77.
1.4545 (1.05)5
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A Leverage-Increasing Recap with Bankruptcy Costs
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Protective covenants:
• The firm may not issue long-term debt with equal or higher
seniority
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