FINANCIAL CONTRACTING - CODE 30176

PROBLEM SET 2
BOCCONI UNIVERSITY

Question 1:
Gladstone Corporation is about to launch a new product. Depending on the success of the new
product, Gladstone may have one of four values next year: 150 million, 135 million, 95 million,
and 80 million. These outcomes are all equally likely, and this risk is diversifiable. Suppose the
risk-free interest rate is 5% and that, in the event of default, 25% of the value of Gladstones
assets will be lost to bankruptcy costs. (Ignore all other market imperfections, such as taxes.)

1. What is the initial value of Gladstones equity without leverage?

Solution: 0.25

(150+135+95+80)
1.05

= 109.52M

Now suppose Gladstone has zero-coupon debt with a 100 million face value due next year.
2. What is the initial value of Gladstones debt?
Solution: 0.25

(100+100+950.75+800.75)
1.05

= 78.87M

3. What is the yield-to-maturity of the debt?

Solution:

100
78.87

1 = 26.79%

4. What is the initial value of Gladstones equity? What is Gladstones total value with
leverage?
Solution:
E = 0.25

(50+35+0+0)
1.05

= 20.24M

V = D + E = 78.87 + 20.24 = 99.11M

Suppose Gladstone has 10 million shares outstanding and no debt at the start of the year.
5. If Gladstone does not issue debt, what is its share price?

Solution: 109.52/10 = 10.95 per share.

6. f. If Gladstone issues debt of 100 million due next year and uses the proceeds to repurchase
shares, what will its share price be? Why does your answer differ from that in part above?
Solution:
99.11
10

= 9.91 per share - bankruptcy costs lowers share price.

Note that Gladstone will raise 78.87M from the debt, and repurchase
Its equity will be worth 20.24 million, for a share price of
action is completed.

20.24
107.96

78.87
9.91

= 7.96M shares

= 9.91 after the trans-

Question 2:
An entrepreneur has financed a project that will generate a cash flow A at t=1 equal to 40
(failure) with probability 0.6 and equal to 200 (success) with probability 0.4. The entrepreneur
has also outstanding debt (to be repaid at t=1) with face value equal to 100. The entrepreneur
is protected by limited liability (so if the cash flow is 0, he will simply repay 0). At t=0
the entrepreneur has the following opportunity: by investing I=50 (I must be paid by the
entrepreneur) he can increase the probability of success of the project (i.e., the probability that
the cash flow will be 200) from 0.4 to 0.8 (so the probability that A=40 will fall to 0.2).
1. Compute the NPV of this opportunity.

Solution:

Without the investment, expected cash flow: 40(0.6) + 200(0.4) = 104

With the investment, expected cash flow: 40(0.2) + 200(0.8) = 168

So the NPV is 168-104-50=14.

2. Show that the entrepreneur will decide not to invest I=50.

Solution:

If the entrepreneur does not invest, he gets 200-100=100 with probability 0.4, i.e. 40.

If he invests, he gets 100 with probability .8, i.e. 80. But he has to pay 50, so his payoff
is 30. He will not invest.

3. Suppose now the entrepreneur and the financier can renegotiate. More precisely, the
financier will accept to reduce the face value of his debt claim from 100 to F (with
40 < F 0 < 100). In exchange, the entrepreneur commits to invest I=50 and increase the
probability of success to 0.8. What is the lowest value of F that the financier is willing
to accept? What is the highest value of F that the entrepreneur is willing to accept?
Solution:

Without renegotiation the value of debt is D = 40(.6) + 100(.4) = 64

With renegotiation the value of debt is D0 = 40(.2) + F 0 (.8).
The lowest value of F that the financier is willing to accept is such that F 0 (.8) = 64 8
and F 0 = 70.
The value of equity under renegotiation becomes E 0 = .8(200 F 0 ) = 160 .8F 0

But the entrepreneur must also pay 50.

Thus the highest F that the entrepreneur is willing to accept is such that 1600.8F 0 50
40 or F 0 87.5.

Forget now about renegotiation and assume that entrepreneur can finance the new project by
issuing new debt (so now the entrepreneur does not make use of his own wealth). The new
debt is pari passu (equal priority) with the old debt and has face value equal to G (so that
total debt is now 100+G).
4. For which values of G will the entrepreneur be willing to finance the new project using
debt?
Solution:
With G, total debt becomes 100+G. The entrepreneurs equity value is 0.8(200 100 G).
Thus, the entrepreneur is willing to finance the project when .8(200 100 G) 40 or
G 50

5. For which values of G the new debtholders are willing to finance the new project? (you
do not need to solve for the actual value of G) .
Solution:
The condition under which debtholders are willing to finance the new project is .8G +
G
50
.2 100+G
Note however that as G 50 this condition can never be satisfied.

Question 3
An entrepreneur has financed a project that will generate a cash flow A at t = 1 equal to 40
(failure) with probability 0.6 and equal to 60 (success) with probability 0.4. The entrepreneur
has also outstanding debt (to be repaid at t=1) with face value equal to 50. The entrepreneur
is protected by limited liability (so if the cash flow is 0, he will simply repay 0). At t=0
the entrepreneur has the following opportunity: by investing I=5 (I must be paid by the
entrepreneur) he can increase the probability of success of the project (i.e., the probability that
the cash flow will be 60) from 0.4 to 0.8 (so the probability that A=40 will fall to 0.2).
1. Compute the NPV of this opportunity;
Solution:
Without the investment, expected cash flow: 40(0.6) + 60(0.4) = 24 + 24 = 48
With the investment, expected cash flow: 40(0.2) + 60(0.8) = 8 + 48 = 56
So the NPV is 56-48-5=3.

2. Show that the entrepreneur will decide not to invest I=5. Explain why. Compute the
market value of debt.
Solution:
If the entrepreneur does not invest, he gets 60-50=10 with probability 0.4, i.e. 4.
If he invests, he gets 10 with probability .8, i.e. 8. But he has to pay 5, so his net payoff
is -1. He will not invest.

The market value of debt is 40(.6) + 50(.4) = 24 + 20 = 44

3. Suppose now that the financier decides unilaterally to reduce the face value of his debt
from 50 to 46. What is the gain/loss of this decision for the financier?

Solution:

If the face value of debt is reduced to 46, the entrepreneur obtains 60-46=14.

If he does not invest: with probability .4, that is 5.6

If he invests: 11.2. Subtracting 5, the entrepreneur obtains 6.2.

Then he will invest. The market value of debt becomes 40(.2) + 46(.8) = 8 + 36.8 = 44.8.
The gain for the financier is 0.8

Question 4
An entrepreneur can finance only one out of two projects, A and B. Both projects require an
initial investment I = 60. Project A generates a cash flow equal to 40 with probability 0.5, or
equal to 120 with probability 0.5. Project B generates a cash flow equal to 0 with probability
0.75, or equal to 250 with probability 0.25. The entrepreneur has no wealth and must borrow
to finance the project. He issues a debt claim with face value F. Financiers cannot observe
the project chosen by the entrepreneur. The risk-free interest rate is 0 and there is perfect
competition in capital markets. The entrepreneur is protected by limited liability.
1. Compute the NPV of the two projects;

Solution:
Project A: 40(0.5) + 120(0.5) I = 80 60 = 20
Project B: 0(0.75) + 250(0.25) I = 62.5 60 = 2.5

2. If debt holders expect that the entrepreneur will pick project A, what is the minimal
value of F that will induce them to finance the entrepreneur? Denote by F this value.
Solution:
Investors expect project A: (0.5)40 + F (0.5) = 60 and therefore F = 80

3. If F = F , which project will be selected by the entrepreneur? Why?

Solution:
Entrepreneur expected utility under A: (0.5)0 + (0.5)(120 80) = 20
Entrepreneur expected utility under B: (0.75)0 + (0.25)(250 80) = 42.5
Entrepreneurs expected utility higher under project B and therefore implements B.

4. If the market instead expects the entrepreneur to select project B, what is the minimal
value of F that will induce them to finance the entrepreneur? Denote by F this value. If
F = F , which project will be selected by the entrepreneur?
Solution:
Investors expect project B: (0.75)0 + F (0.25) = 60 and therefore F = 240
Entrepreneur expected utility under A: (0.5)0 + (0.5)(120 240) < 0
Entrepreneur expected utility under B: (0.75)0 + (0.25)(250 240) = 2.5
Entrepreneurs expected utility higher under project B and therefore implements B.

5. If the project could be financed by issuing equity, which project would be chosen by the
entrepreneur? Why?
Solution:
Fraction 1 sold to investors.
Entrepreneur expected utility under A: (0.5)(40) + (0.5)(120) = (80)

Entrepreneur expected utility under B: 0 + (0.25)(250) = (62.5)

Entrepreneur chooses A and equity finance does not induce any distorsion in the investment decision, due to linearity of claim.