Download 1. Consider a single period binomial setting where the

Financial Economics and Corporate Governance
Professor: García-Marco, Teresa (UPNA)
Exercises:
1. Consider a single period binomial setting where the riskless interest rate is zero, and there are
no taxes. A firm consists of a machine that will produce cash flows of $210 if the economy is
good and $80 if the economy is bad. The good and bad states occur with equal risk-neutral
probability. Initially, the firm has 100 shares outstanding and debt with a face value of $50 due
at the end of the period. What is the share price of the firm?
2. The puzzle of optimal capital structure is that there appear to be cross-sectional regularities in
the observed ratios of debt to equity of U.S. firms. For example, the steel industry appears to
carry a higher percentage of debt than the public accounting industry does. These same
regularities appeared even before the existence of corporate income taxes. How can optimal
leverage be explained without relying on the tax shield of debt or bankruptcy costs?
3. Explain why the proportion of earnings distributed in the form of a share prepurchase has
increased substantially over the past 15 year.
4. Suppose you are a manager who wants to retain as much as possible of the firm’s earnings in
order to increase the size of the firm. How would you react to proposals to repurchase shares
that would make it less costly to distribute cash to shareholders? How does your reaction?.
5. The Chairman of the board of Alphanull Corporation has announced that the corporation will
change its dividend policy from paying a fixed dollar dividend per share. Instead, dividends will
be paid out as a residual. That is, any cash flows left over after the firm has undertaken all
profitable investments will be paid out to shareholders. This new policy will obviously increase
the variability of dividends paid. How do you think it will affect the value of the firm?
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6. Hiroko Fashion Corporation (HFC) can pursue either project Dress, or project Cosmetic with
possible payoffs at year-end as follows:
Bad Economy
(prob. = 30 %)
(in $ millions)
Good Economy
(prob. = 70 %)
(in $ millions)
Project Dress
$2
$9
Project Cosmetic
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Each project costs $6 million at the beginning of the year. Assume there are no taxes, there are
no direct bankruptcy costs, all investors are risk neutral, and the risk-free interest rate is zero.
a. Which project should HFC pursue if it is all equity Finance? Why?
b. If HFC has a $ 5 million bond obligation at the end of year, which project would its
stockholders want to pursue? Why?
7. A firm has a senior bond obligation of $20 due this period and $100 next period. It also has a
subordinated loan of $40 owed to Jack and Jill and due next period. It has no projects to provide
cash flow this period. Therefore, if the firm cannot get a loan of $20, it must liquidate. The firm
has a current liquidation value of $120. if the firm does not liquidate, it can take one of two
projects with no additional investment. If it takes project A, it will receive cash flows of $135
next period, for sure. If the firm takes project B, it will receive either cash lows of $161 or $69
with equal probability. Assume risk neutrality, a zero interest rate, no direct bankruptcy costs,
and no taxes.
a. What has a higher PV: liquidating, project A or project B.
b. Should Jack and Jill agree to loan the firm the $20 it needs to stay operating if they
receive a (subordinated) bond with a face value of $20.50?
c. If the firm does receive the loan from Jack and Jill, which project will the managers
choose if they act in the interest of the equity holders?
8. Discuss why managers might tend to want their organizations to grow.
9. Explain why the threat of hostile takeovers can make firms more short-term oriented?
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References:
Copeland and Weston (1992): Financial Theory and Corporate Policy.
Addison-Wesley Publishing Company Ed.
Grinblatt and Titman (1998): Financial Markets and Corporate Strategy.
Ed. Irwin/McGraw-Hill
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