CORPORATE FINANCE (code IB9Y70)

Examination: November 2021

a) We can immediately say that the value of the unlevered asset is A = £1500 because
the combination of the two assets creates a risk-free cash flow of £1500 at t = 1.
The same value can be obtained by discounting the expected cash flow of each
individual asset at the appropriate cost of capital. Using the asset betas and SML,
r = rf + β × M RP , from the CAPM, we can find the asset cost of capital for each
business. For Sunglasses (G)

rG = 0% + (0.7692) × 10% = 7.69%,

and the asset value is

rU = 0% + (−0.5882) × 10% = −5.88%.

Thus,
0.4 × 500 + 0.6 × 1000
AU = = £850.
0.9412
Hence, AG + AU = A = £1500.

b) The debt is currently risk-free, because the combined cash flow from the assets is
higher than the face value (plus interest at 0%), and hence its value is D = £1200.
Therefore, the current value of equity is E = A − D = £300.
Both the debt and the equity are risk-free. Hence, their cost of capital is rf = 0.
From this, or by using the definition of WACC, we can see that
0.4 × 1500 + 0.6 × 1500
rwacc = − 1 = 0.
1500

c) To calculate the risk-neutral probability, we can use any of the two assets:

650 = q × 1000 + (1 − q) × 500

or
850 = q × 500 + (1 − q) × 1000,
where we have considered that rf = 0, and find that q = 0.3.

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d) The CEO can sell either G or U , but will not sell both, otherwise she would lose
her job. If she sells the G business, she makes AG = £650. After selling this asset
and disboursing the proceeds as dividend, the firm defaults in both states at t = 1
and the other asset is lost to creditors. Hence, the equity holders pocket only the
proceeds from sale, that is £650. Because there are no bankruptcy costs, the debt
holders receive the cash flow from U . Hence, their value is £850.
Alternatively, if the CEO sells the umbrella business, following the same steps as
above the equity value becomes £850, and the debt value £650.
Because she is making decisions on behalf of shareholders, she will opt for the second
approach and sell U . Hence, the new value of equity is E 0 = £850 and the new
value of debt is D0 = £650. Given E = £300, the incremental value of equity is
E 0 − E = £550. As this increment is positive, the CEO would definitely sell instead
of keeping both assets. On the other hand, the debt loses value: D0 − D = −£550,
and therefore would oppose to the decision to liquidate an asset to pay dividends
at t = 0.
While this is a cashing out agency conflict, in this case the agency friction is not
creating any welfare loss, just a transfer from debt to equity, as MM I remains
valid. Our conclusions would be different in the presence of bankruptcy costs or
other frictions.

e) Assume the covenant is added to the debt, which implies that the CEO can sell
an asset, but cannot pay the proceeds as dividends until t = 1. As the proceeds
are reinvested (at the risk-free rate) within the firm, the total cash flow at t = 1 is
comprised of the savings plus the cash flow from the unsold business.
If the CEO sells G and saves £650, the equity value is (using a risk-neutral approach)

£315 = 0.3 × max{500 + 650 − 1200, 0} + 0.7 × max{1000 + 650 − 1200, 0}

where the equity value is augmented by the default option which is in the money in
the up state (S).
If instead she sells U and saves £850, the equity value is

£300 = 0.3 × max{1000 + 850 − 1200, 0} + 0.7 × max{500 + 850 − 1200, 0}

where default is avoided in both states because in particular in the low state (R)
500 + 850 = 1350 > 1200.
The equity value is increased to E 0 = £315 by selling G, but not by selling U . We
can conclude that also with the covenant the CEO will sell an asset to maximize the
equity value, but in this case she will sell G, as opposed to U , and the increment is
E 0 − E = £15. The debt holders would not be able to protect their value with this
covenant, as the new debt price, given the CEO action, is

£1185 = 0.3 × min{500 + 650, 1200} + 0.7 × min{1000 + 650, 1200}

with a loss of D0 − D = −£15, which as before is just a transfer to equity value.

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f) An asset that is pledged as collateral cannot be sold by the CEO. Based on calcula-
tions done in (d), if the debt holders choose U as collateral, the CEO could only sell
G and pay the proceeds as dividend. In that case, the debt value would be £850.
Alternatively, if debt holders choose G as collateral, the CEO could only sell U , and
in that case the debt value would be £650.
We can assume that the debt holders are rational and prefer the first alternative, so
that D0 = £850. While this does not eliminate a loss of value for them, the loss is
D0 − D = −£350, which is smaller than the one under (d) but bigger than the one
under (e).

g) When collateral and covenant are combined, the best course of action for the debt
holders is to use G as collateral because in that case, only U could be sold by the
CEO. However, given the covenant, she would be able to pay the proceed out as
dividend only at t = 1. Hence, as we showed above, the equity value is £300, and
the debt value is

£1200 = 0.3 × min{1000 + 850, 1200} + 0.7 × min{500 + 850, 1200},

with no loss of value.