6. (35 points) Firm XYZ Inc. had to decide on ways to finance its investment opportunity. The firm has no assets or sources of income except some cash (which analysts estimate to be in the ballpark of $50 million) and a patent to develop a new medical product. An upfront investment of $200 million is required for development of this medical product although its success is uncertain. The FDA is equally likely to approve or to reject the product (probability=0.5), and the FDA decision is independent of market conditions or any other risk factor. If it is not approved by the FDA, the patent can be sold at the end of the year to a pharmaceutical for $80 million. If it is approved by the FDA, the patent can be sold at the end of the year to several potential buyers for a substantially higher value: either $300 million or $700 million, depending on market conditions as well as the state of the economy. If approved, the value is equally likely to be $300 million and $700 million, but this outcome (300 or 700 million) will be determined by many different market factors. Additional information: The risk-free rate is 5%. There are 1,700,000 shares outstanding. If the firm is forced into bankruptcy, it will suffer a loss of $20 million in direct bankruptcy cost (such as fees etc). . To finance the development, the firm decided to issue new debt with maturity of one year. Then, the firm raised additional funds by issuing new shares. The cash that the firm had held together with the proceeds from the debt and equity issues summed up to exactly $200 million, which were used to make the investment and begin development. The new debt: o XYZ Inc. issued new debt with face value of $150 million, due in one year. o Since the FDA approval is unrelated to the market or the economy, the risk to the debtors is diversifiable. Therefore, the debt has beta of zero and the cost of this debt is the risk-free rate. The new equity: o The company issued 800,000 new shares (which are 32% of the total number of shares after adding the new shares) o Because the payout to the stockholders does depend on market conditions, the appropriate cost of equity is higher than the risk-free rate. o Suppose that the appropriate expected return on the new stock (given the information available to market participants) is 12%. a) (1 points) Evaluating the investment in development as a project in isolation, what is the IRR (Internal Rate of Return) of the project? 50%[80]+25%[300]+25%[700) [hint: the IRR can be found by solving the equation 0 = 200+ %[700), 1+IRR b) (6 points) Calculate the value of XYZ's debt at the beginning of the year (after raising the capital and making the investment). c) (2 points) What is the yield to debt holders? [i.e. the yield to maturity of the debt, as a percent/rate] d) (6 points) Calculate the value of XYZ's equity at the beginning of the year (after raising the capital and making the investment). [hint: find the mean equity claims considering the possible outcomes, and discount it with the cost of equity rate given above] e) (2 points) What is the price per share? f) (3 points) What would be the stock return earned on the new shares that were issued, if the best-case outcome (patent sold for $700 million) occurs? g) (10 points) Suppose that, instead of $20 million, the cost of bankruptcy was only $10 million. The company raised the same combination of debt and equity to finance the project. For each of the following rates, (i) The expected rate of return to an investor who holds debt (from the recent debt issue) (ii) The expected return to an investor who purchases a new share in the recent stock issue and holds it until the end of the year (iii) The expected return for holding a share through the period beginning two years earlier and until the end of the current year explain if the rate would be higher, lower, or unchanged (compared to if bankruptcy costs were $20). [Explain why. It is not necessary to compute the values, just explain what the effect of lower bankruptcy cost will be and how you know. Hint: the third rate (iii) represents the wellbeing of the existing shareholders. It does not matter what happened in the two years prior to the current project] h) (5 points) Which "market imperfection" that does not exist in the M&M model has an impact on the value of XYZ's securities? 6. (35 points) Firm XYZ Inc. had to decide on ways to finance its investment opportunity. The firm has no assets or sources of income except some cash (which analysts estimate to be in the ballpark of $50 million) and a patent to develop a new medical product. An upfront investment of $200 million is required for development of this medical product although its success is uncertain. The FDA is equally likely to approve or to reject the product (probability=0.5), and the FDA decision is independent of market conditions or any other risk factor. If it is not approved by the FDA, the patent can be sold at the end of the year to a pharmaceutical for $80 million. If it is approved by the FDA, the patent can be sold at the end of the year to several potential buyers for a substantially higher value: either $300 million or $700 million, depending on market conditions as well as the state of the economy. If approved, the value is equally likely to be $300 million and $700 million, but this outcome (300 or 700 million) will be determined by many different market factors. Additional information: The risk-free rate is 5%. There are 1,700,000 shares outstanding. If the firm is forced into bankruptcy, it will suffer a loss of $20 million in direct bankruptcy cost (such as fees etc). . To finance the development, the firm decided to issue new debt with maturity of one year. Then, the firm raised additional funds by issuing new shares. The cash that the firm had held together with the proceeds from the debt and equity issues summed up to exactly $200 million, which were used to make the investment and begin development. The new debt: o XYZ Inc. issued new debt with face value of $150 million, due in one year. o Since the FDA approval is unrelated to the market or the economy, the risk to the debtors is diversifiable. Therefore, the debt has beta of zero and the cost of this debt is the risk-free rate. The new equity: o The company issued 800,000 new shares (which are 32% of the total number of shares after adding the new shares) o Because the payout to the stockholders does depend on market conditions, the appropriate cost of equity is higher than the risk-free rate. o Suppose that the appropriate expected return on the new stock (given the information available to market participants) is 12%. a) (1 points) Evaluating the investment in development as a project in isolation, what is the IRR (Internal Rate of Return) of the project? 50%[80]+25%[300]+25%[700) [hint: the IRR can be found by solving the equation 0 = 200+ %[700), 1+IRR b) (6 points) Calculate the value of XYZ's debt at the beginning of the year (after raising the capital and making the investment). c) (2 points) What is the yield to debt holders? [i.e. the yield to maturity of the debt, as a percent/rate] d) (6 points) Calculate the value of XYZ's equity at the beginning of the year (after raising the capital and making the investment). [hint: find the mean equity claims considering the possible outcomes, and discount it with the cost of equity rate given above] e) (2 points) What is the price per share? f) (3 points) What would be the stock return earned on the new shares that were issued, if the best-case outcome (patent sold for $700 million) occurs? g) (10 points) Suppose that, instead of $20 million, the cost of bankruptcy was only $10 million. The company raised the same combination of debt and equity to finance the project. For each of the following rates, (i) The expected rate of return to an investor who holds debt (from the recent debt issue) (ii) The expected return to an investor who purchases a new share in the recent stock issue and holds it until the end of the year (iii) The expected return for holding a share through the period beginning two years earlier and until the end of the current year explain if the rate would be higher, lower, or unchanged (compared to if bankruptcy costs were $20). [Explain why. It is not necessary to compute the values, just explain what the effect of lower bankruptcy cost will be and how you know. Hint: the third rate (iii) represents the wellbeing of the existing shareholders. It does not matter what happened in the two years prior to the current project] h) (5 points) Which "market imperfection" that does not exist in the M&M model has an impact on the value of XYZ's securities