A firm currently has the following balance sheet Bad state (50 ) Good state (50 ) Expected PV Assets $50 $170 $110 $110 1 1 $100 Debt $42 $42 $42 $42 1 05 $40 Equity $8 $128 $68 $68 1 1333 $60 The dollar amounts in the first three columns are time one cash flows The last column shows the present values of these cash flows Similar to the risk shifting example in class, assume the firm is planning to switch to higher risk lower valued assets in order to help its stockholders The higher risk lower valued assets pay $24 in the bad state and $174 in the good state In the class example, I pointed out that the lender will charge a higher promised interest rate to protect themselves against the possibility that the firm will risk shift What promised interest rate will the lender need to charge in this problem so that they still receive an expected return of 5 on their $40 loan Hint filling in the blanks in the following table will help you answer the question Bad state (50 ) Good state (50 ) Expected PV Assets $24 $174 $99 $99 1 1 $90 Debt $42 1 05 $40 Equity $57 1 14 $50 A 37 5 B 40 0 C 42 5 D 45 0 E 47 5 F 50 0 G 52 5 H 55 0 6 Similar to the example in class when I discussed Is it bankruptcy or bankruptcy costs, the following table shows asset, debt, and equity time 1 cash flows (first two columns of numbers), expected time 1 cash flows (third column of numbers), and present values (last column of numbers) for a firm The amount of money loaned to the firm is $60 and it has a 50 chance of bankruptcy (i e , in the bad state), but bankruptcy costs $0 Bad state (50 ) Good state (50 ) Expected PV Assets $40 $180 $110 $110 1 1 $100 Debt $40 $86 $63 $63 1 05 $60 Equity $0 $94 $47 $47 1 175 $40 Now assume that bankruptcy costs $14 (Of course, you will only have to pay the bankruptcy costs in the bad state ) Including bankruptcy costs in the analysis, what promised interested rate will you need to pay the lender so that the lender still makes an expected return of 5 on the $60 loan to the firm As in class, ignore taxes A 63 33 B 66 67 C 70 00 D 71 67 E 73 33 F 76 67 G 80 00 H 81 67

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A firm currently has the following balance sheet. Bad state (50%) Good state (50%) Expected PV Assets $50 $170 $110 $110 / 1.1 = $100

A firm currently has the following balance sheet.

	Bad state (50%)	Good state (50%)	Expected	PV
Assets	$50	$170	$110	$110 / 1.1 = $100
Debt	$42	$42	$42	$42 / 1.05 = $40
Equity	$8	$128	$68	$68 / 1.1333 = $60

The dollar amounts in the first three columns are time one cash flows. The last column shows the present values of these cash flows.

Similar to the risk-shifting example in class, assume the firm is planning to switch to higher-risk / lower-valued assets in order to help its stockholders. The higher-risk / lower-valued assets pay $24 in the bad state and $174 in the good state.

In the class example, I pointed out that the lender will charge a higher promised interest rate to protect themselves against the possibility that the firm will risk-shift. What promised interest rate will the lender need to charge in this problem so that they still receive an expected return of 5% on their $40 loan? Hint: filling in the blanks in the following table will help you answer the question.

	Bad state (50%)	Good state (50%)	Expected	PV
Assets	$24	$174	$99	$99 / 1.1 = $90
Debt				$42 / 1.05 = $40
Equity				$57 / 1.14 = $50

A. 37.5%

B. 40.0%

C. 42.5%

D. 45.0%

E. 47.5%

F. 50.0%

G. 52.5%

H. 55.0%

______ 6. Similar to the example in class when I discussed Is it bankruptcy or bankruptcy costs, the following table shows asset, debt, and equity time 1 cash flows (first two columns of numbers), expected time 1 cash flows (third column of numbers), and present values (last column of numbers) for a firm. The amount of money loaned to the firm is $60 and it has a 50% chance of bankruptcy (i.e., in the bad state), but bankruptcy costs = $0.

	Bad state (50%)	Good state (50%)	Expected	PV
Assets	$40	$180	$110	$110/1.1 = $100
Debt	$40	$86	$63	$63 / 1.05 = $60
Equity	$0	$94	$47	$47 / 1.175 = $40

Now assume that bankruptcy costs = $14. (Of course, you will only have to pay the bankruptcy costs in the bad state.) Including bankruptcy costs in the analysis, what promised interested rate will you need to pay the lender so that the lender still makes an expected return of 5% on the $60 loan to the firm? As in class, ignore taxes.

A. 63.33%

B. 66.67%

C. 70.00%

D. 71.67%

E. 73.33%

F. 76.67%

G. 80.00%

H. 81.67%