Problem Set 6 Conicts of Interest 1) Agency Costs of Debt (Senior and Pari Passn Debt) Consider a rm that exists in a world with two periods (time 0 and time 1) and two equally likely states of the world at time 1. At time 0 the rm's securities are traded. At time 1 the state is revealed. In the up-state the fnm's assets are worth $120 and in the down-state they are worth $40. The rm has debt outstanding with a face value of $60. Assume that the required rate of return is zero and investors are risk neutral. a) Compute the market value of debt, equity and the total market value of the company at time 0. b) Suppose that the company issues some additional debt with a face value of $40. This debt is pari passu (equal priority) with respect to the existing debt and the proceeds are invested in a zero NPV riskless project (i.e., the money is put in a safe box). How much money is the company able to raise with this debt issue? c) How much did the value of the old debt change? Why? d) How much did the value of equity change? Why? 2) Managerial Incentives Consider a rm nanced with an initial investment of $100 million in February 2012. In exactly one year it must decide whether to go ahead with a project that requires an additional $100 million investment. The present values (as of Febmary 2013) of the film's payoffs from taking or not taking the additional investment in the three future states of the economy are given as follows. This problem is from the book by Grinblatt and Titman, Financial Markets and Corporate Strategy, p. 641. Good Medium Bad Value with investment $250 $1 ?5 $125 Value without investment $50 $50 $50 a) What is the NPV of the project in each of the states as of February 2013? b) When nancing the investment in February 2012, the original entrepreneurs believe that the manager they hire will want to fund the new investment in February 2013 even if it has a negative NPV. Why might they be concerned about this? c) Show that if the rm issues more than $25 million in senior debt but less than $75 million to nance the original investment in February 2012, then it will be able to nance the project with junior debt in the good and medium states of the economy but not in the bad state of the economy. Assume for simplicity that the interest rate on debt is zero. Asymmetric Information 3) Undervalued Equity Consider a rm where insiders know that the rm has assets worth $100 million. The rm has 1 million shares outstanding and no debt, implying that the shares have an intrinsic value of $100 per share without taking any new investments]. Suppose the rm gets an investment opportunity that costs $70 million and whose cash ows have an expected present discounted value of $90 million. Despite insiders' knowledge about the value of the assets, the rm's shares are trading at $70 per share. The rm's investment banking advisors have told the management of the rm that if they wish to issue more shares for any purpose, the market will still only give it $70 per share for each new share issued. Management has no way of revealing the intrinsic value of the rm to the market, but it expects the market value of its shares to converge eventually to their intrinsic value. a) How many shares would the rm have to issue at $70 per share to invest in the project? b) After the rm has undertaken the project, what is the true new value of the rm's assets as lcnown by insiders? c) What is the new intrinsic value per share if the rm raises the proceeds for the project by issuing shares? d) If acting in the interest of existing shareholders, should management take the project? 4) Genoma Inc. Genoma Inc. faces the need to raise external rnds to undertake some new investment opportunities. By investing $100M Genoma will generate a gross return of $140M for sure and the market knows that. Unfortunately, Genoma has no internal mds and, because of the nature of the business, has to raise funds by issuing equity. The problem is 1 The intrinsic value is the price at which the shares would trade if the market valued them properly that the market does not know whether the current value of Genoma assets is $100M or $20M, and regards both outcomes as equally likely. The managers of Genoma do know the true value, but they cannot reveal it, because this will jeopardize their success. Assume that investors are risk neutral and that the proper discount rate is zero. Suppose further that Genoma's managers are loyal agents of the existing shareholders. 3) b) d) g) If the market expects Genoma's managers to issue equity and undertake the investment independent of the true value of the company, what is the fraction of the nal value of the company that the managers have to promise to investors to convince them to invest $100M in the company? If Genoma's managers know that the true value of Genoma's existing assets is 100M would they want to issue equity? What if they know that the true value of Genoma's existing assets is $20M? Suppose instead that the market expects that Genoma's managers will issue equity and undertake the investment only when they know that the true value of the company is $20M. What is the fraction of the nal value of the company that the managers can promise to investors to convince them to invest $100M in the company? Under the assumption in d), if Genoma's managers know that the true value of Genoma's existing assets is $100M would they want to issue equity? What if they know that the true value of Genoma's existing assets is $20M? Explain the effects of market expectations on the rm's investment policy in this example