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THIRD QUIZ FNCE 238/738 October 19, 2011 WRITE ALL ANSWERS ON THE TEST. IF YOUR ANSWER CONTINUES ON THE BACK, MAKE A NOTE OF IT ON THE FRONT. 30 PTS / 25 MINUTES NAME:_____________________________________________ SECTION (12, 1:30, 3):__________________________________

1. (10 pts) ( In this question, assume that everyone is risk-neutral and the discount rate is 0 ) Countrytime Bank made some loans they now regret, and this has put them at some risk of failure. They have 100 in debt coming due in a year, and the value of the bank in a year will be either 85, 115 or 130, each with probability 1/3, so they have a 1/3 chance of failure. The government has determined that a failure of Countrytime would impose an unacceptable cost on society. Show that the management of Countrytime would rather not sell new equity to raise the money necessary to eliminate the chance of failure, but if the government threatens to take away their bank charter, and thereby wiping out the value of equity, if they don’t, then they will sell the new shares. Question 1: 7 points for the analysis for 2 conditions, 3 points for the right answer / explanation; Without the government threat, the following is the expected payoff to the debt holders: 1/3(85) + 1/3(100) + 1/3(100) = 95. The payoff to equity is: 1/3(0) + 1/3(15) + 1/3(30) = 15. If the government threatens to take away the bank charter, then by selling the shares the following is the new value: 100, 130 or 145 with the expected payoff to debt of 1/3(100) + 1/3(100) + 1/3(100) = 100. The payoff to equity is: 1/3(0) + 1/3(30) + 1/3(45) = 25. The value of the original equity has gone down from 15 to 10 (25-15), so original equityholders are worse off if it sells new equity. There is effectively a transfer of 5 to the debt (vs. equity). Therefore the bank would rather not sell the new equity to raise funds. However if the government threatens to wipe away the value of all equity to 0, then it will sell new shares.

2. (10 pts) ( In this question, assume that everyone is risk-neutral and the discount rate is 0) Suppose an entrepreneur has two projects which both cost 75, and the value of his firm in a year depends on which project he chooses, and whether the economy is in Depression ( D ) or Prosperity ( P ), each of which has probability ½: Project D P A 65 100 B 50 110 The entrepreneur wants to raise money toward the 75 cost of the project by selling a bond that would mature in one year. The entrepreneur will pay in whatever the bond doesn’t raise, and then choose the project. Suppose the entrepreneur has decided that the bond will have face value 60, and is trying to decide whether the bond should be convertible into ¾ of the firm’s equity (that is, up until the last moment, the bondholders can convert their bonds into ¾ of the firm’s equity; don’t worry h ere about the convertible being callable). What would you advise the entrepreneur? Why? Question 2: 3.5 points for discussion if not convertible; 3.5 points for discussion if convertible; 3 points for comparison and final answer If the bond is not convertible, then the entrepreneur will prefer project B, because project A pays him either: 65-60=5 or 100-60=40, for an expected value of 22.5; while project B pays him either 0 (50<60) or 110-60=50 for an expected value of 25. So bondholders will expect project B, so they expect to get either 50 or 60, for an expected value of 55, so they’ll pay 55. Thus the entrepreneur pays 75 -55=20 for an expected profit of 25-20=5. If the bond is convertible, then if the entrepreneur chooses project B, then bondholders will convert their bond into ¾ of the equity if the project pays 110, since ¾ of 110 is 82.5 which is better than 60. If the project pays off 50 then they won ’ t convert. The convertible is worth ½(50)+ ½(82.5) = 66.25. The entrepreneur pays the 75-66.25= 8.75 for an expected payoff of ½(0) + ½(110-82.5)=13.75, so his expected profit is 13.75-8.75=5. If he instead were to choose project A, then bondholders will convert if the project pays 100 [ ¾(100) > 60 ]. But if the project is 65 they won ’ t convert. Their expected payoff in this scenario is ½(60)+ ½(75) = 67.5. So the entrepreneur pays 75-67.5 = 7.5 for an expected payoff of ½(5) + ½(25) = 15, for an expected profit of 15-7.5 = 7.5. Therefore making the bond convertible is more favorable to the entrepreneur and the conversion feature helps to properly align incentives.

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3. (5 pts) “Bank borrowing is different from going to the capital markets to sell bonds, because the bank is in a better position, relative to dispersed bondholders, to monitor the borrower. So when our firm borrows money, we should make the bank junior to the bonds, so that when it monitors to protect its interests, it protects the interests of the bondholders senior to it as well.” Agree or disagree? Explain. Disagree. It is true that banks are in a better position than dispersed bondholders to monitor the firm. However the bank debt should be senior than other debt. In an event where the bank is junior to the bonds, if the firm is observed taking on a high-risk activity, the bank can’t make a credible threat to pull the loan. The junior claimant would actually be better off financially by not calling the loan as it is unlikely he will recover much if the firm is forced into bankruptcy. Given little incentive for the junior claimant to force bankruptcy, any threat from him is not credible and there is no reason for him to properly monitor the firm. 4. (5 pts) Here’s a recent offering: HD New Issue-Kohl's sells $650 mln in notes PD 12 October 2011 ET 14:50 LP Oct 12 (Reuters) - Kohl's Corp on Wednesday sold $650 million of senior unsecured notes, said IFR, a Thomson Reuters service. Bank of AmericaMerrill Lynch, Morgan Stanley and Wells Fargo were the joint bookrunning managers for the sale. BORROWER: KOHLS CORPORATION TD AMT $650 MLN COUPON 4.00 PCT MATURITY 11/01/2021 TYPE SR NTS ISS PRICE 99.451 FIRST PAY 5/01/2012 MOODY'S Baa1 YIELD 4.067 SETTLEMENT 10/17/2011 S&P BBB-PLUS SPREAD 183 BPS PAY FREQ SEMI-ANNUAL FITCH BBB-PLUS MORE THAN TREAS MAKE-WHOLE CALL 30 BPS In the bottom right, the press release mentions a call option. What is that option, and what purpose might it serve? The make-whole call option provides the company an ability to redeem the notes prior to maturity at the greater of: a) par value or b) price equal to the remaining payments on the notes discounted at the Treasury rate + 30 bps premium. At issuance the spread over the US Treasury is 183 bps. The ytm of the notes is likely to be much more than 30 bps above the Treasury yield. Thus the make-whole provision gives the issuer the right to call back the notes for much more than what they would be likely worth. Nevertheless it enables the company to get out of the bond contract if necessary providing flexibility in case of an M&A, or debt restructure vs. tendering the bonds, which is considered more costly.

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My Monroe Z View Assessment > Bb Collaborate - 20FL-LA122-18 x M Daily Notifications - rblack8930 x 命 A https://elearn.monroecollege.edu/ultra/courses/ 40124 1/grades/assessment/_2440908 1/overview/attempt/ The following is Green Co.'s Pre-Closing Trial Balance as of December 31, 2017. Green's accounting period is a month, the month of December 2017. (Note that the accounts are not thus the balances in the temporary accounts are for listed in their normal sequence -- rather they are listed in alphabetical sequence.) Account Name _Debit_ Credit_ Gradin Accounts Payable 26,000 Accounts Receivable 28,850 Cash 10,000 Common Stock 12,500 Cost of Goods Sold 68,000 Equipment 73,000 150 Interest Expense Interest Payable 500 Inventory 45,000 Note Payable 21,000 Retained Earnings 53,000 Sales Revenue 179,000 Supplies Expense 7,000 Wages Expense 60,000 Total 292,000 292,000 Place the accounts in the correct order. Use the editor to formor your onswer A Past due This attempt will be submitted…

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