Corporate Finance
3rd Edition
ISBN: 9780132992473
Author: Jonathan Berk, Peter DeMarzo
Publisher: Prentice Hall
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Textbook Question
Chapter 21, Problem 10P
Consider the setting of Problem 9. Suppose that in the event Hem a Corp, defaults, $90 million of its value will be lost to bankruptcy costs. Assume there are no other market imperfections.
- a. What is the
present value of these bankruptcy costs, and what is their delta with respect to the firm’s assets? - b. In this case, what is the value and yield of Hema’s debt?
- c. In this case, what is the value of Hema’s equity before the dividend is paid? What is the value of equity just after the dividend is paid?
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Suppose a company borrows $1 million debt to invest in a project that generates
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to be repaid (interest rate is zero) when the project's cash flow is realized. Assume
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control the firm). Also, assume that renegotiations are allowed and the manager may
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at what company cash flow does strategic default start to occur?
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(b)
Assume that: 1) the corporate tax rate is zero, 2) firms stop their business in one year,
3) earnings before interest and taxes in one year are expected to be worth EBIT, 4) the probability
that the levered firm defaults in one year is p, 5) bankruptcy costs are worth BC, 6) face value of
debt is F, and 7) coupon rate is also rB. Provide a formula for the cost of levered equity rs. The
formula has to depend on: S, EBIT, p, BC, F, rB, and ro only.
Suppose a company borrows $1 million debt to invest in a project that generates uncertain future cash flow (revenue)
of o*$2 million (when debt is due). The debt has to be repaid (interest rate is zero) when the project's cash flow is
realized. Assume 46% of the cash flow (revenue) is lost upon bankruptcy (i.e., when debtholders control the firm).
Also, assume that renegotiations are allowed and the manager may be allowed to stay if debtholders find it better
than firing. Upon renegotiation debt and equity holders have equal bargaining power.
At what company cash flow does strategic default start to occur?
1.0 million
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Chapter 21 Solutions
Corporate Finance
Ch. 21.1 - What is the key assumption of the binomial option...Ch. 21.1 - Why dont we need to know the probabilities of the...Ch. 21.1 - Prob. 3CCCh. 21.2 - What are the inputs of the Black-Scholes option...Ch. 21.2 - What is the implied volatility of a stock?Ch. 21.2 - How does the delta of a call option change as the...Ch. 21.3 - What are risk-neutral probabilities? How can they...Ch. 21.3 - Does the binominal model or Black-Scholes model...Ch. 21.4 - Is the beta of a call greater or smaller than the...Ch. 21.4 - What is the leverage ratio of a call?
Ch. 21.5 - Prob. 1CCCh. 21.5 - The fact that equity is a call option on the firms...Ch. 21 - The current price of Estelle Corporation stock is...Ch. 21 - Using the information in Problem 1, use the...Ch. 21 - Suppose the option in Example 21.11 actually sold...Ch. 21 - Eagletrons current stock price is 10. Suppose that...Ch. 21 - What is the highest possible value for the delta...Ch. 21 - Hema Corp. is an all equity firm with a current...Ch. 21 - Consider the setting of Problem 9. Suppose that in...Ch. 21 - Roslin Robotics stock has a volatility of 30% and...Ch. 21 - Rebecca is interested in purchasing a European...Ch. 21 - Using the data in Table 21.1, compare the price on...Ch. 21 - Consider again the at-the-money call option on...Ch. 21 - Harbin Manufacturing has 10 million shares...Ch. 21 - Using the information on Harbin Manufacturing in...Ch. 21 - Using the information in Problem 1, calculate the...Ch. 21 - Prob. 23PCh. 21 - Prob. 24PCh. 21 - Calculate the beta of the January 2010 9 call...Ch. 21 - Consider the March 2010 5 put option on JetBlue...
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- Which of the following is NOT an effect of the possibility of bankruptcy? O reduce the possible payoff to stockholders. increase financial distress costs. reduce the interest rate on debt. reduce the current market value of the firm.arrow_forwardSuppose a company borrows $1 million debt to invest in a project that generates uncertain future cash flow (revenue) of 0~$2 million (when debt is due). The debt has to be repaid (interest rate is zero) when the project's cash flow is realized. Assume 20% of the cash flow (revenue) is lost upon bankruptcy (i.e., when debtholders control the firm). Also, assume that renegotiations are allowed and the manager may be allowed to stay if debtholders find it better than firing. Instead of equal bargaining power, if lender has 30% bargaining power (lender gets 60% of renegotiation), at what company cash flow does strategic default start to occur? 1.16 million 1.25 million 1.65 million 0.85 millionarrow_forward5. Which ONE of the following best describes the value of the debt issued by a company? The value of a call option on the firm's assets with an exercise price equal to the face value of the firm's debt. Minus the value of a put option on the firm's assets with an exercise price equal to the face value of the firm's debt. The value of the firm's assets minus the value of a call option on the firm's assets with an exercise price equal to the face value of the firm's debt Minus the value of a call option on the firm's assets with an exercise price equal to the face value of the firm's debt. The value of a firm's assets minus the value of a put option on the firm's assets with an exercise price equal to the face value of the firm's debt.arrow_forward
- 8. Which of the following does the trade-off theory predict? A. Bankruptcy costs mean having no debt is always optimal. B. Reducing leverage always reduces firm value. C. In the long run the firm's capital structure converges to the optimal one. D. None of the above.arrow_forwardSuppose company Z is already in financial distress and the equity holders are very close to default. Suddenly there is a shock that causes an increase in the standard deviation of the return on company Z's assets. Which of the following correctly describes the new situation faced by company Z? A) Debt value will increase with the shock and equity holder are more likely to default. B) Equity value will increase with the shock and equity holder are less likely to default. C) Both Debt value and equity value will increase but the likelihood of default is unchanged. D) Both debt value and equity value will decrease and the likehood of default will increase.arrow_forwardConsider a company with a Reddington Immune cash flow stream of assets and liabilities. The asset payments all occur before the liability payments. What can you say about the present value of the entire cash flow stream if the interest rate increases from its current rate? Select one: The new present value is negative. b. We cannot say anything about the sign of the new present value. The new present value is zero. d. The new present value is positive. a. C.arrow_forward
- (1) Why do analysts need to consider different factorswhen evaluating a company’s ability to repay shortterm versus long-term debt? (2) Would the currentamount of the owners’ equity be a reasonable price topay for a company? Why or why not?arrow_forward1) Two years ago ABC company limited recorded a huge loss leading to bankruptcy. how is it possible that a firm announces a record breaking loss yet its stock price rises when the annoucement is made? Explain what the market reaction will be in an efficient market if the firm announces a fully anticipated filing for bankruptcy. 2) Distinquish between coupon rate, yield to maturity and current yieldarrow_forwardIn considering Modigliani & Miller’s (M&M) Propositions I and II in a world with no taxes and no bankruptcy risk, assume Firm A is an all-equity firm with a required return on its assets (Ra) of 10%. Firm B is a levered firm and can borrow in the debt market at 7% (Rd). If M&M’s proposition II holds, what is the cost of equity and the WACC if Firm B is levered to 50% debt: is this capital structure better for Firm B? Show your calculations.arrow_forward
- Under Modigliani and Miller's assumption of perfect capital markets, which of the following is NOT CORRECT? A) The proper WACC equation under perfect capital markets is the "pre-tax" WACC B) Taxes are irrelevant C) Reducing the debt ratio can cause the cost of debt and the cost of equity to decline, even as the WACC stays the same. D) The WACC does not change as the weights of debt and equity change E) Bankruptcy costs reduce the amount bondholders receive when bankruptcy occursarrow_forwardAssume that the risk-free rate increases, but the market risk premium remains constant. What impact would this have on the cost of debt? What impact would it have on the cost of equity? How should the capital structure weights are used to calculate the WACC be determined?arrow_forward5.What is the major drawback of debt financing? Select one: You have to pay back the money Increasing debt changes the gearing ratio of the firm Interest payments must be made before shareholder dividends and irrespective of fluctuations in profits Lenders often require security of the loan against assets of the companyarrow_forward
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