Corporate Finance
Corporate Finance
3rd Edition
ISBN: 9780132992473
Author: Jonathan Berk, Peter DeMarzo
Publisher: Prentice Hall
Question
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Chapter 28, Problem 11P
Summary Introduction

To assess whether the CEO would be better off or worse off, given that he owns 3% of GF and is considering an acquisition. Post acquisition, the market capitalization of GF would suffer a loss of $50 million and the present value of CEO’s compensation would increase by $5 million.

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You are an accountant for the Davanzo Company. The president of the company calls you into her office and says, "I want to ask you about two issues. First, we need to sell one of our investments to raise $1 million because I think I have found a better investment. We could sell the shares of Company X, which are currently worth $1 million even though they have an amortized cost basis $950,000. But I don't want to sell them, because I like the steady stream of cash flow we get related to interest. Or we could sell the bonds in that dog, Company Z. These bonds are also worth $1 million, but they cost us $1.2 million. I hate to admit we made such a big mistake, and if they can somehow avoid bankruptcy, we may actually recover our investment. And then there's that loss. I don't want to report that. Second, I am going to use the $1 million to buy about 20% of the shares of Company M, but I seem to remember that there is some accounting rule that might affect how much we buy. I was also…
You are an accountant for Davanzo Company. The president of the company calls you into her office and says, “I want to ask you about two issues. First, we need to sell one of our investments to raise $1 million because I think I have found a better investment. We could sell the bonds of Company X, which are currently worth $1 million even though they have an amortized cost basis of $950,000. But I don’t want to sell them because I like the steady stream of cash flow we get related to interest. Or we could sell the bonds in that dog, Company Z. These bonds are also worth $1 million, but they cost us $1.2 million. I hate to admit we made such a big mistake, and if they can somehow avoid bankruptcy, we may actually recover our investment. And then there’s that loss. I don’t want to report that. Second, I am going to use the $1 million to buy about 20% of the shares of Company M, but I seem to remember that there is some accounting rule that might affect how much we buy. I was also…
Suppose the CEO of a $750 million all-equity firm personally owns $15 million in company stock. Assume that the risk-neutral CEO makes investment decisions based strictly on the change in value (or expected change in value for risky investments) of her personal holdings, plus private benefits (if any) she gets from the investment. a) Suppose the CEO is considering a risky investment that will generate a gain with a present value of $100 million with 50% probability, but a loss of $150 million (present value) with 50% probability. Will she invest in the risky project? b) Now, suppose that the firm recapitalizes by borrowing $700 million and pays a special dividend of $700 million, and suppose that the CEO reinvests her $14 million dividend back into the recapitalized firm. (In answering this question, ignore any change in the overall value of the firm resulting from the recapitalization.) Given the same assumptions as in (i) above, will she invest in the risky project?
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