Lecture Notes on Corporate Finance Theory

Norvald Instefjord University of Essex

1 Introduction

1.1

These lecture notes contain material for a 30 hours master course on corporate nance theory. They

are based partly on the new book by Tirole: The Theory of Corporate Finance; and also on Dixit: The Art of Smooth Pasting; and Ziegler: A Game Theory Analysis of Options, and in addition on a number of academic journal articles.

1.2

Central to the theory of corporate governance is the separation of ownership and control: the individ-

uals who own the corporation are not the same as those who have control. Much of corporate nance theory are based on problems that arise because of this separation: problems related to transparency, executive accountability, governance failures, but there are also benets to be had: corporate ownership and restructuring can take place quickly and eciently, and investors who may be considered active can quickly establish an inuential stake in a corporation to exert pressure on the board and the management.

1.3

Corporations own real assets that generate a productive cash ow. They nance their operations by

issuing nancial claims which have claims on the productive cash ow of the corporations. There are two claims that empirically have dominated this role: debt and equity claims. A debt claim is a xed claim on the rms cash ow the repayment plan is contractually established. If the rm fails to service its debt the rm either needs to restructure its debt liability i.e. renegotiate its debt contract or choose to default on its debt liability which involves a formal process of bankruptcy with possible liquidation of the rms assets. Much of corporate nance theory has focussed on explaining the security design features of the nancial claims used for nancing corporations.

1.4

Finally, corporations issue liabilities on which they can choose to default. To study the characteristics

of strategic default models it is required that dynamic models are used, and this has opened the avenue for contingent claims valuation techniques in corporate nance. The nal part of the course looks at some simple continuous time models of investment and strategic default.

2 Fisher Separation, Net Present Value, Modigliani-Miller, Miller, and Myers 2.1 The Fisher Separation Theorem states that the rms investment decision is independent of the

preferences of the owner, and that the investment decision is independent of the nancing decision. This theorem has an enormous impact on corporate nance, in that we can separate out investment decisions and nancing decisions, and that we do not need to take account of what type of owner the rm has when making investment decisions (e.g. the rm does not have to invest with low risk because it has risk averse owners). The future prot of the rm depends on its level of investment i: (i) = f (i) (1 + r)i where (1 + r)i is the cost of raising the investment cost i in the capital market. The rst order conditions give us (i) = 0 = f (i) (1 + r) Therefore, the marginal project f (i) earns just the market rate of return all other projects earn a rate higher than the market rate of return. Why should all owners of the rm agree to this strategy? Consider an owner with utility function u(x, y) where x is future payo and y is current investment, and who does not consider borrowing/lending in the capital market, i.e. x = f (i) and y = i. The indierence curve of this owner can be described as du = u u dx + dy = 0 x y 3

or, by rearranging, u/y dx df = = u/x dy di

It is clear that depending on the implied time value of money embedded in the utility function u, the optimal investment for the owner may be such that
df di

is greater or smaller than 1 + r, i.e. does not necessarily have

to lie at the optimal point of investment above. However, if we allow the investor to borrow and lend risk free and amount z, such that x = f (i) + z(1 + r) and y = i + z, we consider the indierence curve above. Now, if the option to borrow or lend is used, dx = (1 + r) dy In the special case that the option to borrow or lend is not used,
dx dy

df di

= (1 + r), so in either case we are

on an indierence curve which is tangential to the capital market line 1 + r. Obviously there is an interest in pushing this line furthest to the north-west, so this line is tangential to the investment opportunity set at the point where
df di

= 1 + r. This point is agreed on irrespective of preferences and nancing, and corresponds

with the optimal point f (i) = 1 + r we found above.

2.2

Fisher Separation gives rise to the concept of net present value, which is a measure of the value added

for any investment project. Since Fisher Separation implies that any real investment should be measured against an equivalent market based investment, we can talk in unambiguous terms about the value of a project as the expected discounted future cash ow of the project (where we use the appropriate market based discount rates). The net present value of a project is the dierence between the value of the project (discounted future cash ow) and the cost of the project (the investment outlay), and is a measure of the value added of the project. Whereas this concept is simple, it can be dicult to implement the net present value rule in practice. Cash ows can be dicult to evaluate as we should really only include the incremental cash

ow associated with the investment decision sunk cost needs to be ignored and opportunity cost needs to be incorporated appropriately. Often, for instance, the opportunity cost of doing nothing is not zero because the corporation is in some way losing out and the alternative to investment is not very easy to get a handle on. It is unclear how such parameter risk or estimation risk should be accounted for in the net present value analysis. A second problem is that the net present value decision rule, which is invest if positive net present value, almost never can be implemented in this simple form. There may be agreement about whether to go ahead with an investment but disagreement about timing. In this case the opportunity cost of choosing an alternative time for investment must be evaluated as an option value of delaying the decision. These option values can be very dicult to evaluate and may need additional modeling. We look at some timing problems at the end of these lecture notes.

2.3

To illustrate the capital structure puzzle of Modigliani and Miller, consider an arbitrage-free market

in which the rms debt and equity are traded. The fact the market is arbitrage-free, implies that we can assign state prices ps to every state s, such that any claim issued in the market with state-contingent payo xs takes the value qx =
s

ps x s

The rm has a productive cash ow ys , and claims on that cash ow c1 , c2 , . . . , cn such that, for every state s s s s, the claims consume fully the productive cash ow ys = c1 + c2 + + cn s s s Using the state prices, we multiply and sum over all states V =
s

p s ys =
s

ps (c1 + c2 + + cn ) = s s s
s

ps c1 + s
s

ps c2 + + s
s

ps cn = V 1 + V 2 + + V n s

so that the total value of the rm is constant and independent of the way in which the cash ow is split into its various liabilities. Or at the very least, this holds as long as there are no third party claimants on the rms productive cash ow (such as taxes or bankruptcy costs), and the rms liability structure does not inuence the state prices of the economy. Whereas the second caveat is reasonable the rst is not. The tax system in most countries favor some specic capital or liability structure, and if the rm defaults on one of its debt claims it will normally incur some deadweight cost of nancial distress. This has given rise to the so called trade-o theory of capital structure: The rm seeks to take on debt because of its tax benets, but not too much because this increases the likelihood of nancial distress. The optimal capital structure balances the two: the marginal tax benets of debt equals the marginal expected bankruptcy costs at the point where the capital structure is optimal.

2.4

The capital structure puzzle refers to the fact that rms spend so much time and resources on the

design of its liability structure when a rst approximation should indicate it is pretty much irrelevant to the total value of the rm. The answer must lie elsewhere, and the corporate nance theory has, therefore, looked for answers to the corporate nance puzzle using frameworks that go beyond the simple trade o argument applied above, where the two main extensions apply agency theory and the economics of information.

2.5

To see that taxes are not a straightforward explanation, consider the following argument put forward

by Miller (1977). Suppose the rm has earnings y every period (ignore risk), which are taxed at the corporate rate C before being distributed to claim holders. If distributed to equity holders as income to equity, there is an additional tax of E imposed. If distributed to debt holders as income on debt, the rm can deduct the income as an expense so deducts the corporate tax of C , but the holders of the debt must pay a private tax on debt income B . Suppose that debt is perpetual with face value D and coupon rate k, which means that 6

every period the income paid to debt holders equals kD, and the retained earnings y kD is paid to equity holders. This means that the total cash ow after tax is kD(1 B ) + (y kD)(1 C )(1 E ) = y(1 C )(1 E ) + kD(1 B ) 1 (1 C )(1 E ) 1 B

Discounting the value using the period discount rate r, we nd the value of a levered rm as VL = y(1 C ) kD(1 B ) + r r 1 (1 C )(1 E ) 1 B =VU +B 1 (1 C )(1 E ) 1 B

where V U is the value of an unlevered rm and B is the market value of the rms debt. The idea in Miller is that if there is undersupply of debt in the economy at large, the taxation of debt income is likely be lower than the taxation of equity income, since it is the investors who pay the least tax on debt that are drawn st to the debt market. Therefore, the factor 1
(1C )(1E ) 1B

is likely to be positive, and there is an aggregate

increase of debt to the market by rms seeking to exploit the tax advantage. Similarly, if there is oversupply of debt, the taxation of debt income is likely to be greater than the taxation of equity income, and rms seek to reduce their borrowing to take advantage of the tax penalty on debt. The only stable equilibrium is the one where the tax advantage is zero, or when 1
(1C )(1E ) 1B

= 0, in which case

VL =VU i.e. leverage is irrelevant. Note however that there is a non-trivial level of industry borrowing necessary to achieve the equilibrium, yet at the equilibrium point the individual rms are indierent between increasing and decreasing their borrowing. Note also that it is essential that there is no short selling allowed, otherwise the Miller model would not have any equilibrium. To see this, consider the equilibrium point above where the marginal investor in the debt market has the same tax burden as the marginal investor in the equity market. This must imply that there are active investors in the debt market who has a smaller tax burden than the marginal investor these would be willing to buy more debt by shorting equity and similarly there will be 7

active investors in the equity market who pay less tax on equity income than the marginal investor in the equity market, these would be willing to buy more equity by shorting debt. Thus, the short selling constraint is always binding, and it is impossible to nd a stable equilibrium point when the short selling is lifted.

2.6

Myers (1977) model deals with the so called debt overhang problem. This problem arises when the

rm has an existing debt liability that dwarfs its current assets, at the same time as it considers to invest in future growth opportunities. We suppose the value of the growth opportunities become known at some time before the investment decision is made, so the ecient investment plan is given by the rule to invest whenever yi where y is the realization of the present value of the future growth opportunities and i is the investment cost. Suppose the model ends immediately after the investment decision is made: then the payo to the debt holders is min(B, y) if investment is made, and 0 if investment is not made

where B is the contractual payment on the debt liability. It is supposed the rm has zero existing assets. The corresponding payo to the equity holders is y min(B, y) if investment is made, and 0 if investment is not made

We notice that for the equity holders, there is an incentive to stick with the ecient investment plan only for B = 0: y i (y min(B, y)) i, and B = 0 Therefore, the existence of a debt liability B > 0 leads to ineciencies in investment.

2.7

The following example illustrates the eciency. Suppose ex ante, y is distributed as y U [1, 2]

and that i = 1.3. The debt liability B = 0.2. If investment is made ex post, the payos to the debt holders are 0.2 if investment is made 0 and the payos to the debt holders are y 0.2 if investment is made 0 otherwise otherwise

The ecient investment plan dictates that investment is made for y 1.3, therefore the value of debt is
VB = 2

0.2dy = 0.2(2 1.3) = 0.14

1.3

and the value of the equity, net of investment, is

VE = 2

(y 0.2 1.3)dy =
1.3

1 2 2 1.5(2) 2

1 2 1.3 1.5(1.3) 2

= 0.105

The total rm value under ecient investment is, therefore, V = VB + VE = 0.245. Now consider the optimal

investment plan for the equity holders. They invest optimally when y 0.2 1.3, or y 1.5. This yield a debt value of
VB = 2

0.2dy = 0.2(2 1.5) = 0.1

1.5

and an equity value of

VE = 2

(y 0.2 1.3)dy =
1.5

1 2 2 1.5(2) 2

1 2 1.5 1.5(1.5) 2

= 0.125

 The total value of the rm is, therefore, V = VB + VE = 0.225. The value of equity has increased by 0.02

and the value of debt has decreased by 0.04. The net eect is a decrease in the total rm value of 0.02.

2.8

The debt overhang problem gives rise to a theory of renegotiation. Here we look at ex ante renegotiation

of the debt liability, i.e. before the present value y is known. Consider the above example with an arbitrary debt liability of B. We can work out the value of the debt liability and the value of the equity as functions of B:
VB = 2 1.3+B

Bdy = B(2 1.3 B) = 0.7B B 2

and
VE = 2

(y 1.3 B)dy =
1.3+B

1 2 2 (1.3 + B)2 2

1 (1.3 + B)2 (1.3 + B)2 2

= 0.245 0.7B + 0.5B 2

We notice that the value of the debt liability has an interior optimum: if we dierentiate VB with respect to

B we nd the optimal point B = 0.35 at which point the value of the debt reaches its maximum point
max VB = 0.06125

This implies that if the debt holders have a nominal debt liability of B = 0.4, they would increase their debt value by accepting a new debt contract with a nominal debt liability of B = 0.35. Although the new debt contract has a lower nominal value, its economic value is increased.

2.9

The Myers model also allows for ex post renegotiation, after the present value of the growth opportunity

is known. Since the equity holders investment policy is dictated by investment whenever y min(y, B) i 10

there will be states where investment is not optimal initially, i.e. where y min(y, B) < i, but where a voluntary debt renegotiation to a new lever B such that y min(y, B ) i will make both parties better o. The debt holders now receive a payo of B 0 (since uncertainty is now resolved they receive this amount for sure), and the equity holders receive a payo of y min(y, B ) i 0.

2.10

If the debt holders can anticipate to renegotiate ex post, they will never accept a renegotiated set-

tlement ex ante that involves B < B, since this puts them in a worse bargaining situation ex post. If ex post renegotiation is not possible and the debt holders have all bargaining power ex ante, the debt holders will renegotiate to the point B if B > B , or not renegotiate at all otherwise. If the equity holders have all bargaining power, they will renegotiate to the lowest debt liability B which leaves the debt holders
wealth equally well o. Thus, if the debt holders value is VB (B) and there exists a B < B such that VB (B ) = VB (B), the equity holders suggest the renegotiated debt B and the debt holders accept this

contract. This implies that if the equity holders have the bargaining power, they will always renegotiate the debt to a level at which the expected ineciency of investment is lower or the same, as would happen if the debt holders have all the bargaining power.

2.11

Two factors prevent renegotiation, or make the renegotiation process costly. The rst factor involves

coordination costs or free riding costs among several debt holders. If the debt structure involves a large debt holder and a small debt holder, the small debt holder realizes that the large debt holder has stronger incentives to renegotiate so may refuse settlement. Thus, he can free ride on the large debt holder. The second factor involves asymmetric information. The debt holders may be reluctant to accept a renegotiated settlement if the equity holders have more information than they have. This is due to the fact that the equity holders may seek to use their information advantage strategically to achieve renegotiation benets also in states where 11

renegotiation is not necessary in order to induce investment. To prevent the equity holders to pursue such strategies, it may be optimal not to accept all proposed renegotiated contracts.

2.12

Exercises:

1. Suppose the corporate tax rate is 35 % at and constant, and the private tax rate varies between 0 and 40% depending on the individual. We assume the corporate tax rate applies to all income distributed from corporations as equity (equity is taxed at zero percent privately is the rms dont pay dividends and the investors dont realize capital gains); and that the private tax rate applies to all income distributed from corporations as debt. We assume that the annual corporate income (across a very large set of small corporations) is 100, and that the rm distributes c as coupon payments on perpetual corporate debt and 100 c as the residual annual equity income. The discount rate is 10% after tax, and we assume that the marginal private tax rate on debt income depends on c: = 0.004c such that for c = 0 there is zero private tax on debt income and for c = 100 there is 40% private tax on debt income. (a) What is the average capital structure in equilibrium? What is the value of all debt? And of all equity? And debt-equity together? (b) Suppose now that there is only a single rm in the economy. What is the optimal capital structure for this rm? What is the value of all debt? And all equity? And debt-equity together? Explain any discrepancy with (a).

12

2. A rm has the following assets: cash worth 10 and an investment project that costs 100 and yields the present value y which is uniformly distributed between 90 and 200: y U [90, 200]. Assume the rm also has a debt liability of 50. The decision to invest can be deferred until the true present value y is realized. (a) Ignoring the debt liability, what is the optimal investment plan and the risk neutral value of the rm ex ante? (b) Now take into account the debt liability when working out the optimal investment plan for the equity holders. Ignore renegotiation options. What is the risk neutral value of the rm ex ante now? (c) Finally work out the optimal investment plan for the equity holders taking into account ex ante renegotiation (assume the debt holders have all the bargaining power) and ex post renegotiation (assume the equity holders have all the bargaining power). What are the respective rm values ex ante in these cases?

3 Agency Models

3.1

The original agency model in corporate nance is the one by Jensen and Meckling (1976). This model

involves a rm whose production function transfer inputs x into output in the form of nancial benet and non-pecuniary benets that can be consumed by the manager/entrepreneur. Let C(x) be the cost of the input and P (x) the value of the nancial benets, and let B(x) = P (x) C(x)

13

Assume x is such that x = arg max B(x)

x

Assume B(x ) = 1. Now dene the nancial value of producing non-pecuniary benets as F = B(x ) B(x) = 1 B(x) This can be interpreted as the cost of choosing an input vector x dierent from the one that maximizes the nancial value of the rm. Of course, it may be optimal to choose F > 0, and we shall see what a rational manager/entrepreneur would do if he was the sole owner of the rm. Dene a utility function U (F, B) such that F + B = 1, which yields the Lagrangian maximization programme max U (F, B) (F + B 1)

F,B,

The rst order conditions for utility maximization yield U F U B = =

F +B = 1 Pick an indierence curve for the manager/entrepreneur: dU = which yields the relationship dB U/F = =1 U/B dF where the last equality follows by applying the rst order conditions above at the optimal point. Therefore, in general the corner solution B = 1 and F = 0 is not the optimal one even when there is no outside owners 14 U U dF + dB = 0 F B

of equity.

3.2

We shall now see what happens when the manager/entrepreneur sells 1 of his stake to outside

shareholders (lets now call him just the manager). We assume the outside shareholders are rational enough to realize what optimal actions the manager now takes, but do not have the power to inuence his actions even though they may be harmful to their claim. The managers Lagrangian now looks takes the form max U (F, B) (F + B 1)

F,B,

where the objective function now takes into account that the manager owns only percent of the equity and is therefore entitled to only percent of the nancial benets. The constraint takes into account, however, that the outside shareholders realize that the rm needs to operate on the original constraint. The rst order conditions are U F U B = =

F +B = 1 If we now investigate the indierence curve for the manager, we nd that U/F dB = =<1 U/B dF Using a geometric argument, we nd that the utility level of the manager has shifted downwards. Also, we nd that it must be the case that the nancial value of the rm has decreased, while the cost of non-pecuniary perks has increased. The total welfare has decreased, since the outside shareholders have zero utility from the transaction (they get what they pay for), and the welfare eects are measured solely by the managers utility.

15

The loss is due to agency costs of outside equity.

3.3

Jensen and Meckling also talk about agency costs of outside debt. This problem is sometimes known

as the risk shifting problem. A simple example under risk neutrality can illustrate this problem. Let the cash ow of the rm be distributed such as to have a mean preserving property with binomial cash ow 1+ with prob 1 2 x= 1 with prob 1 2 The mean cash ow is E() = 1 and the variance of the cash ow is x with face value 1, the cash ow of the debt, xB , is 1 xB = 1 and the cash ow of the equity, xE , is xE = x xB = with prob
1 2 1 2 2.

Now, if the rm has a debt contract

with prob with prob

1 2 1 2

0 with prob

It is pretty obvious that from the equity holders point of view an increase in risk (in terms of the variance of the cash ow) is desirable as this enables the equity holders to expropriate cash ow from the debt holders. We will get back to the risk shifting problem under the sections where we look at continuous time models of debt nancing.

3.4

The risk shifting problem appears to be costly to the debt holders, but given that the debt holders

can anticipate the risk shifting problem at the stage where debt is issued the real costs (if any) are borne by

16

the equity holders. A further example illustrates this point. Suppose the rm has a cash ow x1 or x2 , where 1+ with prob 1 2 x1 = 1 with prob 1 2 or x2 = where 1 + 10 with prob 1 10 with prob
1 2 1 2

and are xed constants. Suppose 0 < < < 9 . In a risk neutral world, the equity holders would

benet from choosing the low risk cash ow x1 if no debt is issued, as E(1 ) = 1 > 1 = E(2 ). The risk x x obviously does not matter here. If a debt contract is issued with face value 1, we nd that the cash ow to the debt holders is either xB1 = or xB2 =

with prob with prob

1 2 1 2

with prob

1 2 1 2

1 10 with prob

and the corresponding cash ow to the equity holders is either with prob xE1 = 0 with prob or xE2 = Since < 9 , it follows that

1 2 1 2

10 with prob 0 with prob

1 2 1 2

< 10 , so the equity holders would benet more from the high risk option.

But this means that the total value of the rm is 1 , and the debt contract is initially worth 1 5 0.5 and the equity contract is worth 5 0.5. Therefore, by selling the rm to rational debt holders who realize that risk shifting will occur, the equity holders retain an equity value of 5 0.5 and raises proceeds from the 17

debt issue of 1 5 0.5. This is less than the value when no debt is issued. Therefore, the costs of the risk shifting problem is really borne by the equity holders. The equity holders will therefore benet from issuing debt with covenants which prevent risk shifting, and this typically occurs in practice as corporate debt is issued under the caveat that should signicant changes occur to the assets of the rm the debt is immediately redeemable.

3.5

Exercises:

1. Consider an entrepreneur with cash A and an investment opportunity that costs i > A. The project has return R with probability p and 0 with probability 1 p. The success probability p is pH if the entrepreneur exerts managerial eort and pL = pH if he shirks. The entrepreneur receives private benets B if he shirks and nothing otherwise. The entrepreneur sells the project to outside investors and retains a return Rb R in the case the project succeeds. (a) Work out the incentive compatibility constraint guaranteeing that the entrepreneur exerts eort. (b) Work out the maximum pledgeable return to outside investors, and also the minimum level of cash A needed to secure external nancing. (c) Would it matter if the outside investors had the option of giving an incentive contract to induce eort in this model? Explain.

4 Asymmetric Information

4.1

This section deals with corporate nancing under asymmetric information which has become a large

part of corporate nance. The section is largely based on chapter 6 in Tiroles book. The literature that deals 18

with issuing securities under asymmetric information assumes that there is a entreprenuer/manager who has superior information issuing a claim to a market with less sophisticated information. There is no problem with this assumption when we are talking about newly started companies or companies who have not yet issued external claims. However, most issues take place by companies who have already issued claims. This obviously raises some questions about whether information that is private within the rm at the time where external claims have been issued also may leak to some market participants when issuing further claims. These issues are largely ignored and the basic entrepreneur/manager model is often assumed. An exception is the Myers and Majluf model in which a corporation employs a manager who seeks to maximize the value of its current equity holders. It takes therefore the view that management is in control of the issue but rarely take advantage of this to pursue own objectives i.e. the manager internalizes the welfare of the rms shareholders. However, when seasoned equity issues takes place there is an obvious question of whether the manager should internalize the welfare of its existing shareholders or its new shareholders. This is analogous to the situation where we consider current action to combat pollution or climate change that has long-term implications for future generations but the future generations have no direct say in the decision making process. It is up to us to decide how much we should internalize the future generations welfare in our decision. Often, moreover, there is a conict between current and future investors. The existing models largely incorporate a manager who internalizes the current shareholders welfare at the cost of future investors welfare. This results in situations where optimal long term decisions may be foregone in order to capture sub-optimal short term gains. The fact that information is released through nancing choices makes the optimality condition ambiguous: it is not clear whether we should maximize with respect to full information or partial information sets.

4.2

To illustrate the problem of capital transfers in an asymmetric information model, consider the fol-

lowing simple risk neutral model. Suppose an entrepreneur owns a project but has no funds to pay for the 19

investment cost i himself. The project has a return of R in the case of success and a return of 0 in the case of failure. There are two types of projects, good or bad. A good project has success probability p such that pR > i and a bad project has success probability q such that i > qR (negative NPV) or qR i but pR > qR (positive NPV). The capital market is competitive and requires a return of 0. The manager knows his own projects type. The market has a probability distribution of project types a project is good with probability and bad with probability 1 . Dene m = p + (1 )q Suppose the entrepreneur tries to sell his project by promising a return R Rb to the investors. They are willing to put up the investment if their expected return is at least as great as the investment cost i. If they could observe project type perfectly, they would require
G p(R Rb ) = i

if the project is of good type and

B q(R Rb ) = i

if the project is of bad type. Clearly, if qR < i there is no solution to the latter equation, and if qR i the
B G solution is such that Rb < Rb . If they cannot observe project type perfectly, and supposing all project would

seek nancing, the constraint becomes m(R Rb ) = i If mR < i, there can be no solution to this equation, and all funding ceases to happen. This case is feasible only if qR < i (there are some negative NPV projects seeking funding). Good projects are therefore underfunded by the sheer existence of bad projects.

20

If mR i there will be funding, but in this case the return promised to investors is such that investors break even on average, i.e. m(R Rb ) = i Investors make money on the good type and lose money on the bad type projects, i.e. p(R Rb ) > i > q(R Rb ) This is a case of over investment, where the good projects cross subsidize the bad projects.

4.3

The basic model can be applied to a study of market timing in which rms issue shares when stock

prices are high. There may be several reasons for such market timing but one is that adverse selection is less of an issue during boom times. Consider, in addition to the terms dened above, an observable variable which can be both positive or negative, such that the success probability is p + for good projects and q + for bad projects. The condition for nancing becomes now ((p + ) + (1 )(q + ))R i or (m + )R i The better the market conditions, the more likely is it that rms can obtain nancing despite the problem of asymmetric information, and the more likely it is that the capital market switches from a state of under investment to a state of over investment.

4.4

Now consider the situation that the rm initially has assets in place. The entrepreneur has already

invested in a project which, with success probability p or q (depending on good or bad type, respectively), will 21

yield a return of R, and otherwise nothing. Assume the probability of good and bad types are and 1 , respectively, as before. If the market values the rm at average values, therefore, the rm is undervalued if of good type and overvalued if of bad type. We assume the entrepreneur initially owns all assets. The entrepreneur may seek to make an additional investment on top of the existing assets at a cost i. The asset has return R with success probability , and we assume R > i such that the investment opportunity is protable both for the good and the bad type. This implies that the success probability for a good type, conditional on new investment, is p + , and the success probability for a bad type, conditional on new investment, is q + . The existing assets cannot be liquidated to raise the investment cost i, and any new claims issued must have a claim on the project portfolio of the existing asset and the new project i.e. no claim can be issued against the new project alone. Consider a pooling equilibrium where investment takes place regardless. In this case the return oered to the investors RI must be such that ((p + ) + (1 )(q + ))RI = i or just (m + )RI = i where m is dened as above. Although this condition ensures new nancing, a problem arises with respect to an entrepreneur managing a good type rm. The initial claim is pR, but there is no guarantee that the retained share in the rm exceeds this amount, i.e. there is no guarantee that (p + )(R RI ) pR

22

which can be rearranged as R p+ i m+

If the average success probability m is close to p there is unlikely to be a problem, since the condition then reduces to R > i which was assumed initially. However, if m is signicantly smaller than p the new project must be very good in order to guarantee the entrepreneur in charge of the good type rm wishes to invest. In this case we get a separating equilibrium in which only the bad type seeks to issue stock for new investment.
B The return promised to the new investors is RI such that

B (q + )RI = i

The implication of a separating equilibrium is that there is a negative stock price response when new equity is issued. The pre-announcement price of equity is V0 = (pR) + (1 )((q + )R i) The post-announcement price of equity is V1 = (q + )R i
B Since pR > (q + )R i (this follows from the fact that pR > (p + )(R RI ) = (p + )(R i/(q + ))), the

stock price announcement is negative when a separating equilibrium is played: V1 V0 < 0 Conversely, when a pooling equilibrium is played the stock price reaction is zero.

4.5

The problem of adverse selection when the rm has assets in place when seeking new investment leads

to the so called pecking order hypothesis of nancing. This hypothesis states that nancing sources can be 23

ranked according to their information intensity. Internal sources of nancing, e.g. retained earnings, have no information intensity as they do not involve outside uninformed parties. Debt may be issued externally, but will normally have lower information intensity than equity, as the debt value is less sensitive to the private information signal of the entrepreneur, and hence inuence the issuing process to less degree than equity. Debt issues will, therefore, normally be ranked ahead of equity issues. Then nally, as a last resort, the rm issues equity, which is highly information intense. We will show the eect of issuing default free debt in our example. This requires that we re-jig our model somewhat since as long as we operate with returns of R or 0, there is no distinction between debt and equity. Suppose there is a salvage value RF , such that conditional on success the project has return R + RF = RS , and otherwise a return of RF . If mRS + (1 m)RF > i risky debt can be issued to raise the investment cost i, and if RF i even risk free debt can be used. It is easy to conrm that the use of risk free debt carries no cost of nancing (as there is no informational cost associated with issuing a claim whose value is independent of information).

4.6

Exercises:

1. A rm owns assets with random value x and new investment opportunities which cost 100 with random present value y . The rm has no cash reserves. Suppose x and y are independent bivariate random variables: x= 100 with prob 200 with prob 105 with prob 115 with prob

1 2 1 2

y=

1 2 1 2

24

Assume the manager of the rm has private knowledge of the realizations of x and y before making the investment decisions whereas the investors are uninformed.

(a) What is the state by state economically ecient investment plan? What is the ex ante value of the rm assuming investment eciency? (b) Suppose the manager issues new equity to nance the investment cost. What is the investment plan that maximizes the value of the current shareholders? What is the ex ante value of the rm assuming this investment plan is adhered to? (c) Suppose the manager issues new debt instead. Explain what happens now. What is the ex ante value of the rm in this instance? (d) A debt overhang is an existing debt liability that matures after the investment decision is made. Explain what impact a debt overhang would have on your answer in (c)?

5 Control Rights, Takeovers and Security Design

5.1

The Aghion-Bolton model is about allocation of control rights between insiders (entrepreneur/manager)

and outsiders (investors/shareholders). The idea is simple by transferring control rights to outsiders, the insider can increase his pledgeable income to outsiders, and thus facilitate access to funding for protable projects. Formally, we can illustrate the idea in a simple model. An entrepreneur with wealth A considers a project with cost i. The outside nancing need is the shortfall i A. The project succeeds with probability p and yields a return of R. We assume p = pH if the entrepreneur behaves and p = pL < pH if the entrepreneur misbehaves. In the latter case the entrepreneur consumes private benets B. This is the moral hazard problem. Also assume that there is the possibility of taking interim action such that rstly, the probability

25

of success is increased uniformly by > 0 (i.e. pH + or pL + depending on the entrepreneurs behavior), and secondly, implies a private cost > 0 to the entrepreneur. Motivating examples include: switch to a more protable strategy; severing a long-time relationship with a collaborator; downsizing; divesting a pet division. The interim action determines welfare in this model. We notice that the incentive compatibility constraint for the entrepreneur is independent of the interim action (as increases the success probability uniformly). Let Rb be the entrepreneurs share of success return R. If the entrepreneur behaves, the return is (pH + )Rb , and if the entrepreneur misbehaves, the return is (pL + )Rb + B. Therefore, to guarantee that the entrepreneur behaves it is necessary that (pH + )Rb (pL + )Rb + B Rb B B = pH pL p

which is independent of and would also arise if the success probabilities were pH and pL . The prot-enhancing action may reduce aggregate welfare (this is the interesting case) if R < because in this case the increase in expected prots is not enough to oset the cost . From a welfare point of view, this action should not be undertaken. Suppose control rights are allocated to investors. Since the investors do not incur the cost (which is borne by the entrepreneur) they would nonetheless like the action undertaken as it enhances prots. Therefore, the net return to outside investors is (pH + )(R Rb ) = (pH + ) R B p

and the NPV of the total investment is (which is also equal to the entrepreneurs utility as the entrepreneur can issue outside claim at competitive prices) N P V = (pH + )R I 26

If we in contrast assume that control rights are not relinquished to outsiders, there is no prot enhancing action taken at the interim stage, so the return to outside investors is pH (R Rb ) = pH and the NPV of total investment N P V = pH R I > (pH + )R I Relinquishing control to outsiders will, therefore, decrease the NPV and the entrepreneurs utility by R, but on the other hand increase pledgeable income by R
B p

B p

. If the entrepreneur is not cash constrained

he will always prefer not to relinquish control and implement the rst best in this case. The problem comes when the entrepreneur is cash constrained and pH R B p < i A < (pH + ) R B p

In this case, it is necessary that the entrepreneur relinquishes control in order to start the project in the rst place. The argument that projects requiring substantial investment up front may never be implemented unless the entrepreneur increases pledgeable income to investors is an argument in favor of shareholder value.

5.2

The Grossman-Hart model deals with value-enhancing takeovers. We consider a rm with value v

which may be taken over by a raider to increase the value to v = v + 1 (synergy gains normalized to 1). The market value is assumed informationally ecient prior to the takeover, i.e. the value before a bid is announced is v, and we assume the raider bids a price v + P with P being the takeover premium. We assume there is a continuum of shareholders with mass 1, which implies there is no pivotal shareholder who can tip the balance in the case a bid is put forth. We assume the raider needs to acquire at least (0, 1) to gain control (i.e. to be able to realize the synergy gains). We also dene as the probability of success of an unrestricted 27

and unconditional oer (dened as an oer that is open to all shareholders willing to tender). The main result in Grossman-Hart is that regardless of the synergy gains being positive the success probability is always limited to =P The reason is the following. If > P then each shareholder would prefer to hold on to his shares, yielding + (1 )v = v + ( v) = v + v v than to tender his shares, yielding only v+P A reverse argument can be made for < P . Exactly percent of the shares in the rm must be tendered (if more are tendered = 1 and if less = 0 - so each shareholder must tender with probability this can be derived formally starting from a nite group of shareholders and taking the limit as the number goes to innity but we will ignore these details here). Given this equilibrium in the takeover market, we nd that the raiders prots are = ( P ) = 0 This is called the free rider problem of takeovers: takeovers fail with positive probability because the nontendering shareholders are free riding on the tendering ones such as to receive a home made takeover price of v + 1 which always dominate the actual takeover price v + P .

5.3

The case which permits value-decreasing takeovers has implications for security design. This is the

Grossman-Hart one-share/one-vote result. Consider the post-takeover value v and the pre-takeover value v, dened as above, and private benets of control w to the raider. For v < v it is a weakly dominant strategy

28

for all shareholders to tender provided the takeover premium P dened as above is greater than zero: P 0. Similarly, when P v v it is a weakly dominant strategy not to tender. However, consider the range vv <P <0 The shareholders are better o collectively if the takeover fails for sure than if it succeeds for sure, since P < 0. Moreover, each shareholders incentive to tender increases if it is more likely that the others tender also, as the synergy gains are negative (the opposite of the free riding eect in the case of value enhancing takeovers). We can, therefore, imagine two types of equilibria: the trust equilibrium where each shareholder does not tender trusting the others not to tender also; and the suspicion equilibrium where each shareholder tenders believing the others to tender also. The trust equilibrium gives the maximum payo to all shareholders and the suspicion equilibrium the minimum payo. The two equilibria may co-exist, but the trust equilibrium Pareto dominates (from the shareholders point of view) the suspicion equilibrium. Moreover, the suspicion equilibrium would disappear if a friendly arbitrageur were to appear to outbid the raider. In sum, therefore, the raider is likely to be constrained to bid P 0, but it is feasible the raider can take control with P = 0. The issue in question is the distribution of ownership rights. We can imagine two structures: either the company has a uniform distribution of the shareholders voting power so that the voting power of each shareholder is directly proportional to the number of shares he owns. This is the one vote/one share ownership structure; or the company has a dual class share structure, with A shares carrying voting power and the B shares carrying no voting power. If the raider needs to acquire of the votes, it is necessary that he buys at least a of the company in the rst case, and at least a of the A shares in the second case. If the A shares have a nancial claim on of the company, the net surplus for the raider is w a(v v )

29

in the rst case and w a(v v ) in the second case. Since < 1 w a(v v ) < w a(v v ) in the second case. The implication is that the raider is more likely to take over the rm with a dual class share structure, and the nancial value of the company is more likely to be less (because of the negative synergy gains). Therefore, the shareholders are less likely to pay the same price for the B shares with a dual class structure as they are for the ordinary shares under a one vote/one share structure. The A shares are on the other hand likely to have the same price as the ordinary shares under a one vote/one share structure (since the premium P is zero). Therefore, it is a value-maximizing strategy for the shareholders that the one vote/one share structure is adopted at the outset.

5.4

Exercises:

6 Timing of Investment, Strategic Default Models of Corporate Debt 6.1 The last section deals with continuous time models applied to corporate nance. Continuous time

models have the advantage that they are fully dynamic models, so any aspect of corporate nance studied will automatically be evaluated from a dynamic point of view. The workhorse model is based on geometric Brownian motions, dy = dt + dZ y where
dy y

is the instantaneous percentage change in the state variable y (the return), dt is the deterministic

part (where is constant is instantaneous return), and dZ is the stochastic part (the noise where 30

is constant and equal to the standard deviation of returns and where dZ is the increments of a standard Brownian motion). The increments of Z: Zt+s Zt , have a distribution which is independent of t, and is normal with mean zero and variance proportional to the length of the time interval: N (0, s). In this section we assume risk neutrality or at the very least a risk neutral uncertainty structure.

6.2

When working with Brownian motions the standard rules of calculus dont apply as the sample paths

are nowhere dierentiable. This is due to the fact that even for small time increments the noise term dont vanish. The rule of calculus are instead given by Itos lemma: df (y) = where (dy)2 = 2 y 2 (dZ)2 = 2 y 2 dt where we use the rule that dt2 = dtdZ = 0 and dZ 2 = dt. Any function of y must evolve according to Itos lemma. If we are considering a function of time as well as y: f (y, t), Itos lemma states that the rules of calculus are normal for the time variable but must include the second order term for the Brownian motion y: 1 df = fy (ydt + ydZ) + ft dt + fyy 2 y 2 dt 2 1 2f f 1 dy + (dy)2 = fy (ydt + ydZ) + fyy (dy)2 2 y 2 y 2

6.3

Taking a geometric Brownian motion y we can derive an absolute Brownian motion x by applying

Itos lemma to the function x = ln y: dx = 1 1 dy + y 2 1 y2 2 y 2 dt = 1 2 dt + dZ 2

31

This Brownian motion can, in contrast to the geometric Brownian motion, go negative. Applying Itos lemma again to the absolute Brownian motion x using the function y = ex we recover the orignial geometric Brownian motion: dy = ex dx + ex (dx)2 = ydt + ydZ
1 The expected discounted value of an absolute Brownian motion x with drift rate 2 2 is equal to

E0

ert xt dt =

ert E(xt )dt

We know that the expectation of the dZ term is zero, hence the expectation is the expected change in x: 1 E(xt ) = x0 + 2 t 2 Hence,
0

1 ert x0 + 2 t dt = 2

ert x0 dt +

1 ert 2 t dt 2

The rst term is

0

ert x0 dt =

1 ert x0 t r

=
0

x0 r

and the second, using integration by parts,

0

1 ert 2 t dt = 2

1 1 2 t 2 r

ert

0 0

1 2 2

1 r

ert dt

Evaluating the rst term on the right hand side we nd it vanishes, so it suces to work out the second:

e
0

rt

1 2 t dt = 2

1 2 2

1 2 r

rt

1 2 2 = r2

Putting it all together, we nd

E0

ert xt dt =

1 x0 2 2 + r r2

32

6.4

Discounting a geometric Brownian motion y with drift parameter and volatility parameter we use

the associated absolute Brownian motion x. Since yt = ext we know that the associated random variable xt
1 is normal N x0 + 2 2 t, 2 t with density function

1 f (xt ) = e 2s

xt m 2s

2

dxt

1 Here we use s = t and m = x0 + 2 2 t. Thus, we can work out the expected value

E(yt ) = where we use the density function above. We nd

ext f (xt )dxt

E(yt ) = =

1 ext e 2s

xt m 2s

2

dxt

xt m 2s

1 ext m em e 2s

2

dxt (zt = xt m)

=e

1 ezt e 2s

z t 2s

2

dzt dxt dxt

= em = em e

1 2 s 2

2 zt 1 ezt 2s2 dzt 2s

1 e 2s

zt s2 2s

2

dzt

= em+ 2 s

1 2

where the integral disappears (i.e. equals 1) by the fact that the integrand is a density function of a normal random variable with mean s2 and variance s2 . Using the denitions of m and s, we nd E(yt ) = ex0 +t Therefore, the discounted value of a geometric Brownian motion is

E
0

yt ert dt

=
0

ert+x0 +t dt = 33

y0 r

(y0 = ex0 )

6.5

We can also work out the present value of a geometric Brownian motion using a dierential equation

approach. Consider an underlying state variable x which is an absolute Brownian motion dx = 1 2 dt + dZ = dt + dZ 2

The earnings ow is a geometric Brownian motion ex with drift parameter and volatility parameter . Let F (x) be the present value of all future earnings ex . By Itos lemma we know that 1 dF = Fx dx + Fxx (dx)2 = 2 1 Fx + 2 Fxx dt + Fx dZ 2

Investors with the right to the earnings ow get E(dF + ex dt), i.e. the expected change in the value of the earnings ow plus the current earnings. The return they require is rF dt, i.e. the market return on the current value. This yields a dierential equation E(dF + ex dt) = rF dt which can we written as 1 Fxx 2 + Fx rF + ex = 0 2 Guess on F = ex for the homogenous part. This yields Fx = F and Fxx = 2 F , so the homogenous equation reduces to 1 2 2 + r = 0 2 which has two roots 1 and 2 (one is negative and the other positive). Therefore, the general solution to the homogenous part is FH = Ae1 x + Be2 with A and B arbitrary constants (since the ODE is linear the linear combinations of any two linearly independent solutions span the entire solution set). For the particular solution we need to nd any solution: 34

Guess F = Kex to get Fx = F and Fxx = F , which implies 1 2 K + K rK + 1 = 0 2 which has solution K= The general solution is, therefore, F = Ae1 x + Be2 x + ex r 1 1 1 2 = r r + 2

To identify the specic solution, we can use the following trick. Suppose the current earnings are ex . Now imagine that we simply increase the starting point from ex to ex+ = ex e . This should increase the value F by a factor of e : F (x + ) = e F (x) Using the general solution, we nd Ae1 (x+) + Be2 (x+) + ex ex+ = e Ae1 x + Be2 x + r r

which necessitates that A = B = 0 unless 1 or 2 equal one. The parameter cannot however be equal to one since this would imply that 1 2 2 + r 2 Therefore, F (x) =
ex r .

=1

1 1 1 = 2 + r = 2 + 2 r = r = 0 2 2 2

6.6

We now consider the problem of harvesting an earnings ow y which follows a geometric Brownian

motion with drift parameter and volatility parameter , at some optimal point in time at a xed one-o

35

cost of K. This is a so called optimal stopping problem. We know that at the point of harvest y , the value of the harvest is the discounted expected value of the future earnings ow F (y ) = y r

Before the point of harvest, the value is a function G(y), which by Itos lemma evolves according to the stochastic dierential equation 1 dG = Gy dy + Gyy (dy)2 = 2 1 Gy y + Gyy 2 y 2 dt + Gy ydZ 2

Since this claim is an asset its return is the required market return E(dG) = rGdt, which yields the dierential equation 1 Gyy 2 y 2 + Gy y rG = 0 2 If we guess a solution G = y , we nd Gy = y 1 and Gyy = ( 1)y 2 . Putting these into the ODE we nd 1 ( 1) 2 y + y ry = 0 2 where we can eliminate y and identify the two roots 1 and 2 which obtains: 1,2 =
1 2 2 1 2 2 2

+ 2 2 r

one positive and one negative. The general solution to the ODE above is, therefore G(y) = Ay 1 + By 2 where A and B are arbitrary constants. Suppose 1 < 0 < 2 . If y 0, we know that there will be no harvest in the foreseeable future, hence G(0) = 0. However, since 1 < 0, limy0 y 1 = . Therefore, the coecient A must be zero. Moreover, at the point of harvest there must be value matching: G(y ) = F (y ) K 36

or By 2 = y K r

This condition is however not sucient to determine the missing parameters B and y so we need one more condition. This is the optimality condition, the so called smooth pasting condition, which states that G must not only match the value at y it must also be tangential: dG(y) dy or B2 y 2 1 = 1 r =
y=y

dF (y) K dy

y=y

If we multiply by y on both sides and divide by 2 , we nd By 2 = y 1 y K = r 2 r

where the rst equality follows from the value matching condition and the second from the smooth pasting condition. This enables us to identify the optimal stopping time (optimal time of harvest): y = K(r ) 1 and the coecient B: B= y 1 r 2 1 y
2

1 2

= K(r )

2 2 1

y K r

1 y

The value of the investment opportunity G is, therefore, G(y) = y K r y y

2

The right hand side here has a natural interpretation. The rst term is the value conditional on harvest being made, and the second term is a number between zero and one which can be interpreted as the risk neutral 37

probability of making the harvest (notice that 2 is not just positive, it is also greater than one). You can see that as y y the second term approaches one.

6.7

Consider an example: the earnings ow follows a geometric Brownian motion with drift parameter

0.03 and volatility parameter 0.5 i.e. we are expecting an earnings growth of 3% per year (continuously compounded) and a volatility of 50% per year. The risk free interest rate is 5% per year (continuously compounded) and the investment cost is 100. If we take the break even level for investment we get y 100 = 0 0.05 0.03 which yields y = 2. We know that the optimal trigger is y = 100(0.05 0.03) where 2 = so the investment trigger y = 2 1.12 19 0.12
19 0.050.03

2 2 1

0.03 1 0.52 + 2

0.03 1 0.52 2 0.52

+ 2(0.5)2 0.05

1.12

This is much higher than intuition tells us, as the optimal value at investment is

950, i.e. 9.5

times the investment cost. The property that strategic decision making involves a higher degree of delay than intuition tells us is something we will come back to when looking at strategic default on debt liability.

6.8

Consider a rm which has made investments that generate an earnings ow y which follows a geometric

Brownian motion with drift parameter and volatility parameter . The rm has also incurred a debt liability which involves paying a coupon ow c to the debt holders. Assume the debt is perpetual. If the debt is risk 38

free, the discounted value of the coupon ow is

BF =

c ert cdt = ert r

c r
c r

Since the debt contract is a corporate contract there is a default risk, so

is the upper bound on the value

of the debt. We assume the equity holders can time the default such as to maximize the value of the equity. This implies that in states where y < c but the equity holders nonetheless chooses NOT to default they must support the rm by an injection of new equity. The dividend ow y c may, therefore, be positive or negative depending on the level of current earnings. Let the debt contract have a value B. By Itos lemma, the evolution of B is 1 dB = By dy + Byy (dy)2 + cdt = 2 1 By y + Byy 2 y 2 + c dt + By ydZ 2

where the term cdt comes from the fact that there is a continuous coupon ow received by the debt holders. The required return on the debt is rBdt, such that putting E(dB) = rBdt yields the dierential equation 1 Byy 2 y 2 + By y rB + c = 0 2 The homogenous part has the solution BH = A1 y 1 + A2 y 2 where A1 , A2 are arbitrary constants and 1 , 2 are as in section 6.6. For the particular solution we guess on B = D constant, which implies By = Byy = 0 and rD + c = 0 so the particular solution is just the value of the risk free debt BF . Therefore, the value of the corporate debt contract is B = A1 y 1 + A2 y 2 + 39 c r

Now if y , there is no chance of default in the foreseeable future. The value of the debt contract must
c therefore B r , i.e. the value of risk free debt. Since 1 < 0 and 2 > 0, the rst term vanishes but the

second explodes, therefore A2 = 0. The value of corporate debt is, therefore (using A = A1 ) B = Ay 1 + c r

The total value of the rm is just the discounted value of the earnings ow:

V =
0

ert yt dt =

y0 r

and the value of the equity is the residual value after subtracting the value of the debt (use y = y) ): E =V B = y c Ay 1 r r

The coecient A can be determined by considering the optimal stopping time for default y . First, at default the value of equity must be zero (value matching): y c Ay 1 r r =0
y=y

Second, at default the value of the equity must be tangential to zero (smooth pasting): 1 A1 y 1 1 r Combining the two, we nd Ay 1 = y c y 1 = r r r 1 =0
y=y

where the rst equality comes from the value matching condition and the second from the smooth pasting condition. This yields the optimal stopping time for default c 1 y = (r ) r 1 1 40

The coecient A can now be identied. Using the value matching condition above we nd A= y c r r 1 y
1

and the value of the corporate debt contract prior to default is equal to B= y r y y
1

c + r

y y

Here, the value of the debt contract has an intuitive interpretation. The term

y y

can be interpreted

as the risk neutral probability of default, so the rst term is the expected payo to the debt holders in the case of default (as in this case the debt holders can collect the default value
y r ),

and the second term is the

expected payo to the debt holders in the case of no-default (as in this case the debt holders can collect the
c risk free debt value r ).

6.9

We now consider the case that there are deadweight default costs associated with the option to default.

If the rm defaults at an earnings level y, the debt holders receive (1 ) y r

and there is a deadweight loss associated with default equal to y r

The debt contract must have the same dynamic prior to default as before, so we can write B = A1 y 1 + c r

The deadweight loss (lets call it L) can be thought of as an asset in the same way as the debt contract, so it must satisfy (prior to default) the ODE 1 Lyy 2 y 2 + Ly y rL = 0 2 41

and will have the general solution L = A2 y 1 + A3 y 2 with A2 and A3 arbitrary constants. As y , there is no chance of default in the foreseeable future so L 0, implying that A3 = 0. Therefore, the default costs are L = A2 y 1 . The equity claim is the residual E =V BL= y c y c A1 y 1 A2 y 1 = (A1 + A2 )y 1 r r r r

where A1 + A2 is to be decided. We notice that the strategic default decision for the equity holders is exactly the same now as it was with = 0, so A1 + A2 = implying the same default trigger c 1 y = (r ) r 1 1 This is intuitive. As the equity holders dont bear any of the default costs ex post, they dont take into account when they choose when to default. The debt holders lose out ex post, however, as the value of the debt just prior to default is B = A1 y 1 + implying A1 = so B = (1 ) y r y y
1

c y r r

1 y

c y = (1 ) r r

(y = y )

(1 )

y c r r

(y )1

c r

y y

Similarly, the value of the default costs can be derived through the value matching condition L = A2 y 1 = y r 42 (y = y )

implying A2 = so the value of the default costs prior to default is L= y r y y

1

y (y )1 r

6.9

Exercises:

1. Consider an earnings ow that follows a geometric Brownian motion dy = dt + dw y where and are constants, dt denotes time increments and dw denotes the increments of a standard Brownian motion.

(a) Calculate the expected discounted earnings ow given by

E0

ert yt dt .

(b) Suppose the earnings ow y belongs to an investment project which has not yet been started. The investment cost needed to initiate the project is a xed lump sum K. Derive the optimal investment trigger y . (c) Suppose the investment is partially nanced by perpetual debt with a xed coupon ow c. Suppose the equity holders can decide strategically when to default on this debt contract. What is the optimal default trigger y ?

43

Answers to Exercises: Section 2:

1. (a) We know that for all c such that < 0.35 there is an incentive to issue more debt and for all c such that > 0.35 there is an incentive to issue less. Hence, the equilibrium is described by = 0.35 or 0.004c = 0.35 which implies c = 350/4 = 87.5. The average capital structure is, therefore, 87.5% debt and 12.5% equity. The individual rm is, however, indierent between issuing debt and equity so some rms may be more levered than the average and others may be less. (b) If there is only one rm present, the rm no longer acts as a price taker since it realizes that changes to its capital structure will lead to changes in the private tax rate on debt. Hence, it seeks to maximize max
c

(100 c)0.65 c(1 ) (100 c)0.65 + c(1 0.004c) + = 0.1 0.1 0.1

It suces to maximize the numerator, so we get the rst order condition 0.65 + 1 0.008c = 0 or, c= 0.35 350 = = 43.75 0.008 8

44