FINA438/838 Midterm Exam Review Questions Solution

1. Sunflower Co. is a US company and it exports most of its goods to the UK. Next year there is
a 45% chance that the US dollars appreciate relative to the British pounds, the demand for
Sunflower's goods from the UK customers will be lower. In this case, the value of Sunflower
will be $100m. On the other hand, there is a 55% chance that the value of Sunflower will be
$200m if the US dollars depreciate. If Sunflower hedges its exchange rate risk, the firm value
can be stabilized at $160m. Sunflower has 10 million shares outstanding and it has no debt. John
is Sunflower's risk manager. Now Sunflower pays John a flat salary of $150,000. For John,
employment income is a dominant source of wealth. John's utility function is described as
U W where U is utility and W is wealth.
(1) What's John's utility with this flat salary?
(2) If Sunflower changes its pay program and plans to pay John some proportion of the
firm value, which is called "performance pay", what value of will make John
indifferent between flat salary and performance pay without hedging?
(3) With performance pay with calculated from (2), will John hedge exchange rate risk?
(4) If John is granted call options with strike price $15, how many call options should
be granted to John to make him indifferent between flat salary and stock option plan
without hedging? Suppose each call option has the right to purchase one share at the
strike price.
(5) With stock option plan with calculated from (4), will John hedge exchange rate
risk?

Solution

(1) Utility of flat salary U W 150,000 387.30

(2) Utility of flat salary = Utility of performance pay without hedging

. .
387.30 0.45 100,000,000 0.55 200,000,000

0.000995

(3) Utility of performance pay with hedging

. .
= 160,000,000 160,000,000 0.000995 399.00 387.30 with no hedge

So John will hedge exchange rate risk if he is paid based on performance.

(4) The firm's value is either $100m or $200m, and you know there are 10 million shares
outstanding. The firm has no debt, so firm value can be divided over the number of shares; each
share will be worth either $10 or $20. Each call option has the right to purchase a share at a price
of $15. When the price is $10, the option to buy at $15 is worthless. When the price is $20, the
option to buy at $15 yields a payoff of $5 per share.

Utility of flat salary = Utility of stock options without hedging

. .
387.30 0.45 0 0.55 5

99,174

(5) When the firm's value is $160m, each share will be worth $16 and the option to buy at $15
has a payoff of $1 per share.

Utility of stock options with hedging

. .
= 1 1 99,174 314.92 387.30 with no hedge

So John will not hedge exchange rate risk if he is rewarded with stock options.

2. Lily Co. plans to start a new project that will last for 3 years. This project entails the purchase
of a machine that costs $1200 million. This machine will be depreciated over 3 years based on
the straight-line depreciation method. The annual income stream is risky, with:

0.5 chance of $300 million

0.5 chance of $800 million

The tax rate is 40% when taxable income is greater than 0. Lily Co. does not pay tax when the
taxable income is below or equal to 0. Assume zero discount rate.
(1) What is NPV of this project without risk management?
(2) Suppose Lily Co. can hedge its earnings to fix earnings at the expected value of
$550m. What's NPV in this case?
(3) Consider that there is another firm, Plum Co., that would always have more than
enough income to receive the full benefit of the deduction. Plum Co. buys the
aforementioned asset at $1200 million and lease it back to Lily Co. at an annual
charge of $240m. If Lily Co. is able to deduct the cost of the lease as an ordinary
expense, what's NPV in this case? Compare this NPV with the one calculated in (2)
and explain the difference with calculation.

Solution

(1) No risk management

Prob 0.5 0.5

Annual Earning 300 800
Annual dep. 400 400
Taxable Inc. -100 400
Tax 0* 160**
After-tax Inc. -100 240
CF 300 640
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 E[CF] 470***

* If earnings are $300m no tax will be paid because taxable income is less than 0.
** = 0.4(800 400) = 160

[Tax] = 0.5 0 + 0.5 160 = 80

*** The expected CF, E[CF] = 0.5 300 + 0.5 640 = 470

And the expected value of this investment opportunity (at a zero discount rate for simplicity) is:

NPV = 1,200m + 3E[CF] = 1,200m + 3*470= $210m

(2) Hedge strategy

Suppose the firm can hedge its earnings to fix earnings at the expected value of $550m.

Prob 1
Annual Earning 550
Annual dep. 400
Taxable Inc. 150
Tax 60
After-tax Inc. 90
CF=E[CF] 490

And compared with the unhedged value of $210m, the NPV of the investment opportunity is
now increase to:

NPVH = 1,200m + 3 490= $270m.

Tax-annual taxable income graph:

Tax due $m

160

80
60

-100 0 150 400 Taxable Earnings $m

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Because the company pays progressive tax rates, reducing taxable income volatility can reduce
taxes. In this case, the expected tax payment decreases from 80 (=0.5 0 + 0.5 160) without
hedging to 60 with hedging.

(3) Tax arbitrage strategy

Plum Co. buys the same asset and receive an annual $400m depreciation allowance, it would
always have more than enough income to receive the full benefit of the deduction (0.4 * $400m
= $160m). The annual cost (after tax) of buying this machine is $240m (=$400m $160m). This
is what it charges Lily Co.

Prob 0.5 0.5

Annual Earning 300 800
Lease cost 240 240
Taxable Inc. 60 560
Tax 24* 224*
After-tax Inc. 36 336
CF=After-tax Inc. 36 336
E[CF] 186***

* = 0.4 60 = 24
** = 0.4 560 = 224

*** Expected cash flow is now:

E[CF] = 0.5 36 + 0.5 336 = $186m

The NPV of the investment (bearing in mind there is no upfront capital cost) is now:

NPVTA = 3E[CF] = 3 186 = $558m,

which is even higher than when the firm hedges (compared with $507.5m above). The reason for
the extra gain is that the depreciation has been given a double tax advantage in this treatment
(Plum Co. deducts the full $240m annually, then Lily Co. deducts the lease cost, which here is
the after-tax cost to Lily).

Annual lease tax shield = 0.4 240 = $96m

Total lease tax shield = 96 3 = 288m, which explains

NPVTA - NPVH = 558 270 = $288m

3. Chex Co. has debt with a face value of 300. If Chex Co. goes bankrupt, its bondholders will
bear a bankruptcy cost 70. Assume zero interest rate. The following table shows the distribution
of Chex's firm value next year:

Probability Firm Value

0.1 200
0.2 300
0.4 500
0.2 700
0.1 900

(1) Without risk management, what is the expected firm value before bankruptcy cost, the
expected debt value, and the expected equity value?
(2) Suppose Chex Co. can hedge and fix the firm value to its expected value before
bankruptcy cost calculated from (1) minus T=5 where T is hedging cost. Will
shareholders of Chex Co. hedge if bondholders have already purchased bonds at a
price of 300 (i.e. ex post analysis)? Will shareholders of Chex Co. hedge if
bondholders have not purchased bonds (i.e. ex ante analysis)? Justify your answer
with calculation.
(3) Propose a non-hedging strategy that can avoid expected bankruptcy costs.

Solution

(1) Without risk management,

Probability Firm Value before Bankruptcy Cost Debt Value Equity Value
0.1 200 130* 0
0.2 300 300 0
0.4 500 300 200
0.2 700 300 400
0.1 900 300 600
Expected value 510 283 220

* = 200 - bankruptcy cost 70 = 130

(2) Hedge strategy

Suppose the firm is now able to hedge and fix the firm value to its expected value minus T, 510-
5, where T=5 is the transaction cost associated with the hedge.
Probability Firm Value Debt Value Equity Value
1 505* 300 205

* = expected firm value without bankruptcy - T = 510 - 5 = 505

Shareholders seem to be better off if the firm does not hedge. To sort this out we must look at the
issues from two different time perspectives.

Ex Post analysis

First, imagine that bondholders had already purchased bonds at a price of 300. In this case the
shareholders would prefer not to hedge, since equity is worth 220 without the hedge and only
205 with the hedge. So shareholders will not hedge.

Ex Ante analysis

Rationally, bondholders will recognize that once shareholders have their money, the latter will be
tempted to adopt the unhedged strategy. Anticipating this choice, the bondholders will only pay
the unhedged value of debt 283.

Now consider the situation from the shareholders' perspective. If shareholder can commit to a
hedge strategy and convince bondholders that they will not deviate from this strategy, then
bondholders would be willing to pay 300 for the bonds. What are the total proceeds of the
shareholders?

Proceeds of shareholders = value of equity + additional 17 from bondholders

= 205 + 17 = 222.

The additional proceeds of the bond issue 17 more than outweigh the fall in share price. Thus,
shareholders gain from hedge if they can send a credible commitment to bondholders that they
will hedge risk. In this case, the shareholders will hedge.

(3) Leverage strategy can achieve the same ends. Suppose that the firm simply funded its
operations at a lower level of leverage. In this case imagine that debt has a face value of only
200. Now the lowest value of the firm is sufficient to pay off debt in full and there is no
probability of default.

Probability Firm Value Debt Value Equity Value

0.1 200 200 0
0.2 300 200 100
0.4 500 200 300
0.2 700 200 500
0.1 900 200 700
Expected value 510 200 310

4. Tropicana Co. is exposed to interest rate risk. Its future earnings have a present value (PV) of
either 150 or 400, each with a 0.5 probability. Currently, the firm has a senior debt with a face
value of 120. The transaction cost in the event of bankruptcy is 80. The firm now needs to select
one of the following new investments with earnings independent of those from existing
operations:

Capital cost PV of earnings E[NPV]

Project A 180 200 20

10; 0.5
Project B 180 -10
330; 0.5

The capital cost of each project is 180. Project A generates an earnings stream with a certain
present value of 200, which leaves a net present value (NPV) of 20. Project B generates a risky
earnings stream that has a present value either 10 or 330, each with a 0.5 probability. With the
capital cost of 180, the NPV of Project B is -10. Tropicana Co. will issue new junior debt with
face value 180 to fund the selected new project.
(1) Suppose Tropicana Co. does not manage its risk. What is the expected value of firm,
the expected value of senior debt (old debt), the expected value of junior debt (new
debt) and the expected value of equity with Project A? What are these expected
values with Project B? What price are the junior bondholders willing to pay for the
new debt? Is Tropicana Co. able to finance its selected new project?
(2) Suppose Tropicana Co. commits itself in some credible way to hedge interest rate risk
that arises from new projects and the PV of Project B's earnings is stabilized at 170 at
no cost. What is the expected value of firm, the expected value of senior debt (old
debt), the expected value of junior debt (new debt) and the expected value of equity
with Project A? What are these expected values with Project B? Which project will
the shareholders of Tropicana Co. select? With this selected project, what price are
the junior bondholders willing to pay for the new debt?
(3) Suppose that Tropicana Co. chooses to raise 100 in new equity and 80 in new debt.
What is the expected value of firm, the expected value of senior debt (old debt), the
expected value of junior debt (new debt) and the expected value of equity with
Project A? What are these expected values with Project B? Which project will the
shareholders of Tropicana Co. select? With this selected project, what price are the
junior bondholders willing to pay for the new debt?

Solution

(1) Without risk management

Firm Values of the two projects:

 New project A B
Original 200 10 330
operations (p = 1) (p = 0.5) (p = 0.5)
150 350 160 480
(p = 0.5) (p = 0.5) -80* (p = 0.25)
=80
(p = 0.25)
400 600 410 730
(p = 0.5) (p = 0.5) (p = 0.25) (p = 0.25)

* Bankruptcy cost 80.

If Project A is selected,

Prob Value of firm Old debt New debt Equity

.5 350 120 180 50
.5 600 120 180 300
Expected value 475 120 180 175

Value of firm = 0.5(350+600) = 475

Old debt = 0.5(120+120) = 120
New debt = 0.5(180+180) = 180
Equity = 0.5( 50 +300) = 175

If Project B is selected,

Prob Value of firm Old debt New debt Equity

.25 80 80 0 0
.25 410 120 180 110
.25 480 120 180 180
.25 730 120 180 430
Expected value 425 110 135 180

Value of firm = 0.25(80+410+480+730) = 425

Old debt = 0.25(80+120+120+120) = 110
New debt = 0.25( 0+180+180+180) = 135
Equity = 0.25( 0+110+180+430) = 180

This illustrates the classic asset substitution problem. Since project selection is made after debt
has been issued, shareholders favor project B, which offers an equity value of 180 compared
with 175 for A, even if project B's NPV is negative.

Since bondholders anticipate this choice, they would only be willing to pay 135 for the new debt
issue even though the face value is 180. The cost of project B is 180. The amount raised from the

debt issuance 135 would be insufficient to fund the project. So the firm is unable to finance
project B.

Does that mean that A will be chosen? Suppose indeed that the firm announced that its intention
to choose A. Unfortunately, bondholders do not trust shareholders. Bondholders believe that
shareholders will change their minds and use the 180 to fund project B. Thus, investors would
still only subscribe 135 for the new bond issue. It is unable to accept either project, not only the
bad project B but also project A with a genuine positive NPV.

(2) Hedge strategy

Suppose that the firm can commit itself in some credible way to hedge any risk that arises from
new projects. Since there is no risk in A, there is no need to hedge risk. The values of debt and
equity are exactly the same as calculated earlier.

If Project A is selected,

Value of firm = 0.5(350+600) = 475

Old debt = 0.5(120+120) = 120
New debt = 0.5(180+180) = 180
Equity = 0.5( 50 +300) = 175

Assume with a costless hedge, the firm could fix its earnings at 170.

If Project B is selected with hedge,

New project B
Original 170
operations (p = 1)
150 320
(p = 0.5) (p = 0.5)
400 570
(p = 0.5) (p = 0.5)

Prob Value of firm Old debt New debt Equity

.5 320 120 180 20
.5 570 120 180 270
Expected value 445 120 180 145

Value of firm = 0.5(320+570) = 445

Old debt = 0.5(120+120) = 120
New debt = 0.5(180+180) = 180
Equity = 0.5( 20+270) = 145

With the hedge, the shareholders will select Project A because equity will be worth 175 if A is
chosen against only 145 if B is chosen. If a credible hedge is in place, bondholders will find it
rational to anticipate that shareholders will choose project A and will be willing to pay the full
180 for the debt.

(3) Leverage strategy

Suppose that the firm chooses to raise 100 in new equity and 80 in new debt.

New project A B
Original 200 10 330
operations (p = 1) (p = 0.5) (p = 0.5)
150 350 160 480
(p = 0.5) (p = 0.5) -80* (p = 0.25)
=80
(p = 0.25)
400 600 410 730
(p = 0.5) (p = 0.5) (p = 0.25) (p = 0.25)

* Bankruptcy cost 80.

If Project A is selected,

Prob Value of firm Old debt New debt Equity

.5 350 120 80 150
.5 600 120 80 400
Expected value 475 120 80 275

Value of firm = 0.5(350+600) = 475

Old debt = 0.5(120+120) = 120
New debt = 0.5( 80+ 80) = 80
Equity = 0.5(150+400) = 275

If Project B is selected,

Prob Value of firm Old debt New debt Equity

.25 80 80 0 0
.25 410 120 80 210
.25 480 120 80 280
.25 730 120 80 530
Expected value 425 110 60 255

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Value of firm = 0.25(80+410+480+730) = 425

Old debt = 0.25(80+120+120+120) = 110
New debt = 0.25( 0+ 80+ 80+ 80) = 60
Equity = 0.25( 0+210+ 280+530) = 255

The shareholders will select Project A because it yields an equity value of 275 compared with
255 for B. The bondholders will anticipate the choice of A and will subscribe the full 80 for the
new debt.

5. SkyHi Company currently pays its manager a flat salary of 200. With this pay scheme, the
manager's productivity is such that the firm's profit is either 1000 with a probability of 0.4 or
2000 with a probability of 0.6.

SkyHi is considering to pay the manager a performance-related compensation at a level V

where V is the profit before deduction of compensation. This payment scheme will improve
productivity to either 1200 with a probability of 0.4 or 2400 with a probability of 0.6.

Assume the manager is risk averse and undiversified. His wealth is accumulated from his
employment compensation. His expected utility is a function of wealth and effort:

Utility with low effort =

Utility with high effort = 1

(1) If SkyHi pays performance-related compensation, what must the minimum value of
be to compensate the manager for risk and effort?
(2) Given that performance-related compensation must include a risk premium, which
compensation schedule (flat salary or V) would SkyHi choose to pay the manager?
Show your calculation to justify your answer.
(3) Suppose that SkyHi hedges the riskiness of V (i.e., replace 0.4(1000) + 0.6(2000) by
1600; or replace 0.4(1200) + 0.6(2400) by 1920) and pays some fraction of V.
Ignore transaction costs of hedging. What does the minimum value of have to be so
that compensation is competitive and motivates the manager to high effort? In
addition, what is the gain from hedging and paying by performance to SkyHi as the
owner compared to performance pay without hedging?
Solution

(1) If the manger is paid a flat salary of 200, her expected utility is 2000.5 = 14.1421. For the
manager to be compensated for the risk and hard work inherent in performance-related
compensation, must be set such that her expected utility is no lower than under a flat salary
(2000.5 = 14.1421):

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EU(flat salary and assuming low effort) = EU(compensation at V and assuming high effort)
2000.5 = 14.1421 = 0.4[(1200 ) 0.5 - 1] + 0.6[(2400 ) 0.5 - 1]
= 0.12257

(2) The expected earnings of the manager under performance pay:

E(performance-related compensation) = 0.4 1200 0.12257 + 0.6 2400 0.12257 = 235.34,

which is higher than the flat pay 200.

E(profit net of flat pay) = 0.4 1000+0.6 2000 - 200 = 1400

E(profit net of performance pay) = 0.4 1200 + 0.6 2400 - 235.34 = 1684.66

SkyHi will choose performance pay because the improvement in productivity from performance
pay far outweighs any additional payment to the manager to compensate him for risk and for
disutility of high effort.

(3) In this case, SkyHi hedges risk but still motivates the manager to provide high effort by
paying some fraction of V. With high effort, the profit before compensation is stabilized at
1920. To motivates the manager to high effort, V must satisfy

( V)0.5 - 1 = ( 1920)0.5 - 1 = 14.1421

= 0.11942

Remember to deduct 1 for the disutility of high effort and recall that the competitive level of
utility is 2000.5 = 14.1421.

Because of the hedge, the manager will not face risk and will end up with certain compensation:

E[performance-related compensation with high effort and hedge] = 0.11942*1920 = 229.28

Without the hedge, the expected compensation was 235.34. The savings of 6.06 (= 235.34 -
229.28) is the risk premium, which is no longer necessary. So the owners gain is 6.06 from
hedging.

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6. Lai Company is exposed to property damage risk and commodity price risk. Property damage
risk is independent of commodity price risk. It has annual earnings shown in this table:

Low Commodity High Commodity

Price Price
(Prob=0.5) (Prob=0.5)
No Property Damage
500 800
(Prob=0.5)
Property Damage
200 500
(Prob=0.5)

What are Lai's expected earning and standard deviation for the firm as a whole?

Solution

xi pi xipi pi(xi-Mean)^2
500 0.25 125 0
200 0.25 50 22,500
800 0.25 200 22,500
500 0.25 125 0
Mean= 500 Variance= 45,000
Stdev= 212.13

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