Week 4 (5.1+5.2+5.3)

Question 1

Answer 1

Question 2

Answer 2

Question 3

Answer 3

Question 4

Answer 4

Question 5

What does the free cash flow hypothesis state

Answer 5

According to thefree cash flow hypothesis, leverage increases firm value because it commits the firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by managers.

Question 6

When you have a new equity stake, how do you calc you ownership stake?
you have equity, new equity and new debt

Answer 6

Owners equity = value -debt - new equity
total equity = owners equity + new equity
owners stake = owners equity / total equity

Question 10

Answer 10

Question 11

Answer 11

Question 12

Answer 12

Question 13

Answer 13

Question 14

Formula expected payout debtholders

Answer 14

p(1+rf)d+(1-p)value low risky state

Question 15

Required interest rate debtholders

Answer 15

(1+r)= (1+rf)D-(1-p)value lowrisky / pd

Question 16

When does risk shifting not happen?

Answer 16

No risk shifting: equity financing overcomes the moral hazard problem
* MM Proposition 1 does not hold: firm value is lower if the firm is financed with too much debt
* MM Proposition 2 does not hold: WACC is higher if the firm is financed with too much debt

Question 17

What is the tradeoff theory?

Answer 17

Tradeoff theory tells us the firm should balance the cost of financial distress against the benefit of the tax shield
* (+ other agency costs/benefits)

Question 18

What is the Leverage Ratchet Effect

Answer 18

Once existing debt is in place…
1. Shareholders may have no incentive to decrease leverage, even if it increases firm value
2. Shareholders may have an incentive to increase leverage even if it decreases firm value
Leverage Ratchet Effect: over time, this can lead to a gradual increase in leverage
⇒ can explain many contractual features in debt contracts often observed in practice, such as: short maturities, restrictive covenants, collateral, …

Question 19

What is moral hazard

Answer 19

• Shareholders have control over the firm’s actions
• But shareholders’ actions are unobservable and therefore not contractible
• Even if shareholders want to commit to a certain action, they cannot write a contract that can enforce this action
• Any action needs to be incentive-compatible

Question 20

What are ways that overcome commitment problems?

Lev. ratchet implies firms cannot commit to a future capital structure

Answer 20

To overcome the commitment problem, firms/creditors use:
* Shorter maturities → automatic reduction in leverage
* Collateral → exclusive access to asset, not vulnerable to future leverage changes
* Seniority provisions → avoid dilution through new debt issuance
* Restrictive covenants → prohibit increases in leverage (at cost of lower operational flexibility)
* Relationship banking → bank has market power over borrower
* Reputation building → overcome commitment problem by building a reputation

Question 21

What are the three types of Agency costs?

Answer 21

Agency costs
* Leverage Ratchet Effect: excessive leverage can build up over time
* Excessive risk-taking (risk shifting)
* Under-investment due to debt overhang

Question 22

Why would shareholders prefer a value-destroying (lower/negative NPV) project?

Answer 22

The key is limited liability: when the firm defaults (state L), shareholders’ payoffs are capped at 0
* Yet in state H, shareholders enjoy the entire benefit from higher payoffs
* Shareholders can shift risk on debt holders: “Heads I win, tail you lose”

Stronger incentives to take excessive risk if
* Firm has large outstanding debt levels (high 𝐷)
* Firm can shift value from default states to non-default states (high risk sensitivity 𝑉” − 𝑉$)

Question 23

Why can equity seen as a call option on the firm’s assets with strike
price (1 + r)𝐷

Answer 23

Equity represents ownership in a company and is likened to a call option on the firm’s assets. A call option gives the holder the right (but not the obligation) to buy an asset at a predetermined price (the strike price) by a certain date.
Limited liability gives equity a call option-like payoff function

Question 24

Why is risky debt like risk-free debt with face value 𝐷 and a short position
in a put option on the firm’s assets with strike price(1 + r)𝐷:

Answer 24

Risky Debt as a Short Position in a Put Option: Risky debt holders are compared to being in a short position in a put option on the firm’s assets. A put option gives the holder the right (but not the obligation) to sell an asset at a predetermined price (the strike price) by a certain date.

Question 25

Limited liability gives equity a call option-like payoff function, what does this lead to?

Answer 25

• As a result, shareholders have an incentive to invest in risky projects and shift risk on debt holders
• Anticipating this behavior, debt holders charge higher interest rates ex-ante
• To avoid high interest rates, shareholders would like to commit to less risky projects ex-ante

Question 26

What is debt overhang?

Answer 26

Bottom line: shareholders may prefer to forgo positive-NPV investments, even though they would increase firm value

Question 27

What do risk shifting and debt overhang have in comen and what makes them similar?

Answer 27

• The problem arises when undertaking new projects mostly benefits existing debt holders
• Similar to risk shifting, most relevant for firms with relatively high leverage (close to financial distress)
• In contrast to risk shifting, debt overhang implies that shareholders may choose to forego positive NPV investments → under-investment