Foundations of Finance Y.

Bergman ©
#4

➀
Good
➌
Good
Bad
➍
➁ Good ➎
Bad
Bad
➏
0 1 2 Time

E1 E2

pays $1 pays $1
at ➀ ; at ➁ ;
$0 $0
otherwise otherwise
Price at t = 0 Price at t = 0
P1 = $0.30 P2 = $0.60

E3 E4 E5 E6

pays $1 pays $1 pays $1 pays $1

at ➌ ; at ➍ ; at ➎ ; at ➏ ;
$0 $0 $0 $0
otherwise otherwise otherwise otherwise

Price at t = 0 Price at t = 0 Price at t = 0 Price at t = 0

P3 = $0.03 P4 = $0.21 P5 = $0.18 P6 = $0.36

Yesodot #4 (Canvas)
Foundations of Finance Y. Bergman ©

Elementary Security E2

$0
$0
$0
$0
$1
E2
$0
pays $1
0 1 2 Time at ➁ ;
$0
otherwise
Price at t = 0
P2 = $0.60

Elementary Security E4

$0
$0
$1
$0 E4
$0
$0 pays $1
at ➍ ;
0 1 2 Time $0
otherwise

Price at t = 0
P4 = $0.21

Elementary securities examp

 Foundations of Finance Y. Bergman ©

Present-value of random cash-flow

$6
$10
$0

$5
$4
$8

0 1 2 Time

Mimic cash-flow by creating

portfolio of elementary securities

10 ⊗ E1 + 4 ⊗ E2 +
+ 6 ⊗ E3 + 0 ⊗ E4 + 5 ⊗ E5 + 8 ⊗ E6

PV = Cost = Price
= 10*0.30 + 4*0.60 +
+ 6* 0.03 + 0*0.21 + 5*0.18 + 8*0.36
= $9.36

Random cash-flow (Canvas)

Foundations of Finance Y. Bergman ©

General valuation of a risky cash-flow

n3
n1
n4

n5
n2
n6

0 1 2 Time

Prices of the elementary securities are:

$p1, $p2, $p3, $p4, $p5, $p6.

Then

Present Value (PV) of the risky cash-flow (security) is:

PV = p1n1 + p2n2 + p3n3 + p4n4+ p5n5+ p6n6

measured in time zero dollars

Finance tree (PV = n.p)

 General valuation of a risky cash-flow
$n3
$n1
$n4

$n2 $n5

$n6

Prices of the elementary securities are:

$ pi
Then
Present Value (PV0) of the risky cash-flow (security) is:
6
PV = ∑ $ pi ni
i =1

Measured in time zero dollars

$0 0.6
P2 = :2 "‫ למשל עבור "כרטיס‬,‫המחירים הם בזמן אפס‬
$21.0

19.11.2012 :‫עדכון אחרון‬ 12

Foundations of Finance Y. Bergman ©

Bond
One year to maturity, default-risk free, zero coupon
$0
$1000
$0

$0
$1000
$0

0 1 2 Time

PV = Price = 1000*0.30 + 1000*0.60 +

0* 0.03 + 0*0.21 + 0*0.18 + 0*0.36 = $900

Sure time-1 $1000 discounted to time-0 $900

Sure time-1 $1 discounted to time-0 $0.9
Time-1 Discount- Factor = d1 = 0.9 ($ time-0/ $time-1)
1000* d1 = 900

Time-0 $900 grow to sure time-1 $1000

Time-0 $900 grow to sure time-1 (1 + r1)*900 = $1000
Riskless Interest-rate as of time-0 for money maturing at time-1
is r1 = 11.11%

One yr bond (canvas)

 Y. Bergman ©
Foundations of Finance

Bond
Two years to maturity, default-risk free, zero coupon
$1000
$0
$1000

$1000
$0
$1000

0 1 2 Time

PV = Price = 0*0.30 + 0*0.60 +

1000* 0.03 + 1000*0.21 +
1000*0.18 + 1000*0.36 = $780
Sure time-2 $1000 discounted to time-0 $780
Sure time-2 $1 discounted to time-0 $0.78
Time-1 Discount- Factor = d2 = 0.78 ($ time-0/ $time-2)
1000* d2 = 780

Time-0 $780 grow to sure time-2 $1000

Time-0 $780 grow to sure time-2 (1 + r2)2*780 = $1000
Riskless Interest-rate as of time-0 for money maturing at time-2
is r2 = 13.22%

Two yr bond (canvas)

Foundations of Finance Y. Bergman ©

Bond
Two years to maturity, default-risk free, 10% coupon
$100+1000
$100
$100+1000

$100+1000
$100
$100+1000

0 1 2 Time

PV = Price =
100*0.30 + 100*0.60 +
+ 100* 0.03 + 100*0.21 + 100*0.18 + 100*0.36 +
+ 1000* 0.03 + 1000*0.21 + 1000*0.18 + 1000*0.36 =

100*(0.30 + 0.60) + PV(1st Coupon)

+ 100* (0.03 + 0.21 + 0.18 + 0.36) PV(2nd Coupon)
+ 1000* (0.03 + 0.21 + 0.18 + 0.36) = PV(Face-value)

$90 $78 $780

100*(0.90) + 100* (0.78) + 1000* (0.78) =
100*(0.90) + 1100* (0.78) =
100/(1. + 0.1111) + 1100/ (1. + 0.1322)2 = $948

10% coupon Two yr bond

Foundations of Finance Y. Bergman ©

Stock, Bonds, and Capital Structure

Founder wants to sell project at time 0.

$10M Good economy

$4M Bad economy

Time
0 1

How much will he get?

Price of project at time 0 is:

Value of (10M ⊗ E1 + 4 M ⊗ E2)

= 10M × $0.3 + 4M × $0.6 = $5.4M

Also called “Present Value” or “PV.”

Financing setting
Foundations of Finance Y. Bergman ©

Incorporation: alternative #1

$10M
$5.4M

$4M

Time
0 1

Founder issues 1 million shares of stock (equity)

Each share:

$10 10/5.4 – 1 = +85%

$5.4

$4 4/5.4 – 1 = –26%

Realized Return

Incorporation; alt #1
Foundations of Finance Y. Bergman ©

Incorporation: alternative #2
Founder issues 1 million shares (equity)
and 3000 bonds, $1000 face-value each (debt)

$10M

=
$4M

Debt (default free) Equity (residual claim)

$3M $7M
D = $2.7M E = $2.7M
+
$3M $1M

Firm Value = V = Debt + Equity = D + E = 2.7 + 2.7 = $5.4M

50 - 50 debt - equity financing

one bond one share

$1000 +11.11% $7 +160%

$900 $2.7

$1000 +11.11% $1 –63%

Incorporation; alt #2
Foundations of Finance Y. Bergman ©

Incorporation: alternative #3
Founder issues 1 million shares (equity)
and 6000 bonds, $1000 face-value each (debt)

$10M

=
$4M

Debt (risky) Equity (residual claim)

$6M $4M
D = $4.2M E = $1.2M
+
$4M $0M
Bankruptcy

Firm Value = V = Debt + Equity = D + E = 4.2 + 1.2 = $5.4M

78%-debt ; 22%-equity financing
Financing does not matter!

one (junk) bond - risky one share

$1000 +43% $4 +233%

$700 $1.2

$666.67 –4.5% $0 –100%

Incorporation; alt #3
Foundations of Finance Y. Bergman ©

Incorporation: alternative #4
Founder issues 1 million shares (equity)
and 15,000 bonds, $1000 face-value each (debt)

$10M

=
$4M

Debt (riskys) Equity (residual claim)

$10M $0M
D = $5.4M E = $0M
Bankruptcy
+
$4M $0M
Bankruptcy

Firm Value = V = Debt + Equity = D + E = 5.4 + 0 = $5.4M

100%-debt ; 0%-equity financing (pure debt)
Financing does not matter!

one (junk) bond - risky one share

$666.67 +85% $0
$360 $0

$266.67 –26% $0
like stock in pure equity financing!

Incorporation; alt #4
 OPTIMAL CAPITAL STRUCTURE OF THE FIRM

BANKRUPT

BANKRUPT

SOLVENT
FIRM SOLVENT
BANKRUPT
P (! 3)
PROFIT

P (! 2) F
P (! 1)
F

!1 !2 !3 !1 !2 !3 !1 !2 !3 !1 !2 !3

PURE EQUITY RISKLESS DEBT RISKY DEBT PURE DEBT

FIRM VALUE

E E E

D D D

MAXIMUM VALUE OF FIRM

AND

OPTIMAL CAPITAL STRUCTURE