RÉPÉTITOIRE ACF

PROBLEM SET 4
Genève, 20 décembre 2022

University of Geneva
GSEM

ADVANCED CORPORATE FINANCE

PROBLEM SET 4

TABLE OF CONTENT

page

Probem 5 2

Probem 2 4

Probem 3 6

End 8
 Problem 5

The data of the problem are as follows :

V = market value of firm assets = 95
F = face value of the zero-coupon debt = 65
r = continuous resk free rate = 5%
σ = volatility of return on firm assets per year = 37%
T = maturity of the debt = 7 years
1. We have D = V − E, where the equity E is de value of a call option on
assets with strike equal to F. Using the Black and Scholes formula, the price of
corporate debt is then given by

D = V (1 − N (d1 )) + F e−rT N (d2 )

with
ln (V /F ) + rT 1 √ ln (95/65) + 0.05 × 7 1 √
d1 = √ + ×σ T = √ + × 0.37 7 ≃ 1.234656
σ T 2 0.37 7 2
√ √
d2 = d1 − σ T = 1.234656 − 0.37 7 ≃ 0.255728
N (d1 ) ≃ 0.8915207 ; N (d2 ) ≃ 0.60092

Hence

D ≃ 95 × (1 − 0.8915207) + 65 × e−0.05×7 × 0.60092 ≃ 37.83

2. The probability of default is

p (V < F ) = 1 − N (d2 ) ≃ 1 − 0.60092 ≃ 0.4

3. The rate of return on corporate debt rD is the solution of the following

equation:
D (1 + rD )7 = F
Thus
( )1 ( )1
F 7 65 7
rD = −1≃ − 1 ≃ 0.0804 ≃ 8.04%
D 37.8305
In the continuous setting, we can also compute the yield to maturity:
( )
1 65
yield to maturity = ln ≃ 0.07733 ≃ 7.73%
7 37.8305

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 4. If the volatility of return on assets is reduced to 20% then the probability
of default will be
p (V < F ) = 1 − N (d2 )
with
ln (95/65) + 0.05 × 7 1 √
d2 = √ − × 0.2 × 7 ≃ 1.1140307
0.2 × 7 2
√ √
d1 = d2 + σ T ≃ 1.1140307 + 0.2 × 7 ≃ 1.64318
N (d1 ) ≃ 0.94983 ; N (d2 ) ≃ 0.867367

The value of the debt become

D = 95 × (1 − 0.94983) + 65 × e−0.05×7 × 0.867367 ≃ 44.496

Hence the value of the probability of default will decrease to

p (V < F ) ≃ 1 − 0.867367 ≃ 0.1326

and the return on debt will decrease to

( )1
65 7
rD ≃ − 1 ≃ 0.055634 ≃ 5.56%
44.496

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 Problem 6

Consider the assumptions of problem 6 :

V = market value of firm A assets = 125
F = face value of the zero-coupon debt = 75
T = maturity of the debt = 7 years
r = continuous risk free rate = 5%
σ = volatility on firm A assets per year = 27%
1. The market value of equity is
E = V × N (d1 ) − F × e−r×T × N (d2 )
where
ln (125/75) + 0.05 × 7 1 √
d1 = √ + × 0.27 7 ≃ 1.56222
0.27 7 2
√ √
d2 = d1 − σ T ≃ 1.56222 − 0.27 7 ≃ 0.84787
We deduce that
E = 125 × 0.940882 − 75 × e−0.05×7 × 0.8017438 ≃ 75.237
and
D = V − E ≃ 125 − 75.237 ≃ 49.763
Interpretation of N (d2 ) . We have the formula :
N (d2 ) = 1 − probability of def ault
and we deduce that N (d2 ) is the probability that the firm will be able to meet its
financial obligations. N (d2 ) is also the probability that the firm will not default
on his debt obligations.
2. Suppose that the merger is going to reduce the volatility from 27% to 12%.
The parameters d1 and d2 become
ln (125/75) + 0.05 × 7 1 √
d1 ≃ √ + × 0.12 7 ≃ 2.87009
0.12 7 2
√ √
d2 = d1 − σ T ≃ 2.87009 − 0.12 7 ≃ 2.55260
N (d1 ) ≃ 0.99795 ; N (d2 ) ≃ 0.994654

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 Consequently,

E = V × N (d1 ) − F × e−r×T × N (d2 )

≃ 125 × 0.99795 − 75 × e−0.05×7 × 0.994654 ≃ 72.175

The financial structure has changed. But according to the Modigliani-Miller

Theorem, the value of the firm assets remain unchanged. Thus,

D = V − E ≃ 125 − 72.175 ≃ 52.825

We observe that the value of equity is decreasing, while the value of debt is
increasing.
3. In this question, we use N (d1 ) = 0.99795.
A synergy gain ∆V that would make the merger a positive N P V for share-
holders must verify the condition : The impact of ∆V on the equity value exceeds
the variation of equity due to the reduction of the risk of assets.
In quantitative terms, this condition become

∆E ≥ 0 ⇔ N (d1 ) × ∆V ≥ 75.237 − 72.175

75.237 − 72.175
⇔ ∆V ≥ ⇔ ∆V ≥ 3.068
0.99795
Thus the minimum synergy is ∆V ≃ 3.068 .

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 Problem 7

Assumptions of problem 7 :
E = 400 millions et βE = 1.2
D = Current value of the debt = 75
F = Face value of the debt = 100
r = four year risk free rate = 5.13%
Nous considérons la valeur de l’équity E comme étant celle d’un call d’échéance
4 ans sur les actifs de la firme, dont le strike est la face value F de la dette. Il en
résulte les formules suivantes:

E = V × N (d1 ) − F × e−r×T × N (d2 )

ln (V /F ) + rT 1 √ √
d1 = √ + × σ T ; d2 = d1 − σ T
σ T 2
Dans ces formules, V est la valeur actuelle des actifs de la firme, à savoir:

V = E + D = 400 + 75 = 475 millions

Nous en déduisons:
ln (4.75) + 0.0513 × 4 ln (4.75) + 0.0513 × 4
d1 = + σ ; d2 = −σ
2σ 2σ
De la formule d’évaluation des capitaux propres, nous obtenons une relation
entre N (d1 ) et N (d2 ) :

475 × N (d1 ) − 100 × e−0.0513×4 × N (d2 ) = 400

Cette relation est en fait une équation non linéaire à une seule inconnue σ,
puisque d1 et d2 ne dépendent tous les deux que de la volatilité σ :
( ) ( )
ln (4.75) + 0.2052 ln (4.75) + 0.2052
475×N + σ −100×e−0.2052 ×N − σ = 400
2σ 2σ
(E)

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 La valeur de σ peut alors se calculer par approximations successives à partir
d’un chiffre positif quelconque. Nous partons par exemple d’une valeur initiale de
10% et en utilisant Pi ≃ 3.142, nous obtenons les résultats suivants:

Proxy de σ Prox de E
10% 393.526
30% 393.58
40% 394,238
50% 396.326
55% 397.993
65% 402.427
61% 400.405
59% 399.605
60% 400.044

L’équation (E) peut aussi être résolue à l’aide d’un logiciel tel que Matlab ou
mathématica. Et en utilisant une valeur plus précise de Pi, nous obtenons encore
une valeur de σ proche de 60%.
Par ailleurs, et d’après le cours, Lecture 7, slide 17, nous avons:
V V
βE = βA × × N (d1 ) ; βD = βA × × (1 − N (d1 ))
E D
D’où en particulier:
βE
βU = βA = V
E
× N (d1 )
Il nous reste à calculer N (d1 ) . Or la formule de d1 est connue:

ln (V /F ) + rT 1 √ ln (475/400) + 0.0513 × 4 1 √
d1 = √ + ×σ T = √ + ×0.60 4 ≃ 2.06945
σ T 2 0.60 4 2

D’où N (d1 ) = 0.980748. Il s’ensuit alors que:

βE E βE 400 1.2
βU = = = ≃ 1.03036
V
E
× N (d1 ) V N (d1 ) 475 0.980748

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 Problem 8

Assumptions of problem 8 :
V = current value of KD industries = $25
F = face value of the zero-coupon debt = 15
T = maturity of the debt = 3 years
r = continuous risk free rate = 4.5%
σ = volatility on return of assets per year = 30%
1. If βV = 1, βV being the beta of assets, then
V
βE = N (d1 ) βV
E
According to the Black and Scholes formula, we have

E = V × N (d1 ) − F × e−r×T × N (d2 )

with
ln (25/15) + 0.045 × 3 1 √
d1 = √ + × 0.3 3 ≃ 1.5027
0.3 3 2
√ √
d2 = d1 − σ T ≃ 1.5027 − 0.3 3 ≃ 0.9831
N (d1 ) ≃ 0.933542 ; N (d2 ) ≃ 0.837221

Hence

E = 25 × 0.933542 − 15 × e−0.0453 × 0.837221 ≃ 12.36615 ≃ 12.37

and
25
βE = 0.93354 × ≃ 1.8873
12.36615
2. Assume that the debt issued by KD is composed of senior debt and junior
debt:
FS = face value of the senior debt = $10
FJ = face value of the junior debt = $5
F = FS + FJ = face value of the total debt = $10 + $5 = $15

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 To determine the yields of these debts, we start by calculating their values DS ,
DJ and T D = DS + DJ .
Determination of DS . We have :
ln (25/10) + 0.045 × 3 1 √
dS1 = √ + 0.3 3 ≃ 2.28302
0.3 3 2
√ √
dS2 = dS1 − σ T ≃ 2.28302 − 0.3 3 ≃ 1.7634
( ) ( )
N dS1 ≃ 0.9888 ; N dS2 ≃ 0.96108

Hence

DS = 25 × (1 − 0.9888) + 10 × e−0.045×3 × 0.96108 ≃ 8.6771

Determination of T D. We have :
ln (25/15) + 0.045 × 3 1 √
d3 = √ + 0.3 3 ≃ 1.5027
0.3 3 2
√ √
d3 − σ T ≃ 1.5027 − 0.3( 3 ≃ 0.9831
√ )
N (d3 ) ≃ 0.933542 ; N d3 − σ T ≃ 0.837221

We deduce that

T D ≃ 25 × (1 − 0.933542) + 10 × e−0.045×3 × 0.837221 ≃ 12.6338

E ≃ V − T D ≃ 25 − 12.6338 ≃ 12.3662

And the value of the junior debt is

DJ = T D − DS ≃ 12.6338 − 8.6771 ≃ 3.95675 ≃ 3.96

Determination of the yields. The yields of the senior and junior debt
contracts are denoted by γS , γJ , respectively :
( ) ( )
1 FJ 1 5
γJ = ln ≃ ln ≃ 0.078 ≃ 7.8%
T DJ 3 3.95675
( ) ( )
1 FS 1 10
γS = ln ≃ ln ≃ 0.0473 ≃ 4.73%
T DS 3 8.6771

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 3. Assume that βV = 1. The senior debt and the total debt being call options
on the firm assets, we can use the following formulas :
V ( ( )) 25
βS = 1 − N dS1 × βV ≃ × (1 − 0.9888) × 1 ≃ 0.03227
DS 8.6771
V 25
βT D = (1 − N (d3 )) × βV ≃ × (1 − 0.933542) × 1 ≃ 0.1315
TD 12.6338
V 25
βE = N (d3 ) × βV ≃ × 0.933542 × 1 ≃ 1.8873
E 12.3662
To compute de beta of the junior debt, we follow two equivalent methods.
Method 1 is based on the result that the beta of assets is the weighted
average of the beta of equity, the beta of senior debt and the beta of junior debt.
Consequently, the beta of the junior debt contract is the solution of the equation
E DS DJ
βV = × βE + × βS + × βJ
V V V
We obtain
V E DS
βJ = × βV − × βE − × βS
DJ DJ DJ
25 12.3662 8.6771
≃ ×1− × 1.8873 − × 0.03227
3.95675 3.95675 3.95675
≃ 0.3491 ≃ 0.35

Method 2 is based on the fact that the total debt is a portfolio composed by
the senior and junior debts. Consequently, the beta of the junior debt contract is
the solution of the equation
DS DJ
βT D = × βS + × βJ
TD TD
The resolution leads to
TD DS 12.6338 8.6771
βJ = × βT D − × βS ≃ × 0.1315 − × 0.03227
DJ DJ 3.95675 3.95675
≃ 0.3491 ≃ 0.35

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