Corporate Financial Policy (1)

In the following questions, assume the firm will earn a single (uncertain) cash flow and ignore discounting for simplicity. Given the probability distribution of free cash flow, what is the expected value of the firm?

• 900

• 600

• 400

• 1200

Suppose the firm has debt obligation of 500 to pay. What is the firm’s shareholder value?

• 400

• 500

• 100

• 700

Suppose the firm has debt obligation of 1000 to pay. What is the firm’s shareholder value? (Hint: if the firm does not have enough cash flow to pay its debt, assume its debtor will take all cash available and shareholders will be left with nothing.)

• 66.67

• 200

• 0

• -100

Now assume the firm can decide to change its business strategy such that in the bad state, it will suffer a major loss, but in the good state, it will be slightly more profitable. What is the expected value of this risky strategy?

• -100

• -400

• 0

• 100

If shareholders decide to pursue the risky strategy, what will happen to shareholder value as a result?

• Shareholder value will increase by 33.33.
• Shareholder value will increase by 100.
• Shareholder value will decrease by 100.
• Shareholder value will decrease by 400.

In the earlier example, the risky project does not require any new investment by shareholders. Suppose, instead, that the strategic shift requires new investment. Which of the following statements is true?

• As long as the investment cost does not exceed 33.33, it is profitable.
• As long as the investment cost does not exceed 100, it is profitable.
• If the strategic shift requires investment, it is not worth it.
• If the strategic shift is always worth it since creditors end up paying for the failure.

The situation capture by the earlier example is referred to in corporate finance as...

• Risk-shifting
• Debt overhang
• Trade-off
• Pecking order

Assume instead that the firm can invest in a project that costs 50 but will yield 100 cash flow in all three states of the world (forget the strategic shift). The NPV of the project is:

• 50

• 100

• -50

• 0

If the firm invests in the project, the shareholder value will be:

• 50

• 66.67

• 100

• 0

The situation capture by the earlier example is referred to in corporate finance as...

• Debt overhang
• Risk-shifting
• Trade-off
• Pecking order