Introduction
to Financial Management
Fall
2001
PT-MBA
& EMBA
Consider the following 100% equity firm, with total assets of $100. If the firm raises $1,000 in 1-year debt with a coupon rate of 12%, the firm has an interest obligation of $120 plus the principal repayment. Consider the following investment project for the firm. The firm invests the $1,000 from the creditors in a machine that will have the following possible payoffs in 1 year.
a.
$10,000
b.
$5,000
c.
$1,000
d.
$100
f.
$0
g. –$100
h. –$1,000
i. –$5,000
j. –$10,000
Each of these outcomes has an equal probability of occurring (p = 11.11%). The expected payoff from the investment is: 0.1111 × $10,000 + 0.1111 × $5,000 + · · · · · + 0.1111 × –$10,000 = $0. Hence, this would under normal circumstances not be an attractive investment opportunity.
Consider the payoffs
to the creditors versus the shareholders in each of these possible scenarios
(assume r=0%, i.e., there is no discounting):
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So, the first two rows represent the normal scenario for the firm, where there is enough money to pay to the creditors. The darker shaded area - rows 3 - 6, represent the scenario where the firm is in default (financial distress). The final rows represent total bankruptcy. Note how the cash flows for the creditors are fixed (i.e., independent on the outcome of the project) for the normal scenario, while they are residual cash flows (i.e., dependent on the outcome of the project) for the default situation. For shareholder this is exactly reversed. The idea is to give decision, or control rights (voting rights) to the investors that have residual cash flows, because they will be more motivated to make things better in the firm.
Also, note that while the overall expected payoff of the project is $0 (unattractive!), the expected payoff for the shareholders is: 0.1111 × $8,980 + 0.1111 × $3,980 + · · · · · + 0.1111 × $0 = $1,440 (attractive, because they started with a $100 value in equity!) and the expected payoff for the creditors is: 0.1111 × $1,120 + 0.1111 × $1,120 + 0.1111 × $1,100 + 0.1111 × $200 + · · · · · + 0.1111 × $0 = $404.44 (unattractive, because they were originally promised a $1,120 payment!)
Covenants will protect
the bondholders and prevents the firm from taking particular type of actions
that are potentially beneficial to shareholders but detrimental to creditors
(like investing their money into a risky investment as above)