!!"# ! - !"#$%&"' ) *+,*-%*.

/'01*20

noLe: lor exLreme preclslon, all lnLermedlaLe compuLaLlons have been carrled ouL wlLh exacL
values. llgures of lnLermedlaLe resulLs ln Lhls soluLlon may be rounded for slmpllclLy of
noLaLlon only. llnal resulLs are Lhe only ones Lo be rounded accordlng Lo Lhe rules of Lhe
game.
art I
uest|on 1
1ext: AcLlng on behalf of a group of exLernal lnvesLors, LourlmonL bank approaches Lhe helrs
of !ohn Mackenzle who wlll probably soon own 83 of Mk-1alnmenL (Lhe wlll has noL gone
Lhrough probaLe yeL). 1helr ob[ecLlve ls Lhe purchase of Mk-1alnmenL. Powever, Lhere ls
greaL uncerLalnLy surroundlng !ohn's deaLh, and !ohn's famlly mlghL noL be able Lo sell as
qulckly as Lhe unknown lnvesLors would wlsh. LourlmonL bank Lhen approaches Lhe owners
of Lhe remalnlng 13 of Mk-1alnmenL. We assume LhroughouL Lhls parL LhaL Lhe markeL
value of equlLy ls 130 000 Lhousands of Aces, and LhaL we are aL Lhe end of 2013.
1he owners of Lhe 13 of Mk-1alnmenL would be very lnLeresLed ln selllng Lo LourlmonL bank, however Lhe
laLLer worrles abouL Lhe posslblllLy LhaL Lhe Mackenzle famlly wlll never be able or wllllng Lo sell.
Conslder 2 scenarlos:
Scenarlo 1: Lhe famlly of !ohn Mackenzle ls declared Lhe owner of 83 of Mk-1alnmenL, and Lhey agree Lo sell
Lhelr shares Lo Lhe unknown lnvesLors. 1he owners of Lhe remalnlng 13 are also wllllng Lo sell.
valuaLlon dlscounLs assumlng lmmlnenL sale of 100 of Mk-1alnmenL Lo new lnvesLors (scenarlo 1):
Lack of conLrol dlscounL: 0
Lack of markeLablllLy dlscounL : 3

Scenarlo 2: Lhe famlly of !ohn Mackenzle has noL yeL been granLed ownershlp of Lhe 83 of Lhe shares
belonglng Lo !ohn Mackenzle. Powever, Lhe owners of Lhe remalnlng 13 would llke Lo sell.
valuaLlon dlscounLs assumlng lmmlnenL sale of 13 of Mk-1alnmenL Lo new lnvesLors (scenarlo 2):
Lack of conLrol dlscounL: 10
Lack of markeLablllLy dlscounL : 13




So|ut|ons:
SoluLlons are found ln Lhe Lable below (ln red):

1. ulscuss Lhe sale of Mk-1alnmenL Lo LourlmonL bank ln scenarlo 1
Why ls Lhe lack of conLrol dlscounL equal Lo zero ln scenarlo 1? Choose Lhe besL answer ?
A. 8ecause !ohn Mackenzle's famlly own 83 /


8. 8ecause the owners of the 8S stake wou|d max|m|ze the va|ue of a|| the shares]
C. 1here should be a lack of conLrol dlscounL dlfferenL from zero.



Correct answer |s 8
2. Assumlng scenarlo 1, calculaLe Lhe value of Lhe 13 sLake ln Mk-1alnmenL
value of Lhe 13 sLake 18 S2S

3. Assumlng scenarlo 2, calculaLe Lhe value of Lhe 13 sLake ln Mk-1alnmenL
value of Lhe 13 sLake 14 918

Lxp|anat|ons:
1. 1he lack of conLrol ls equal Lo zero ln scenarlo one because we can safely assume LhaL
LourlmonL 8ank wlshes Lo buy 100 of Lhe shares, and LhaL Lhey wlll offer Lhe same prlce Lo
all shareholders. 1he owners of Lhe 83 wlll negoLlaLe and maxlmlze Lhe prlce per share for
all Lhe shares.
2. lf scenarlo one Lakes place, we musL calculaLe Lhe value of Lhe 13 sLake
LqulLy value 130 000 (glven)
ro raLa value of 13 equlLy lnLeresL 19 300 (13 of 130 000)
Less: lack of conLrol dlscounL 0
Less : lack of markeLablllLy dlscounL - 973 (3 of 19 300)
Va|ue of the 1S stake 18 S2S




3. lf scenarlo 2 Lakes place, we musL calculaLe Lhe value of Lhe 13 sLake Laklng lnLo accounL
Lhe new dlscounLs:
LqulLy value 130 000 (glven)
ro raLa value of 13 equlLy lnLeresL 19 300 (13 of 130 000)
Less: lack of conLrol dlscounL - 1 930 (10 of 19 300)
Va|ue assum|ng |ack of contro| 17 SS0
Less : lack of markeLablllLy dlscounL - 2 633 (13 of 17 330)
Va|ue of the 1S stake 14 918



uest|on 2

1ext:
CalculaLlng cosL of equlLy, cosL of debL and Lhe caplLal sLrucLure of Mk-1alnmenL.
ln order Lo calculaLe cosL of equlLy uslng Lhe CAM, we musL obLaln Lhe markeL rlsk
premlum, Lhe rlsk free raLe, and Lhe beLa of Mk-1alnmenL. ln order Lo calculaLe Lhe levered
beLa of Mk-1alnmenL, we musL flrsL obLaln Lhe caplLal sLrucLure.
1hls quesLlon has four parLs.
uest|on 2 part 1 - text: CalculaLe Lhe markeL rlsk premlum uslng a 30 year perlod
uest|on 2 part 1 - so|ut|on:
Average markeL reLurn: 10.2
Average rlsk free raLe : 4.82
MarkeL rlsk premlum: 6.09

Lxp|anat|ons:
1he average markeL reLurn ls calculaLed as Lhe arlLhmeLlc mean of reLurns durlng Lhe perlod
1962-2013.
1he average rlsk free raLe ls calculaLed as Lhe arlLhmeLlc mean of rlsk free reLurns durlng Lhe
perlod 1962-2013.
1he rlsk premlum ls Lhe annual excess reLurn on Lhe markeL over Lhe rlsk free raLe. 1he
markeL rlsk premlum ls calculaLed as Lhe average of Lhe dlfference of Lhe markeL reLurn and
Lhe rlsk free raLe over Lhe perlod 1962-2013.



uest|on 2 part 2 - text:
AlLhough Mk-1alnmenL ls noL llsLed on Lhe unlverse ClLy SLock Lxchange, flve years ago lL
publlcly lssued 13 000 bonds wlLh an orlglnal maLurlLy of Len years. Lach bond has a par
value of 1000 Aces and an annual lnLeresL raLe of 8. Coupons are pald annually. 1he
currenL markeL prlce of Lhe bond ls 1030 Aces.
Also, flve year ago Mk-1alnmenL borrowed 30000 Lhousand Aces from Lhe bank aL a flxed
lnLeresL raLe of 9. lL was an amorLlzlng loan over Len years wlLh a consLanL annulLy.
WhaL ls Lhe cosL of debL Lo be used ln Lhe calculaLlon of Lhe welghLed average cosL of
caplLal?
uest|on 2 part 2 - so|ut|on: cosL of debL ls 6,79

Lxp|anat|ons:
1o calculaLe Lhe cosL of debL Lo be used ln Lhe calculaLlon of Lhe WACC, we wlll use Lhe cosL
of Lhe publlcly Lraded bonds, and noL Lhe amorLlzlng loan.
1o calculaLe Lhe yleld of Lhe bond, we calculaLe Lhe lnLernal raLe of reLurn (l88 formula ln
Lxcel) applled Lo Lhe followlng sLream of cash flows:

1he lnlLlal cash flow ls Lhe markeL value of Lhe bond: 1030. 1hls ls Lhe amounL LhaL we would
have Lo pay ln order Lo purchase Lhe bond.
1he cash flows per year are Lhe bond coupons: 1000 * 8 = 80
1he lasL cash flow lncludes Lhe bond value whlch ls repald aL Lhe end:
1000 + 80 = 1080.
1he cosL of debL ls Lhe yleld of Lhe bond or Lhe l88: 6.79

!"#$ !"#% !"#& !"#' !"#(
)* +#"%"
80,00 80,00 80,00 80,00 1 080,00
,-- &.'/0


uest|on 2 part 3 - text: CalculaLe Lhe beLa of Mk-1alnmenL.
Slnce Mk-1alnmenL ls noL a publlc company, we wlll use Lhe comparables meLhod. AfLer
Lhorough research, we have found LhaL SofLwlre and Pardwlre are Lhe only publlc companles
LhaL we may conslder as belng "comparable" Lo Mk-1alnmenL (Lhey have Lhe same rlsk
proflle). CalculaLe Lhe beLa LhaL we wlll use ln Lhe WACC compuLaLlon uslng Lhe average
unlevered beLa of SofLwlre and Pardwlre:
uest|on 2 part 3 - so|ut|on: levered beLa = 0,77
Lxp|anat|ons:
1o calculaLe Lhe beLa, Lhe quesLlon guldes us Lo use Lhe mulLlples meLhod.
ln order Lo calculaLe Lhe beLa of Mk1alnmenL from comparables companles beLas, we wlll
flrsL need Lo unlever Lhelr beLas wlLh Lhe markeL value of debL and equlLy. We already have
Lhe markeL value of equlLy (glven), we need Lo calculaLe Lhe markeL value of neL debL.
A) CalculaLlon of Lhe markeL value of Mk1alnmenL's neL debL:
1he markeL value of Lhe loan ls Lhe presenL value of Lhe fuLure paymenLs. aymenLs are
consLanL, we calculaLe Lhe paymenLs wlLh Lhe Lxcel formula (vM) uslng Lhe lnlLlal amounL
borrowed (30 000), Lhe lnLeresL raLe (9) and Lhe number of years (10 years). 1he annulLy ls
equal Lo 7 791.
luLure annulLles are dlscounLed Lo calculaLe Lhe markeL value of Lhe loan (from 2014 Lo
2018) uslng Lhe cosL of debL (6.79) as Lhe dlscounL raLe. 1he markeL value of Lhe loan ls
Lhus 32 127 Lhousand Aces.
1he markeL value of Lhe bonds ls calculaLed as Lhelr lndlvldual markeL value mulLlplled by Lhe
number of bonds: 1000 * 1030 = 13 730 Lhousand Aces

1he LoLal markeL value of Mk1alnmenL's neL debL ls :
markeL value of loan 32 127
+ markeL value of bonds + 13 730
- cash holdlngs - 8000
= Market va|ue of Mk1a|nment's net debt (th Aces) 39 877



8) CalculaLlon of of Mk1alnmenL's beLa:

SofLwlre Pardwlre Mk-1alnmenL
MarkeL value of equlLy (Aces) 900 000 9 000 000 130 000
value of neL debL (Aces) 1 000 000 7 000 000 39 877
Levered beLa 0.93 1.16

u / L 1.11 0.78 0.31
unlevered beLa 0.32 0.73

Mean unlevered beLa

0.64
Levered beLa

0.77

1he beLa coefflclenLs can be obLalned ln several ways: by uslng Lhe glven
formula (hlsLorlcal covarlance beLween Lhe dally share prlce reLurns and a
dally lndex reLurns dlvlded by Lhe sLandard devlaLlon of Lhe markeL lndex
reLurns), Lhe Lxcel funcLlon LINLS1 or Lhe regresslon analysls Lool ln Lxcel.

1he flnanclal sLrucLure ls calculaLed by dlvldlng Lhe markeL value of neL uebL
by Lhe markeL value of LqulLy. lor SofLwlre, Lhe u/L raLlo ls equal Lo
(1 000 000 / 900 000) = 1,11

1he levered beLa ls calculaLed uslng Lhe followlng formula :
!
!
!
!"#!!
!
! !
!
!
!"#!!
!
!

1he avallable daLa covers Lhe perlod 12/4/2011 - 31/12/2013.

1he unlevered beLa ls calculaLed uslng Lhe followlng lormula:


Lxample: for SofLwlre, Lhe calculaLed levered beLa ls equal Lo 0.93, Lhe u/L
raLlo ls 1,11 and Lhe Lax raLe ls 30. Pence, Lhe unlevered 8eLa ls equal Lo
[0.93/(1+(1-30)x1.11)] = 0.32

1he average unlevered beLa ls equal Lo Lhe sum of Lhe Lwo calculaLed
unlevered beLas dlvlded by 2: [(0.32 + 0.73)/2] = 0.64

lor Lhe calculaLlon of Lhe levered beLa for Mk1alnmenL, Lhe proporLlon of neL
uebL musL be used ln Lhe calculaLlon. 1he cash avallable ls equal Lo 8000, so
neL debL = 47 877 - 8000 = 39 877. Pence Lhe u/L raLlo ls equal Lo 39 877 /
130 000 = 0.31
Levered beLa for Mk1alnmenL = unlevered beLa * [1+((1-30)* u/L)]
= 0.64* [1+((1-30)* 0.31)] = 0.77
E
D
equity
unlevered
V
V
T ! " +
=
) 1 ( 1
#
#


uest|on 2 part 4 - text: CalculaLe CosL of LqulLy
uest|on 2 part 4 - so|ut|on: 9.34
Lxp|anat|ons:
1he cosL of LqulLy ls calculaLed uslng Lhe CAM formula: 8e=8f + x (8m-8f). Pence, Lhe
1argeL's cosL of equlLy ls equal Lo [4.82 + 0.77 x (6.09)] = 9.34



uest|on 3

1ext: Clve a range for each beLa (SofLwlre and Pardwlre) aL a confldence level of 93 (you
may use regresslon analysls ln Lxcel), and check LhaL Mk-1alnmenL's unlevered beLa ls ln Lhe
lnLerval.
So|ut|on:
Levered beta Softw|re nardw|re
upper bound 1.03 1.27
|ower bound 0.82 1.06

Is the |evered beta of these two f|rms (Softw|re &
nardw|re) w|th|n the |nterva| ? ?LS ?LS

Un|evered beta Softw|re nardw|re
upper bound 0.38 0.82
|ower bound 0.46 0.69

Is the un|evered beta of these two f|rms (Softw|re
and nardw|re) w|th|n the |nterva|? ?LS ?LS

Lxp|anat|ons:

1o glve a range for beLa aL a confldence level of 93, lL ls necessary Lo use Lhe
regresslon analysls Lool ln Lxcel. 1he reporL provlded by Lxcel presenLs deLalled
sLaLlsLlcs for Lhe regresslon analysls, lncludlng Lhe upper and lower bounds of Lhe
coefflclenLs for Lhe speclfled confldence level.

Levered and unlevered beLas were calculaLed ln Lhe prevlous quesLlon. 8ecall LhaL Lo
flnd Lhe correspondlng unlevered beLas, lL ls necessary Lo apply Lhe followlng
formula:




E
D
equity
unlevered
V
V
T ! " +
=
) 1 ( 1
#
#


uest|on 4
1ext: uslng daLa from quesLlon 2, calculaLe Lhe welghLed average cosL of caplLal.

So|ut|on:
Mk1alnmenL u/L 0,31
roporLlon of debL () VD 23.47
roporLlon of equlLy () VL 76.33
ke 9.34
kd 6.79
WACC 8.42

1he WACC ls obLalned by uslng Lhe followlng formula:


noLe LhaL when compuLlng Lhe caplLal sLrucLure for WACC, v
L
and v
u
denoLe Lhe markeL
value of LqulLy and Lhe markeL value of neL uebL, respecLlvely.
1ax raLe for Lhe afLer-Lax cosL of debL ls 30 (uaLa for layers Lab).
1he cosL of equlLy and Lhe cosL of debL were found ln prevlous quesLlons.

(1 )
E D
E D
E D E D
V V
WACC K K T
V V V V
= + !
+ +


uest|on S:
So|ut|on and exp|anat|ons
lf a pro[ecL ls golng Lo be flnanced only wlLh debL
Lhe relevanL dlscounL raLe ls Lhe afLer-Lax cosL of
debL
IALSL

When valulng a pro[ecL, Lhe relevanL dlscounL raLe
ls Lhe welghLed average cosL of caplLal, whlch ls
closer Lo Lhe cosL of equlLy Lhan Lo Lhe cosL of
debL
IALSL
1he WACC ls noL necessarlly closer Lo Lhe cosL
of equlLy, lL ls dependenL on Lhe caplLal
sLrucLure.
Lven lf a pro[ecL does noL have Lhe same rlsk as
Lhe flrm, Lhe relevanL cosL of caplLal Lo be used
should be equal Lo Lhe flrm's WACC
IALSL
Lach pro[ecL should lncorporaLe lLs own rlsk
lnLo Lhe dlscounL raLe.
When valulng a spln-off, Lhe cosL of caplLal does
noL necessarlly equal Lo Lhe WACC of Lhe flrm,
1kUL
lf Lhe spln-off has a dlfferenL rlsk from Lhe
flrm, Lhe dlscounL raLe wlll be ad[usLed Lo
reflecL Lhls rlsk.
Accordlng Lo Lhe pecklng order Lheory, new debL ls
preferable Lo new equlLy
1kUL
Accordlng Lo Lhe pecklng order Lheory,
cosL of flnanclng lncreases wlLh
asymmeLrlc lnformaLlon, companles wlll
prefer lnLernal flnanclng, Lhen new debL,
Lhen new equlLy.
All else equal, Lhe use of long-maLurlLy debL ls
expecLed Lo be greaLer ln Lhose markeLs ln whlch
lnflaLlon ls hlgh
IALSL
Accordlng Lo Lhe sLaLlc Lrade-off Lheory,
companles do have an opLlmal level of debL
1kUL
Companles musL balance Lhe cosLs and
beneflLs of debL and equlLy. 1hey do have an
opLlmal level of debL.
lf lnvesLors have homogeneous expecLaLlons, Lhe
markeL ls efflclenL, and Lhere are noL Laxes, no
LransacLlon cosLs, and no bankrupLcy cosLs, whaL
does Lhe Modlgllanl and Mlller proposlLlon l say?
8
A bankrupLcy rlsk rlses wlLh more leverage
Accordlng Lo Modlgllanl and Mlller flrsL
proposlLlon, debL ls lrrelevanL when valulng a
company
8 managers cannoL change Lhe value of Lhe
company by uslng more or less debL



C managers cannoL lncrease Lhe value of Lhe
company by employlng Lax savlng sLraLegles

Accordlng Lo Modlgllanl and Mlller roposlLlon ll
wlLhouL Laxes,
C
A Lhe caplLal sLrucLure declslon has no effecL on
Lhe cosL of equlLy

8 lnvesLmenL and Lhe caplLal sLrucLure declslon
are lnLerdependenL
ln Lhe above formula, we see LhaL cosL of
equlLy (rL) lncreases as debL lncreases.
C Lhe cosL of equlLy lncreases as Lhe use of debL ln
Lhe caplLal sLrucLure lncreases





art 2
uest|on 1
So|ut|on

Lxp|anat|ons
See Modlgllanl & Mlller Lheory for explanaLlons.
ln Lhe lasL paragraph, we lnLroduce a llnk wlLh a crlsls conLexL, and we deflne "fllghL Lo
quallLy" as lnvesLor's behavlor wlLhln a crlsls LhaL makes Lhem buy asseLs percelved as safe
(lnvesLmenL grade securlLles).

Lower or negaLlve operaLlng earnlngs puL companles under flnanclal sLress. Companles may even face flnanclal dlsLress. CosLs of flnanclal dlsLress lnclude dlrecL cosLs such
as cash expenses assoclaLed wlLh Lhe bankrupcy process, and lndlrecL cosLs such as loss of lnvesLmenL opporLunlLles and loss of confldence from lnvesLors and credlLors. ln
Lhe conLexL of a crlsls and durlng flnanclal Lurmoll, lnvesLors wlll Lurn Lowards asseLs whlch are [percelved as safe / percelved as rlsky / percelved as belng of average
quallLy] and Lry Lo sell asseLs [percelved as safe / percelved as rlsky / percelved belng of average quallLy] . 1hls shlfL ln lnvesLmenL behavlours ls called ["fllghL Lo llquldlLy"
/ "fllghL-Lo-quallLy"/ "fllghL Lo quanLlLy"]. AnoLher characLerlsLlc assoclaLed wlLh Lhls conLexL ls [an lncrease ln credlL spreads / a decrease ln credlL spreads / unchanged
credlL spreads] on mosL asseLs excepL for Lhe [rlsklesL asseLs / lowesL quallLy asseLs / safesL and mosL llquld asseLs].
Lven lf lL ls ofLen vlewed as secondary, one of Lhe mosL lmporLanL declslons a company makes ln Lhe pursulL of maxlmlzlng lLs value ls Lhe declslon on how Lo flnance
lnvesLmenLs LhaL wlll enable Lhe flrm Lo generale sales. 1hls ls called Lhe caplLal sLrucLure declslon.
Powever, under Lhe mosL resLrlcLlve seL of assumpLlons, such as [hlgh Laxes, seml-sLrong efflclenL caplLal markeLs, no agency cosLs / no Laxes, perfecL caplLal markeLs and
no agency cosLs / no Laxes, sLrong efflclenL caplLal markeLs, hlgh agency cosLs], Modlgllanl and Mlller sLaLe LhaL Lhe value of a company ls [noL affecLed / affecLed] by lLs
caplLal sLrucLure. 1hls proposlLlon lmplles LhaL managers [can / cannoL] creaLe value by slmply changlng Lhe caplLal sLrucLure of Lhe company. Conslder a company wlLh a
100 equlLy flnanclng. 1he value of Lhe company ls equal Lo Lhe presenL value of lLs free cash flows or operaLlng earnlngs, and [none of Lhe / all of Lhe / parL of Lhe) Lhe
operaLlng earnlngs are avallable Lo Lhe shareholders. Conslder now a company wlLh a 30 debL flnanclng and a 30 equlLy flnanclng. lLs operaLlng earnlngs are spllL
beLween Lhe equlLyholders and Lhe debLholders. 1he value of Lhe operaLlng earnlngs, and Lhe value of Lhe flrm, [ls / ls noL / may someLlmes] change because of Lhe change
ln Lhe caplLal sLrucLure.
When Modlgllanl & Mlller lnLroduce Laxes, Lhe use of debL [provldes a Lax shleld / ls lncreased by Lhe Laxes / ls mlnlmlzed by Lhe Laxes] LhaL enhances Lhe value of Lhe
company [buL decreases / and magnlfles / buL leaves an unchanged] reLurn on equlLy. 1he welghLed average cosL of caplLal ls [lower / ldenLlcal / hlgher] Lhan Lhe one we
would geL ln a world wlLhouL Laxes because Lhe use of Laxes [reduces Lhe/ lncreases Lhe / leaves an unchanged] overall WACC. lL would follow LhaL a company would seek
Lo [mlnlmlze / change / maxlmlze ] Lhe use of debL, and a flrm wlLh [no slgnlflcanL equlLy and almosL 100 debL / 30 equlLy and 30 debL / 60 debL and 40 equlLy]
would have Lhe hlghesL value by beneflLlng from Lhe leverage effecL. Powever, Lhe downslde of flnanclal leverage ls LhaL durlng economlc slowdowns, or slmply lf a
company overesLlmaLed lLs operaLlng earnlngs, companles wlLh more debL wlll have lower value and reLurns on equlLy Lhan Lhose wlLh less debL.


uest|on 2
1ext: LsLlmaLe Lhe annual probablllLy of dlsLress of Mk-1alnmenL uslng 3,9 as Lhe rlsk-free
raLe. use Lhe same daLa as Lhe one from arL 1 CuesLlon 2, excepL for Lhe markeL value of
Mk-1alnmenL's bond whlch ls noL 1030 Aces any more, buL raLher 330 Aces.
8emlnder: flve years ago Lhe company publlcly lssued 13 000 bonds wlLh an orlglnal
maLurlLy of Len years. Lach bond has a par value of 1000 Aces and an annual lnLeresL raLe of
8. Coupons are pald annually.
Also, flve year ago Mk-1alnmenL borrowed 30 000 Lhousands of Aces from Lhe bank aL a
flxed lnLeresL raLe of 9. lL was an amorLlzlng loan over Len years wlLh a consLanL annulLy.
So|ut|on:
Annual probablllLy of dlsLress for Mk-1alnmenL : 13.00
CumulaLlve probablllLy of Mk-1alnmenL's survlval over Lhe 3 years: 44.37
CumulaLlve probablllLy of Mk-1alnmenL's bankrupcy over Lhe 3
years: 33.63

Lxp|anat|ons:
1he soluLlon can be found elLher by uslng Lhe Lrlal and error meLhod, or Lxcel Solver.
uslng Lhe Lrlal and error meLhod, we seL a cell wlLh a probablllLy of dlsLress value (l.e.
p=10), and Lhen we calculaLe cash flows LhaL lncorporaLe Lhls probablllLy of dlsLress Cld
Cld = Cl (1-p)
Cld represenL cash flows Laklng lnLo accounL Lhe probablllLy p LhaL Mk1alnmenL mlghL
bankrupL.
1hen we calculaLe Lhe dlscounLed value aL 3,9. We alm for Lhls value Lo be zero. We Lhen
change Lhe value of p and selecL Lhe value LhaL makes Lhe presenL value of cash flows equal
Lo zero.

0 1 2 3 4 3
?ears 2013 2014 2013 2016 2017 2018
SLandard cash flows
-330.00 80.00 80.00 80.00 80.00 1 080.00
Cash llows Laklng Lhe
probablllLy of dlsLress lnLo
accounL
-330.00 68.00 37.80 49.13 41.76 479.20
ulscounLed value of each cash
flow
-330.00 64.21 31.34 41.37 33.20 339.78
resenL value
0.10




ln Lhe above example, Lhe value of p ls 13, and Lhe presenL value ls almosL zero (0.10).
CumulaLlve probablllLy of Mk-1alnmenL's survlval over Lhe 3 years = !! !!"#!
!
= 44.37
CumulaLlve probablllLy of Mk-1alnmenL's bankrupLcy over Lhe 3 years = 1 - 44,37 = 33.63

uest|on 3
1ext: 1he defaulL of Lhe compeLlLor aL Lhe end of uecember changes Lhlngs. Assess Lhe
lmpllcaLlons of Lhe changes ln parameLers by calculaLlng Lhe cosL of caplLal before and afLer
Lhe crlsls for an unknown company ln unlverse clLy, and choose Lhe slLuaLlon LhaL ls mosL
llkely Lo happen ln a crlsls.
So|ut|on:

Lx|st|ng s|tuat|on |n S|tuat|on 1 S|tuat|on 2
November 2013 |n December 2013 |n December 2013
8lsk free raLe: 4.30 3.30 3.30
LqulLy 8lsk premlum: 4.00 6.00 4.00
uefaulL spread (888): 1.30 6.00 3.30
of equlLy 30.00 33.00 30.00
CosL of equlLy: 8.30 9.30 7.30
CosL of debL: 6.00 9.30 7.00
CosL of caplLal: 6.33 8.22 6.20

SlLuaLlon mosL llkely Lo happen ln a crlsls : S|tuat|on 1


Lxp|anat|on:
CosL of equlLy = 8lsk free raLe + LqulLy 8lsk premlum
CosL of debL = 8lsk free raLe + uefaulL spread
CosL of caplLal = !"#$ !" !"#$%& !! !" !"#$%& ! ! !! !!"#$ !" !"#$ !! !" !"#$
of debL = 1 - of equlLy
SlLuaLlon 1 ls mosL llkely Lo happen ln a crlsls, because cosL of equlLy wlll lncrease.



uest|on 4
So|ut|ons and exp|anat|ons:
IMLICA1ICNS IN CCkCkA1L IINANCL


Imp||cat|ons |n Investment po||cy 1rue lalse

1he number of new lnvesLmenL pro[ecLs by flrms
wlll be hlgher and Lhe lnvesLed amounL wlll be
greaLer because of Lhe lncreased welghLed cosL of
caplLal for all flrms
*
1he hlgher Lhe cosL of
caplLal, Lhe lower Lhe
neL presenL value of
fuLure cash flows, Lhe
lower Lhe number of
pro[ecLs wlLh a poslLlve
nv.


Imp||cat|ons for I|nanc|ng po||cy: 1rue lalse

Cne of Lhe reasons flrms wlll choose equlLy raLher
Lhan debL ls LhaL cosL of debL has lncreased more
Lhan cosL of equlLy
*

CosL of debL wlll
lncrease more Lhan cosL
of equlLy ln a crlsls.


Imp||cat|ons for D|v|dend po||cy: 1rue lalse

Companles wlll lssue hlgher dlvldends ln a crlsls *
Companles wlll noL
necessarlly pay graLer
dlvldends ln a crlsls. lf
anyLhlng, Lhey wlll Lend
Lo behave
conservaLlvely.
Companles wlll buy back more exlsLlng shares ln a
crlsls *

8uy back shares ls a
pollcy equlvalenL Lo LhaL
of paylng dlvldends. So
companles wlll noL
necessarlly buy back
more shares ln a crlsls.