Exercises to lecture note 5 - Lecture Note 5: Lecture Note...

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Lecture Note 5: 1 Lecture Note 5 Exercises 1. Vaporware Products has no internal funds. It is located in the Republic of Upper Lasagna, where debt is illegal. Thus, in order to invest in new projects, it will have to issue equity. Vaporware has a wonderful (riskless) project available, which costs $100 in year zero and yields $140 in year 1. The payoff to this project is public information-it is known both by managers and the market. The problem is that the market does not know whether the current value of Vaporware's existing assets are $100 or $20, and they regard both outcomes as equally likely. The CEO of Vaporware knows the true value of the existing assets, but in the Republic of Upper Lasagna it is strictly forbidden to discuss your existing assets, so the managers are not able to reveal their true value. Assume that investors are risk neutral, the discount rate is zero, no taxes, and the management of Vaporware maximizes the value of the existing shareholder's stake. There are currently 100 shares outstanding. A. If the market expects that Vaporware's managers will issue equity and undertake the investment no matter what (that is, independent of the true value of the existing assets), how many shares will Vaporware have to issue in order to raise $100? B. If the management knows the true value of the existing assets is $100, would they want to issue equity (under the scenario in A)? C. If the management knows the true value of the existing assets is $20, would they want to issue equity (under the scenario in A)? D. Suppose that instead of the scenario in (A), the market expects that Vaporware's management will issue equity and invest only when the managers knows the true value of the existing assets is $20. How many shares will Vaporware have to issue in order to raise $100? E. Under the assumption in D, if the management knows the true value of the existing assets is $100, would they want to issue equity? F. Under the assumption in D, if the management knows the true value of the existing assets is $20, would they want to issue equity? 2. There are two equally probable states of nature. The true state is revealed to management at t=0 and to investors at t=1. Asset values and investment opportunities are: Good state Bad state Asset-in-place 150 50 Investment opportunity (NPV) 20 10 The firm has no cash or marketable securities and the investment opportunities require $100, so the firm must issue stock to raise $100 if it goes ahead.
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Lecture Note 5: 2 (1) What is the firm’s expected value, with or without new equity issue? (2) With new equity issue and the investment, what is the firm’s expected value that the old shareholders get, if the state is good and if the state is bad? (3) If the managers have superior information about the firm’s prospect, should they issue
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Exercises to lecture note 5 - Lecture Note 5: Lecture Note...

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