Foundations_ Chapter-3 : Stulz.pdf
Hi David,
I am a confused concerning several concepts in this document:
1/ Q 44-1 :
• Debt Equity Ratio at the beginning is without taking account of project and D/E ratio at end take into account project?
• Value of D/E ratio at end of year is 3,33. I think that it assumes that cash flow of project at the end of year (Pay-off) has the same probability of outcome as Gold Future. I have tried to prove it in another spreadsheet (see attached) in you original Spreadsheet. In this new spreadsheet I assume 2 scenarios with 50% probability of outcome each. I finally found the same result as solution (i.e. 3,33). Could we then assume that project pay-off has not the same probability (assume for example that project firm is to diversify its activity in a new industry without ant link with gold industry so probability of outcome for this future pay-off is different). I have tried to compute this case (I assume in my example that future pay-off is a certain outcome so that probability=100%). Am I wrong?
• If I am not wrong, following the results could we conclude that the more the probability of project pay-off the less the project is dilutive for shareholders?
2/ In Merton Model, Value of risky debt = Value of risk free debt minus (-) the Value of a Put Option on firm’s assets. So if I own a risky obligation and I conclude a swap in which I pay fixed rate = risk free rate and received Libor; could I consider that I have hedged market risk of the risky bond (i.e. due to interest rate movement) and not the credit risk (i.e. due to credit spread movement) ?
3/ I have tried to link this exercise with other concepts which seems linked (I do not know whether it is a good idea!): Cash Flow at risk and Surplus at Risk.
For Surplus at risk (http://www.bionicturtle.com/how-to/spreadsheet/8.b.3_surplus_at_risk_sar/).
1. Could we consider that Surplus is Equity? Indeed, because of seniority, we first compute Firm value (Vt), we observe Face Value of debt (Dt) and we compute Equity as a residual (Et). In this linked spreadsheet, could we consider Asset as Vt, Liabilities as Dt and Surplus as Et? In this case, is return on surplus Return on Equity (ROE, which is itself a residual return)? Is Surplus at risk is Equity at risk?
2. If ROE is residual, could we consider that debt return (cost) is benchmark for equity return? Then could we construct a risk adjusted (from risk) ratio (Residual return/Risk which risk could be total risk or residual risk)?
3. Comparatively of Q44-1, could we say that this Surplus at Risk example i) takes into account return on the period and volatility on the period for at once Debt and Value (and by “deduction” equity return) ii) do not take into account new project (and its cash flow) ?
For Cash Flow at risk (http://forum.bionicturtle.com/viewthread/43/ and http://forum.bionicturtle.com/viewthread/339/) :
4. Comparatively of Q44-1, could we say that these Cash Flow at Risk examples i) takes into account return on the period and volatility on the period for project cash flow (pay-off) ii) take into account cash flow that firm generate ?
5. In Q44-1, given the Debt and Equity structure of a firm, we try to assess whether characteristics (Cash flow) of new project is finally dilutive for shareholders. In theses examples, given a ability for a firm to generate cash flow (which are risky b/c of its variance), we try to asses whether characteristics of new project (Cash flow; its variance; how these project is link with market[i.e. thanks to beta] and cash flows of firm ) is finally worth undertaking for firm.
6. I have some difficulties to link case of Q44-1 and this CFAR example (case of a firm that has decision to take concerning new project given its Debt/Equity structure; and CFAR decision rules). Could we have a situation of a firm that accept decision b/c CFAR is ok and reject the decision b/c it is dilutive for shareholder?
Thank you very much for your help.
Hervé
PS : sorry i have tried several time to attache spreadsheet but it does not work (size<3000KB). Is there another solution ?
Hi David,
I am a confused concerning several concepts in this document:
1/ Q 44-1 :
• Debt Equity Ratio at the beginning is without taking account of project and D/E ratio at end take into account project?
• Value of D/E ratio at end of year is 3,33. I think that it assumes that cash flow of project at the end of year (Pay-off) has the same probability of outcome as Gold Future. I have tried to prove it in another spreadsheet (see attached) in you original Spreadsheet. In this new spreadsheet I assume 2 scenarios with 50% probability of outcome each. I finally found the same result as solution (i.e. 3,33). Could we then assume that project pay-off has not the same probability (assume for example that project firm is to diversify its activity in a new industry without ant link with gold industry so probability of outcome for this future pay-off is different). I have tried to compute this case (I assume in my example that future pay-off is a certain outcome so that probability=100%). Am I wrong?
• If I am not wrong, following the results could we conclude that the more the probability of project pay-off the less the project is dilutive for shareholders?
2/ In Merton Model, Value of risky debt = Value of risk free debt minus (-) the Value of a Put Option on firm’s assets. So if I own a risky obligation and I conclude a swap in which I pay fixed rate = risk free rate and received Libor; could I consider that I have hedged market risk of the risky bond (i.e. due to interest rate movement) and not the credit risk (i.e. due to credit spread movement) ?
3/ I have tried to link this exercise with other concepts which seems linked (I do not know whether it is a good idea!): Cash Flow at risk and Surplus at Risk.
For Surplus at risk (http://www.bionicturtle.com/how-to/spreadsheet/8.b.3_surplus_at_risk_sar/).
1. Could we consider that Surplus is Equity? Indeed, because of seniority, we first compute Firm value (Vt), we observe Face Value of debt (Dt) and we compute Equity as a residual (Et). In this linked spreadsheet, could we consider Asset as Vt, Liabilities as Dt and Surplus as Et? In this case, is return on surplus Return on Equity (ROE, which is itself a residual return)? Is Surplus at risk is Equity at risk?
2. If ROE is residual, could we consider that debt return (cost) is benchmark for equity return? Then could we construct a risk adjusted (from risk) ratio (Residual return/Risk which risk could be total risk or residual risk)?
3. Comparatively of Q44-1, could we say that this Surplus at Risk example i) takes into account return on the period and volatility on the period for at once Debt and Value (and by “deduction” equity return) ii) do not take into account new project (and its cash flow) ?
For Cash Flow at risk (http://forum.bionicturtle.com/viewthread/43/ and http://forum.bionicturtle.com/viewthread/339/) :
4. Comparatively of Q44-1, could we say that these Cash Flow at Risk examples i) takes into account return on the period and volatility on the period for project cash flow (pay-off) ii) take into account cash flow that firm generate ?
5. In Q44-1, given the Debt and Equity structure of a firm, we try to assess whether characteristics (Cash flow) of new project is finally dilutive for shareholders. In theses examples, given a ability for a firm to generate cash flow (which are risky b/c of its variance), we try to asses whether characteristics of new project (Cash flow; its variance; how these project is link with market[i.e. thanks to beta] and cash flows of firm ) is finally worth undertaking for firm.
6. I have some difficulties to link case of Q44-1 and this CFAR example (case of a firm that has decision to take concerning new project given its Debt/Equity structure; and CFAR decision rules). Could we have a situation of a firm that accept decision b/c CFAR is ok and reject the decision b/c it is dilutive for shareholder?
Thank you very much for your help.
Hervé
PS : sorry i have tried several time to attache spreadsheet but it does not work (size<3000KB). Is there another solution ?
