L 09.10Contingent Financing

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Contingent Financing

Lecture 9 / 10

Dr. Tahir Khan Durrani CEngr, MCIT, ACII, MSc, MPhil, CMBA, PhD

Meditation of the week:

“To make no mistake is not in the power of man; but from their errors and mistakes the wise and good learn wisdom for the

future.” Author unknown.



Topic Objectives

• Provide a formal reviewof post-loss financing.

• Resolve post-lossfinancing problems bydeveloping contingentfinancing vehicles.

• To show that simple

contingent financingvehicles add little or novalue.

Dr. Tahir Khan Durrani 2



Comparison of Post-loss financing and Simple

Contingent Financing

• A counterparty agrees to provide the firm with debtor equity financing conditional on some defined eventoccurring.

• The financing is available on terms appropriate tomarket condition of the firm after the event.

• The estimated cash flows from post-loss investmentdecisions are not affected, by the availability of

contingent financing.• The only exception is when investment is time

sensitive and delay is costly.

Dr. Tahir Khan Durrani

3



Line of Credit

• It’s a commitment to make credit available should a

loss event occur, at conditions under which the firm

could secure new debt after the loss.

• Helps to capture the NPV of post-loss investmentopportunities.

• It smooth dividend payment

• It doesn’t resolve the problems of fundability and

agency costs that results in dysfunctional investment

decisions.


4



Line of Credit

• Contingent financing simply anticipates problems, it doesn’t resolve them.

• Similar to post loss financing except wherepost-loss investment is time sensitive.

• Terms on which money is available is fixedin advance and hence can build some degreeof hedging.

– the bank might anticipate post-loss credit risk in advance and price this upfront.


5



Line of Credits and Value Triggers

• Prime autos has an existing product line that is generating asteadily growing earnings stream. Earnings for the coming year areexpected to be 500, and this is expected to grow at 1% per year.The current cost of equity, k E, is 0.09.

• The firm has an existing debt of 2000 with cost of debt, k D, of 0.06.

• The firm has the following investment opportunity. A sports carcan be introduced, and there are two choices. The first is to useconventional design that is sure to sell quite well. The cost of setting up production, distribution and marketing is 5000, and theexpected value of future sales is a certain 7000.

• The second idea is to introduce a radical design, both in technologyand shape. The present value of future income will either be 1000or 11000, each with a probability of 0.5. The capital cost of theproject also would be 5000.

• The transaction cost of issuing either debt or equity is 250 andbankruptcy costs of 750.


6



Example ...

• Value of the firm without new investment: – VoF = e/(k-g) = 500/(0.09-0.01) = 6,250

• Value if project A is undertaken: – Total earnings = 6,250 + 7,000 = 13,250.

– With debt financing total debt obligation would be 2,000 + 5,250= 7,250

– Equity will be worth 13,250 – 7,250 = 6,000

• Value if project B is undertaken: – VoF = 6,250 + {0.5(1,000) + 0.5(11,000)} = 12,250

– VoE = 12,250 – 7,250 = 5,000

• Shareholders are better off with project A.


7



Prime Autos Suffers a Liability Loss

• Before the firm commits to the new products, it is

hit with a liability suit (3,750).

• A trust fund is set up that will hold 60% of

earnings from the existing product. The trust has

priority over creditors and shareholders.

• The Firm now is faced with the decision of

whether to undertake one of the new products, and

if so, which. Under this analysis the firm issuesnew shares to finance the new project.

• The firm raises equity for the full capital cost

(5000) plus the transaction cost (250).Dr. Tahir Khan Durrani

8



Analysis with equity financing

• Project A is Chosen – The existing operations are now worth a present value

200/(0.09 – 0.01) = 2500.

– If the firm choose project A, total value will be 2500 + 7000 =

9500. – There is no possibility of default, debt will be worth its full face

value of 2000, and equity (old plus new) will be the worth

7500.

– To ensure that new investors will subscribe the full 5250. Thenew equity must be worth this amount and the old equity will

be worth 2250.

– In other words, the new shareholders will hold a proportion

(5250:7500) of the total number of shares.Dr. Tahir Khan Durrani 9



Analysis with equity financing

• Project B is Chosen – In the worst case the firm will be worth 2500+1000 = 35000,

which is still enough to pay thy old debt of 2000.

– However the project performs, there is no bankruptcy and the

old debt is worth its face of 2000. – The total firm value is {0.5(2500 + 1000) + 0.5(2500 +

11000)} = 8500.

– The equity is worth 8500 – 200 = 6500.

– If we use the same argument as above, the new equity is worth5250 and the old equity is worth 1250.

– With equity financing, project A would be preferred by the

firm’s original owners.




Analysis with Debt Financing

• Project A is Chosen – If the firm chooses project A, total value will

be 2500 + 7000 = 9500.

– The firm has an old debt obligation of 3000 anda new debt obligation of 5250.

– There is no possibility of default, and debt will

be worth its full face (2000 senior debt and5250 junior debt).

– equity will be worth 2250.





• Project B is Chosen – In the worst case the firm will be worth 2500 + 1000 =

3000.

– Since the debt obligation is 7250, the firm will be

bankrupt.

– After deducting bankruptcy cost 750, there will be

only 2750 to divide between creditors of which senior

debt will get 2000 and junior debt 750. – In the best case the firm is worth 2500 + 11000 =

13500, which is divided 2000 to senior debt, 5250 to

junior debt, and 6250 to equity.





• The values of the various claims are now:• Senior debt = 0.5(2000) + 0.5(2000) = 2000

• Junior debt = 0.5(750) + 0.5(5250) = 3000

• Equity = 0.5(0) + 0.5(6250) = 3125

• The firm is truly locked into the assets

substitution problem if it tries to finance the

new project with debt after the liability loss.




Analysis with Debt Financing • If creditors lent 5250, the firm would then wish to choose

B since equity is more valuable under this choice.

• However this gain in value comes about by a default on

junior debt if the project turns out bad.

• Investors would anticipate the choice of B an subscribeonly 3000 for the new debt.

• This is not enough to fund the project.

• An attempt to signal that will A will be chosen has theusual credibility problem because creditors can anticipate

that shareholders have an incentive to switch their choice

after the money is raised.





• The firm may be unable to undertake eitherproject with debt financing

• Thus, the only feasible choice for the firm, after

the liability suit, is to finance the project with newequity.

• In contrast, the firm could have used either equity

or debt before the liability suit.• The increase in leverage caused by the liability

settlement has constraint the options for post-loss

financing. Dr. Tahir Khan Durrani 15



Summary of stakeholder claims with different options for post-

loss financing the new project

Equity Debt

Project A:

Senior debt

New Debt/Equity

Equity

2000

5250

2250

2000

5250

2250

Project B:

Senior debt

New Debt/Equity

Equity

2000

5250

1250

2000

3000

3125





• If the firm could have raised the amount of 5250 to payfor the project in a new debt issue, project B would have

been chosen because old equity could have been worth

3125 as opposed to the 2250 with project A.

• But if the firm tried to issue new debt, investors would

anticipate choice of project B and would subscribe only

3000 for the new debt issue despite its face value of

5250.• The firm would not have been sufficient money to pay

for the project and would be locked in the substitution

trap.





• The resolution was to pay for the project with apost-loss equity issue, in which case project A

look much better to original shareholders (2250

compared with 1250 for project B).• If the debt had been issued with a face of 5250,

we could have thought of its value as being the

difference between its nominal value of 5250 and

the default put of 2250, yielding a net value of

3000.





• Now consider what would happen if the firm hadaccess to a line of a credit up to a value of at least

5250.

• After the loss original shareholders would be betteroff by drawing on the LOC for the 5250 and choosing

project B, in which case the bank offering such as

LOC would anticipate this sort of behavior.

• If the probability of the liability loss were 0.5, thenthe bank would require a securing fee of 0.5 time the

value of the post-loss default put option: that is,

0.5(2250) = 1125.Dr. Tahir Khan Durrani 19



Shareholder Value without LOC

• Now consider whether it would make sense to setup the LOC:

– Without or with the liability loss; raise new equity issue and

undertake project A.

– Assume the probability of liability loss is 0.5.

– Value of owner’s share is weighted average of value without

liability loss and the value after liability loss.

– Without loss, firm choose A and equity is 6000. With loss firm

choose to raise 5250 in new equity and undertake A, leaving

original equity worth 2250.

– Ex ante equity value without LOC

= 0.5(6000) + 0.5(2250) = 4125


20



Shareholder value with LOC

• Equity is worth 6,000 without the liability loss.• With liability loss the firm is free to draw the full 5,250,

then B will be chosen and equity will be worth 3,125, asshown in the table.

• The bank anticipates the ex post choice of B and chargesan up-front fee equal to the expected value of then-defaultput option (5,250 -3,000 = 2,250).

• Ex ante equity value:

– VoE = 0.5(6,000) + 0.5(3,125) – 0.5(2,250) = 3,437.5

– The LOC has removed a discipline that spot capital marketsimpose on investment choice. Underinvestment aspect of debtfinancing prevents the firm from making inferior project choice.


21



Options

• An option is a claim without any liability. Itis a claim contingent upon the occurrence of

certain conditions.

• Thus an option is a contingent claim.

• An option is a contact that gives the holder a

right, without any obligation, to buy or sell

an asset at an agreed price on or before a

specified period of time.




Options

• The option to buy an asset is known as a calloption, and the option to sell an asset is called a

put option.

• The price at which option can be exercised iscalled an exercise price or a strike price.

• The asset on which the put or call option is

created is referred to as the underlying asset. • Depending on when an option can be exercised, it

is classified in one of the following two categories




Options

• European option: When an option is called to beexercised only on the maturity date, it is called a

European option.

• American option: When the option can beexercised any time before its maturity, it is called

an American option.

• When will an option holder exercise his right? – He will exercise his option when doing so provides

him benefits over buying or selling the underlying

asset from the market at the prevailing price.




Options

• In-the-money: a put or a call option is saidto in-the-money when it is advantageous for

the investor to exercise it. In the case of in-

the-money call options, the exercise is lessthan the current value of the underlying

asset, while in the case of the in-the-money

put options, the exercise price is higher thenthe current value of the underlying asset.




Options

• Out-of-the-money: A put or a call option isOut-of-money if it is not advantageous for

the investor to exercise it. In the case of the

out-of-money call options, the exerciseprice is higher than the current value of the

underlying asset, while in the case of the

out-of-money put options, the exercise priceis lower than the current value of

underlying asset.




Options

• At-the-money: When the holder of a put or acall option does not lose or gain whether or

not he exercise his option, the option is said

to be at-the-money. In case of the out-of-the-money options the exercise price is equal to

the current value of the underlying asset.




Call option

• A Call option on a share (or

any asset) is a right to buy

the share at an agreed

exercise (strike) price.





Out-of-the- money

(Bad outcomes)

Value of the

call option

Exercise Price

Value of the Share

(The Underlying Asset)

Unlimited

Pay-off Potential

In-the- money

(Good outcomes)

0

Pay-off of a call option Buyer




Value of the Share

(The Underlying Asset)

Out-of-the- money

(Bad outcomes)

Exercise Price

Unlimited

Pay-off Potential

In-the- money

(Good outcomes)

0

Loss

Value of the call

option

Pay-off of a call option writer



Call option

• Suppose that the current share price (S) of Surf Computer’s share is Rs. 110. You expect that price in a 3

month period (St) will go up to Rs. 120. But you do fear

that price may also fall below Rs. 110.

• To reduce the chance of your risk and at the same time tohave an opportunity of making profit, instead of buying

the share, you can buy a 3 month call option on Surf’s

share at an agreed exercise price (E) of, say, Rs.105.

• Ignoring the option premium, taxes, transaction costs and

the time value of months? You will exercise your option

since you get a share worth Rs. 110 by paying an exercise

price if Rs. 105.Dr. Tahir Khan Durrani 31



Call option

• You will gain Rs. 5 that is, the pay-offer the valueof your call option at expiration (Ct) is Rs. 5. Your

call option is in-the-money at maturity.

• What will you do if the price of the share is Rs. 100

when the call option on Surf’s share expires?

Obviously, you will not exercise the option. You

gain nothing.

• Your call option is worthless and is out-of-the-

money at expiration. You may notice that the value

of your call option can never be less than zero.





The Call Option Holder's Pay-off at Expiration

Rs Rs Rs Rs Rs

Share price (St) 100 105 110 115 120

Buyer's Inflow:

of Share - - 110 115 120

Buyer's outflow:

Exercise price - - 105 105 105

Call premium 5 5 5 5 5

Net Pay off -10 -5 0 +5 +10




120

0

10

5

-5

-10

100 105 110 115

Break-even Price

Premium

Limited Loss

Area Exercise Price Unlimited Profit

Potential

Share Price

Pay- Off

Pay-off of the Call option buyer




The Call Option Seller's Pay-off at Expiration

Rs Rs Rs Rs Rs

Share price (St) 100 105 110 115 120

Seller's Inflow:

Exercise price - - 105 105 105

Call premium 5 5 5 5 5

Seller's Inflow:

Share price 100 105 110 115 120

Net Pay off 10 5 0 -5 -10




Unlimited Loss

Pay- Off

Share Price

Break-even Price

Limited Loss Area

Exercise Price

Pay-off of the Call option Seller

120

0

10

5

-5

-10

100 105 110 115

Premium



Put Option

• A put option is a contract that

gives the holder a right to sell a

specified share (or any otherasset) at an agreed exercise price

on or before a given maturityperiod.


P t O ti



Put Option

• A put option (sometimes simply called a"put") is a financial contract between two

parties, the seller (writer) and the buyer of

the option.• The buyer acquires a long position offering

the right, but not obligation, to sell the

underlying instrument at an agreed-upon

price (the strike price).




Put Option

• If the buyer exercises the right granted by the option, theseller has the obligation to purchase the underlying at the

strike price.

• In exchange for having this option, the buyer pays the

writer a fee (the option premium).

• The terms for exercise differ depending on option style.

• A European put option allows the holder to exercise the

put option for a short period of time right beforeexpiration, while an American put option allows

exercise at any time before expiration.




Put Option

• The put buyer either believes it's likely the priceof the underlying asset will fall by the exercise

date, or hopes to protect a long position in the

asset.

• The advantage of buying a put over short selling

the asset is that the risk is limited to the premium.

• The profit, for a put buyer, is limited to the strike price less the underlying asset’s spot price (in

addition to the premium already paid).




Put Option

• The put writer does not believe the price of the underlying security is likely to fall.

• The writer sells the put to collect the

premium.• The total loss, for the put writer, is limited

to the strike price less the spot and premium

already received.

• Puts can also be used to limit portfolio risk,

and may be part of an option spread.Dr. Tahir Khan Durrani 41



Put Option

• A naked put (also called an uncovered put ) is aput option where the option writer (i.e., the

seller) does not have a position in the underlying

stock or other instrument.

• This strategy is best used by investors who want

to accumulate a position in the underlying stock -

but only if the price is low enough.

• If the investor fails to buy the shares, then he

keeps the option premium as a 'gift' for playing

the game.




Put Option • If the market price of the underlying stock is below

the strike price of the option when expiration arrives,the option owner can exercise the put option and force

the writer to buy the underlying stock at the strike

price.• That allows the exerciser to profit from the difference

between the market price of the stock and the option's

strike price.

• But if the market price is above the strike price when

expiration day arrives, the option expires worthless

and the writer profits by keeping the premium

collected when selling the option.Dr. Tahir Khan Durrani 43




Value of Share

(The underlying asset)

Exercise Price

Limited

profit

In-the-money Out-of-the-money

Value of the put option

(Option buyer)

Pay-off for a put option buyer




In-the-money Out-of-the-money

Pay-off for a put option Seller

Exercise Price

Limited

Profit

Value of Share

(The underlying asset)

Value of the put

option

(Option Seller)

P t O ti



Put Option

• Suppose you expect price of HBL’s share to fall in thenear future. Therefore, you buy a 3 month put option

at an exercise price (E) of Rs. 50.

• The current market price of HBL’s share (S) is Rs. 48.

If the price actually falls to (St) Rs 35 after three

months, you will exercise your option.

• You will buy the share for Rs 35 from market and

deliver it to the put-option seller (writer) to receive Rs50.

• Your gain is Rs 15, ignoring the put option premium,

transaction costs and taxes.Dr. Tahir Khan Durrani 46

P t O ti



Put Option

• You will forgo your put option if the share pricerises above the exercise price; the put option is

worthless for you and is value is zero.

• A put buyer gains when the share price fallsbelow the exercise price.

• Ignoring the cost of buying the put option(called

put premium), his loss will be zero when the

share price rises above the exercise price since

he will not exercise his option.





The Put Option Holder's Pay-off at Expiration

Rs Rs Rs Rs Rs

Share price (St) 18 25 28 30 40

Buyer's Benefit:

Exercise option 30 30 30 - -

Buyer's Cost:

Put Premium 5 5 5 5 5

Buy share 18 25 28 - -

Net Pay-off (Profit) 7 0 -3 -5 -5




40 35 30 25 20

0

-10

10

20

30

5 10 15

Premium

Profit

Potential

Break-even price

Exercise

price

Share Price

Pay-off

Pay-off for a put option buyer




The Put Option Holder's Pay-off at Expiration

Rs

Rs

Rs

Rs

Rs

Share price (St) 18 25 28 30 40

Seller's Benefit:

Put Premium 5 5 5 5 5

share 18 25 28 - -

Seller's Cost:

Exercise option 30 30 30 - -

Net Pay-off -7 0 3 5 5




Pay-off

Share Price

Loss

Potential

Exercise

price

Premium

Break-even price

40 35 30 25 20 15 10 5

10

0

-20

-30

-10

Pay-off for a put option seller

Default Put Option



Default Put Option.

• Debt is a fixed obligation for a firm.

• In return for borrowing money. The firm commits to a

series of interest payments plus repayments of principle.

• These payments take priority over payments to

shareholders; equity is the residual claim.

• One of the decisions the firm makes constantly, though

often by default, is whether to continue or to liquidate its

operations.• The decision to continue is rational if the ongoing value

exceeds the liquidation value.





D f lt P t O ti



Default Put Option.

• The firm has debt with a face value shown as D.

• The firm can discharge its debt liability by repaying debt

for this amount, and the value of debt is shown as its face

value D if the firm is solvent.

• Suppose the total value of the firm, labeled V(F), is lessthen D.

• The firm simply does not have sufficient value to

discharge its debt obligation.• Under the absolute priority rule of bankruptcy, the equity

is now worthless and the whole firm essentially belongs to

the creditors.


Defa lt P t Option



Default Put Option.

• Consequently, the value of Debt is the 45o line when V(F)

< D.

• When V(F) ≥D. The value of equity is the residual;

• Zero, when V(F) < D, and

• D when V(F) ≤ D; and

• V(F) – D when V(F) > D.

• The equity value is shown by a line coincident with the

horizontal axis up to point D and sloping up at 45o

thereafter.

• The relationships between the debt and equity can be seen

as option positions.


Default Put Option



Default Put Option.

• First, notice that the payoff line to equity is the same as

that for a call option.

• If we consider that debt and equity are simply claims on

the value of the firm, we see them immediately as

derivates.• Notice that equity is zero when the underlying asset (the

value of the firm) is less than D, and equity is worth the

firm value minus D otherwise.

• Thus, equity emerges as a call option on the underlying firm value with as exercise price equal to the face value of

debt. This relationship is denoted:

• V ( E ) = C { V ( F ), D } Dr. Tahir Khan Durrani 56

Default Put Option



Default Put Option.

• This equation says that the value of equity, V(E),is the same as a call option, C{.}, on the value of

the firm, V(F), where exercise price is the face

value of debt, D.

• Start with the 45o line shown as a thin solid line

labeled V(F); this is the value of the firm.

• If we subtract the face value of debt, D, from V(F)

we are left with the dotted line V(F) – D.

• The downwards arrow shows the effect of

deducting D from V(F).


Default Put Option



Default Put Option.

• Also drawn on the diagram is a put option with astriking price equal to the face value of debt.

• This put option shown as a dashed line and

labeled the “default put option”.

• If this put option is added to V(F) – D as shown

by the upwards arrow, we are left with the bold

solid kinked line, which is the equity payoff

shown in the Figure;

• We have shown how the equity call option is

related to other firm values.

• Dr. Tahir Khan Durrani 58



Contingent Equity-Loss Put Equity Options

• The firm makes arrangements for acounterparty to provide equity capital under

agreed terms and circumstances.

– The firm can issue a put option on its stock.

– In exercising this option, the firm may issue

new shares and put these to the counter-party at

the agreed striking price. – In insurance these are options on preference

shares.


59



Design Choices for Loss Equity Put Options

• A put option is issued by the firm on its ownstock.

• They are triggered by some risky event of

risk management concern (property orliability loss).

• The option is exercised only when two

triggers are activated: – The stock price must fall below the strike price.

– Loss event must occur (liability loss, currency

loss etc). Dr. Tahir Khan Durrani

60



Loss Events and Stock Prices


61

LossEvent £

Upper

Trigger

Lower

Trigger

Expected fallin Stock Price

(a) Profit onExercise

Share Price

A

Z X S P1 Y P2

(b)

Normal put




• Figure (a) shows the expected relationship between loss

events and expected stock prices.

• There is no magic in the convex shape; the main thing is

that the curve is upwards-sloping, meaning that losses

result in an expected fall in the share prices.

• The relationship might not be deterministic.

• There may be idiosyncratic features of a loss that can

cause its effect on stock price to be greater or less thandepicted;

• The relationship is only an expected one.





• Figure (b) shows the payoff to a normal put option whereS is the striking price; this is the solid line kinked at S that

shows the profit to the firm conditional on any given stock

price.

• The price of the option has not been deducted, so this is agross payoff.

• Now suppose the option has a second trigger, which is the

loss event.

• Let us start with the current stock price as P1 as shown in

the figure (b).

• At P1 the option is “out-of-the-money”.




Loss Events and Stock Prices • Suppose now that a loss event occurs of sufficient size to

satisfy the lower trigger shown by arrow and marked ∆ on the

horizontal axis of the figure (a).

• The same change in the stock price is shown in part (b) also as

a arrow marked ∆.

• Thus, starting with P1, a loss event above the price S to point

X , and the option is now in the money and can be exercised.

• Had the current stock price been P2, the same loss been

sufficient to depress the stock price, and the option wouldhave been out of money (point Y ).

• Thus, the double trigger put option (like a normal put option)

becomes more valuable the lower the stock price.




Trigger 1

• Two event trigger option: – The property loss must lie between the lowerand upper triggers, as shown in fig. 1a above.

– Any loss outside the trigger event will preclude

exercise even if the option is otherwise in themoney.

– Points X and Z are not triggers, but are theexpected stock values that correspond to the

real event triggers. – If the loss takes the prices below Z or above X,

the option that is otherwise valuable is lost.


65



Trigger 2

• Instead of the option knocking out when loss eventexceeds the trigger, we can cap the option payout

at value A, as shown in fig. (b).

• Combine the long put option with an exerciseprice of S and a short put option with a strike price

of Z; and a short position in a bond valued at A.

• The two options would create no incentive for thefirm with a loss above the upper trigger to

manipulate its size.


66



Trigger 3

• Design the loss put option with a floating strike price.• The strike price is fixed in relation to the value of the

stock would have taken before the loss.

– For loss put option triggered by fire or earthquake loss,

the strike price could be set relative to the stock priceon the day preceding the event.

• It avoids a situation in which the firm is holding an in themoney option, cannot be exercised because the event

trigger has not quite been activated.• It doesn’t avoid the incentive problems


67



CatEPut ™ options

• Designed by AON and issued under its trade mark.• Issued by insurance firms in conjunction with their

exposure to accumulated natural catastrophe claims.

• These are preference share issues, that have buy-back

option features within a specified time period.• The enable a firm to undertake post-loss investment

projects, and the value created will shore up the value of existing debt.

• It partly hedges the loss further securing the debt.• On exercise a senior claim is created rather than an equity

dilution.


68



Value Added through Loss Equity Puts

• They reduce the probability, and the expected directcosts, of bankruptcy.

• Equity injection after the loss permits the firm to capturevalue through post-loss investment.

• These effects both increase the value of the firm and

moderate the increase in leverage that follows major lossevents.

• Apart from reducing the prospect of bankruptcy, they alsoaddress the crowding-out problem.

• Its priced ex ante, firm finances post-loss investmentwithout immediately facing the higher marginal costs of capital raised in external markets.


69

Embedding a Short Loss Put Option in the



Embedding a Short Loss Put Option in the

Firm’s Debt

• For events that are so large, the main losers are thecreditors, who must bear the bankruptcy costs orrenegotiate with shareholders.

• By embedding a short put option in the debt , we

can replicate the passing of much of the firm tocreditors without incurring the bankruptcy costs.

• For bondholders this restructuring is better

anticipated in the terms of the debt issue, thanrelying on ex post negotiation, where theirbargaining position is weaker and will beartransaction costs.


70



Equity Put Options and Future Underinvestment

• We return to the Prime Autos example:• Suppose that Prime autos paid for both the

liability loss of 3,750 and the new investment of 5,250 with a post loss equity issue.

• This now means all the firm's earnings are nowcaptured by shareholders and creditors. It needs toraise total of 9000

• This means the PV of all cash flows is: – 6,250 + 7,000 = 13,250

– Total VOE = 13,250 – 2,000 = 11,250


71



Equity Put Options and Future Underinvestment

Equity Debt

Project A:

Senior debtNew Debt/Equity

Equity

20005250

2250

20005250

2250

Project B:

Senior debt

New Debt/Equity

Equity

2000

5250

1250

2000

3000

3125


The stakeholder values under the various post-loss investment and

financing Options in prime Autos are summarised as follows:

F th I f ti



Further Information

• Prime has 1,000 original outstanding shares.

• New shares issued:N = Cm/(ET – C) = 9000(1000)/(11,250 – 9,000)

= 4,000 shares.

– Share price = 11,250/5000 = 2.25

• It is equity value of 2250 for original shareholders. If loss did not occur, equity would be worth 6000 or 6 pershare.

• Assume the firm is financing the liability claim with an

equity put option, with a strike price, of 5.• To pay the liability claim of 3750 firm will exercise the

put option and issue 750 shares.

• Firm can now finance A or B.


73

P l E i Fi i f N I



Post-loss Equity Financing of New Investment

• Project A is chosen: – To raise 5,250 in new equity, how many shares do we

need:

• n = 5,250(1750)/(11,250 – 5250) = 1531

– We now have 1531 + 750 +1000 = 3281

– New share price = 11,250/3281 = 3.4288

– Original shares are worth 3,429.

– Shares from the put option are worth 2,571

– The counterparty hedged part of the 3,750 liability

loss.


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Post-loss Equity Financing of New Investment

• Project B is chosen: – Worst case scenario the firm is worth:

• 6,250 + 1,000 = 7,250 (no default on debt)

– Total VoF is {0.5(7250) + 0.5(17,250) = 12,250

– VoE = 10,250

– New equity is 5,250

– Equity on put option is 2,143

– Original equity is 2,857


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Equity Debt

Project A:

Senior debt

New Debt/Equity

Put CounterpartyEquity

2000

5250

25713429

2000

5250

25713429

Project B:

Senior debt

New Debt/Equity

Put Counterparty

Equity

2000

5250

2143

2857

2000

5250

2143

2857


P t l fi i l it t



Post-loss financing vs. loss equity puts.

• After exercising the option and paying off theliability defendants, the firm would rationallychoose project A, regardless of whether its fundedby debt or equity.

• Since the trust had priority over all thestakeholders, the liability was like senior debt andeffectively increased the firm’s leverage.

• The equity put unlevers the firm and provide a

partial hedge.• This removes the post-loss asset substitution

problem and the firm can make its investmentdecisions in the same way as if no loss had

occurred. Dr. Tahir Khan Durrani

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L i O t



Learning Outcomes• We learnt that the ability of

contingent financing to addvalue is limited.

• LOC can remove capital market

scrutiny, but is important for

earnings smoothing.• Contingent equity partly hedge

the firm, provide with post-loss

liquidity and mitigate

underinvestment and assetsubstitution problems.

• The effectiveness of loss equity

puts.“The only time you cannot afford to fail is

the last time you try ” Charles Kettering

L 09.10Contingent Financing

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