Prof. Mark Roe brings up the following issues:

  1. "In a bankruptcy any single creditor is entitled to get the liquidation value of its claim. So any creditor can assert that what it would get if Chrysler sold its factories quickly would be more than the 32 cents per dollar that Treasury had guaranteed Chrysler's secured creditors before the government deal fell apart this week." Establishing the liquidation value can be difficult whether or not Chrysler is liquidated. "Although the judge doesn't actually need to liquidate Chrysler, the judge must determine what it would have gone for if there were a liquidation. Some creditors appeared ready to bring that case to the bankruptcy judge."
  2. "The whole class of secured creditors is entitled to the "fair value" of their claims. Usually fair value -- the money that can be obtained from operations -- is greater than liquidation value, though Chrysler may be an exception. The government thinks the fair value issue will be resolved easily. That's because in a bankruptcy proceeding the creditors whose claims amount to two-thirds of the total amount of debt can bind the rest to take the deal. Indeed, the judge doesn't have to figure out whether value is fair, if the class of creditors votes in favor. And since two-thirds have already raised their hands in favor of 32 cents on the dollar, it seems to be a done deal. But this time it might not be so easy. Not all of those who've already raised their hands in favor prior to bankruptcy, especially the smaller investors, will still be raising their hands inside Chapter 11. They can change their mind, and some just didn't want any negative publicity before the bankruptcy."
  3. "There could be a legal fight over whether the vote of Citibank and the other "big four" creditors -- J.P. Morgan Chase, Morgan Stanley and Goldman Sachs, who together hold 70% of Chrysler's debt -- should be counted toward the two-thirds threshold that would bind the company's other 42 creditors. The Bankruptcy Code requires that the votes of creditors be given in "good faith." It won't be hard for the smaller creditors to argue that Citibank and other TARP recipient's votes aren't in full good faith. In agreeing to Treasury's offer of 32 cents for each $1 of their debt, the objectors would say, Citibank and some others were influenced by the fact that Treasury was keeping them afloat with federal subsidies. If this type of litigation begins, it won't be easily resolved."
  4. "Fiat will want to rationalize Chrysler's bloated dealership network. Indeed, this once seemed a core aspect of any effort to reconstruct Chrysler, so the last day's focus on a few secured creditors seems misplaced. But terminated dealers won't go quietly. They'll argue that their contracts can't be easily rejected by a bankruptcy judge because they're protected by state franchise laws. And in any event, they are entitled to some form of payment (reduced or otherwise) from a bankrupt Chrysler if their dealerships are terminated."
  5. "If Chrysler could make cars that more people wanted to buy, bankruptcy would be much easier -- and probably not necessary. But that's not the case, so figuring out who will bear what amount of the losses will take place in a bankruptcy court, where too many players have leverage under the law, and where the reality of Chrysler's weak operational prospects makes a fast and easy resolution unlikely if the company can't be quickly sold."


We first compute Taxable Income as Revenue less COGS less SG&A less Depreciation; we then multiply it by (1-tax rate) to get Unlevered Income. (The implicit assumption is that Depreciation is not included in COGS or in SG&A.) We then add back Depreciation to get Free Cash Flow (FCF).

2010 2011 2012 2013
Revenue 25 28 33 40
COGS 20 22.4 26.4 32
SG&A 2 2 3 4
Depreciation 2 2.24 2.64 3.2
EBIT 1 1.36 0.96 0.8
Taxes 0.35 0.476 0.336 0.28
Unlevered Income 0.65 0.884 0.624 0.52
FCF 2.65 3.124 3.264 3.72
Present Value 2.30435 3.124 3.264 3.72

The required rate of return is computed using the CAPM as 3 + 1.5(8) = 15%

The last line of the table computes the present value of the FCF each year using the 15% discount rate. Adding them up, we get $12.412 million. However, we need to subtract from this, the initial investment requirements of $5m plus $1m for working capital, which gives us $12.412-$6 = $6.412. To this, we add the present value of the working capital that can be recovered at the end of 2013, 1/(1.15)4, or $0.5718m. This gives us a NPV of $6.9841m.

Note: Don't ask me how an initial investment of $5m. allows for a total depreciation of $12.24 over the four years! IRS accounting rules :-)


  1. The closing prices can be used to compute returns as in column 3, as Pt/Pt-1-1. The average return is then computed as 0.119865 or 11.9865%
  2. Column 4 contains the deviations of the returns each month from this mean. The last column is the square of these deviations. The variance of the underlying distribution is then computed as the sum of these squared deviations divided by 7, which is the number of observations less 1. This estimated variance works out to 0.2935 and the square root of the estimated variance constitutes an estimate of the standard deviation, which is 0.5418 or 54.18%
  3. My confidence regarding the estimate can be expressed in terms of the 95% confidence interval for the mean. For this, I need to know the standard error of the mean, which is the standard deviation divided by the square root of 8, i.e. 0.5418/√8 = 0.1916. The 95% confidence interval, then, is 0.119865 ± 1.96(1.1916) = (-0.2556,0.4953). I can then say that the true underlying mean is within this range with a probability of 95%.
  4. My prediction would be 5.88(1.119865) = $6.5848. (5.88 is the price on May 1, and 11.98% is the average monthly return.
Sq Dev
5/1/2009 5.88 -0.01672 -0.13659 0.018656
4/1/2009 5.98 1.273764 1.153899 1.331484
3/2/2009 2.63 0.315 0.195135 0.038078
2/2/2009 2 0.069519 -0.05035 0.002535
1/2/2009 1.87 -0.18341 -0.30327 0.091973
12/1/2008 2.29 -0.1487 -0.26856 0.072127
11/3/2008 2.69 0.228311 0.108446 0.01176
10/1/2008 2.19 -0.57885 -0.69871 0.488197
9/3/2008 5.2


  1. Since the yield-to-maturity of the bond when it was first issued was the same as its coupon rate, the price at issue must have been par, i.e. $1000.
  2. The yield increases as the price drops because the yield is the yield-to-maturity, i.e. the annual return that would be obtained if the bond were held to maturity and all the promised payments were made. If the bond price drops to almost half of its issue price, as happenned on 4/27, the yield would soar to almost 48%, as shown in the table. Of course, the likelihood of actually getting the 47% is not very high!
  3. The bond price rose over the six days presumably because the likelihood of the bond being paid off rose. This must have been due to good news about the stock and hence the stock price would have risen as well.
  4. The bond's price sensitivity to yield can be computed as [(51.375-52)/52]/[(48.105-47.241)/47.241] = -0.65718. This is a measure of what is known as the duration of the bond, i.e. the remaining bond maturity adjusted for the timing of the cashflows on the bond. Even though there are almost 2 years left before the bond matures, there are intermediate cashflows at different points in time. The duration is the weighted average of the time to these different cashflows with weights equal to the proportion of the price obtained at the different points, where the yield is used to compute present values of the cashflows. With such high discount rates, the weight of the final payment is much lower than it would be, otherwise.


  1. We would need to make some kind of prediction as to when Ford would return to profitability -- perhaps in another four years or May 2013.
  2. The predicted rate of growth would be equal to the predicted ROE times the predicted retention ratio. Retention ratios will have to be high, perhaps 40%, and the ROE, maybe on the order of 12% leading to a growth rate estimate of 4.8%
  3. Using the information given, the required rate of return according to the CAPM would be 1% + 2.86(7) = 21%. Assuming that Ford will resume paying a dividend at that point of $1.2 per year (which is about the average in 2004), this gives us a stock price for Ford, as of May 2012 as 1.2/(0.21-0.048) = $7.4. Discounting this back to the present, we get 7.4/(1.21)3= $4.18.
  4. It's unlevered beta can be computed as βlevered[E/(E+D)], assuming that the beta of debt is zero. This gives us an unlevered beta of 2.86(14.02/(154.2+14.02)] = 0.23836.


  1. Agency costs arise whenever you hire someone else to do something for you; your interests(as the principal) may deviate from those of the person you hired (as the agent). Hence the agent may take actions that are suboptimal and inefficient and may lead to opportunity costs. Furthermore, to prevent this, the principal will be obliged to spend resources to monitor the agent. These are also unproductive expenditures caused solely because of the agency problem. Agency costs are the sum of these opportunity costs plus the unproductive out-of-pocket costs.
    Agency costs of debt arise because stockholders acting on behalf of bondholders may take excessive risk and may also invest insufficiently in the business. Bondholders impose costs in the form of restrictions called covenants on the stockholders.
  2. Electric Utilities will have the lowest beta because they are regulated monopolies with relative stable cashflows.
    Food Processing is probably the next lowest -- food is a staple and demand will not fluctuate that much.
    Autos are more of a luxury and the betas of auto and truck manufacturers will be higher.
    Betas of Semiconductor firms will be highest because demand for them is a derived demand -- when the economy turns up, the demand for intermediate goods such as semiconductors will shoot up.
  3. When a firm makes an announcement of a new product, it usually indicates that the firms profits will rise. Hence, according to the Efficient Markets Hypothesis, the market takes this into account and causes the price to rise.
  4. This is because the bond price is quoted net of coupon. The "dirty" price, which is inclusive of coupon will drop.
  5. This is because the projects could differ in scale. A project that is smaller might end up with a lower NPV even if its IRR is higher.
  6. Sasha is wrong -- the floor space should be assigned a cost because it could be rented out. If it's not being rented out, then that's a mistake; alternatively, it may be kept vacant to allow for its use in new projects. If so, the firm believes its value as a "real" option is greater than the dollar return from renting it out.
  7. This is because there are other costs related to debt. For example, as the amount of debt increases, the probability of bankruptcy rises and the expected bankruptcy costs go up. Similarly agency costs of debt rise, as well.
  8. This is because idiosyncratic risk can be diversified away and doesn't have to be borne by the investor.


The article does not necessarily contradict Prof. PV. First of all, the stock price had previously already factored in the value of any potential acquisitions, as mentioned in the article (that the stock had jumped 22%). The new stock issue would have the impact of reducing the firm's leverage (Peter Chu said the net gearing would fall sharplyl), which might be seen as too low by the market. Finally, the very low price at which the new equity was placed provides new -- and negative -- information regarding the value of the stock.