Ignacio Vinke 435228

Financial Markets and Institutions Business 35202

University of Chicago Booth School of Business
Individual Homework 1
Douglas W. Diamond
Consider the example in class note 1. Borrowers and lenders are risk neutral and value
investments by taking discounting the expected value of payments at the riskless rate of
interest of zero.
1. Suppose that the firm has debt with face value 600 in place. The borrower has not
yet chosen between project 1 and project 2. Before making the choice, the
borrower offers the lender the chance to renegotiate the debt. The borrower makes
a take it or leave it offer, implying that this is the only chance to renegotiate.
The borrower asks the lender to reduce the face value promised to the lender from
600 to 325. The borrower offers the lender nothing in return for this concession,
but points out that it might influence the project choice. Will the lender accept or
reject the offer? Explain and show why or why not.

We can see that the value of debt is higher under the proposed scenario (debt = 325 vs.
300 under the current status). We know that what project to pursue will be determined by
the borrower according to whats more beneficial to them. Under the 325 case, as the
value of equity will be higher in project 1, the firm will always choose to go for project 1.

This is also the project the debt owners want them to pursue, in order to extract a value of
debt of 325. Both parties are aligned towards the same project. Furthermore, even though
the proposal should be accepted, it has to be considered whether this affects future
distress situations or negotiations. Creating a large moral hazard, or having to monitor the
company could affect the decision.
2. What is the lowest face value that the lender would accept as a take it or leave it
alternative to the status quo face value of 600? Show how you determine this.
What face values of debt below 600 does the borrower prefer to owe compared to
the status quo face value of 600?
Any face value of debt above 300 should be accepted. The current value of debt is 300,
and anything that promises the investor a larger quantity should be taken. We also know
that they will always take project 1, as equity is more valuable to them under this project,
reaffirming the reasons why we should take this offer. The ideal debt value would be 448,
as it is in this point where the debtors extract the most value, while ensuring the firm
wants to pursue project 1, and not project 2 (risk shifting). The range of offers to
renegotiate the debt will ultimately have to be between 301 and 448 to extract the largest
value for both parties. Anything larger than that and the firm will want to choose project
2, undermining the debtors; anything lower than 300 and the debtors will refuse. In the
interest of future deals, both parties should compromise on an intermediate point.