Examiners’ commentaries 2014

Examiners’ commentaries 2014

FN3092 Corporate finance

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2013–14. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refers to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.

General remarks

Learning outcomes

At the end of this course, and having completed the Essential reading and activities, you should be
able to:

• explain how to value projects, and use the key capital budgeting techniques (NPV and IRR)
• understand the mathematics of portfolios and how risk affects the value of the asset in
equilibrium under the fundamental asset pricing paradigms (CAPM and APT)
• know how to use recent extensions of the CAPM, such as the Fama and French three factor
model, to calculate expected returns on risky securities
• explain the characteristics of derivative assets (forward, futures and options), and how to
use the main pricing techniques (binomial methods in derivatives pricing and the
Black–Scholes analysis)
• discuss the theoretical framework of informational efficiency in financial markets and
evaluate the related empirical evidence
• understand the trade-off firms face between tax advantages of debt and various costs of debt
• understand and explain the capital structure theory, and how information asymmetries
affect it
• understand and explain the relevance, facts and role of the dividend policy
• understand how corporate governance can contribute to firm value
• discuss why merger and acquisition activities exist, and calculate the related gains and
losses.

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FN3092 Corporate finance

What are the Examiners looking for?

In general, the Examiners are looking for a solid demonstration of understanding of the above
learning outcomes from candidates. Typically, the examination questions cover a wide range of
topics from the syllabus. They are often set in such a way as to enable students to be tested on their
understanding of the concepts and techniques and their ability to apply them in scenarios.

Candidates should read widely around each topic covered in the subject guide. Essential and
supplementary readings are important if you wish to achieve high grades. Typical weaknesses that
Examiners have identified in this examination are as follows:

• Candidates’ answers are often too general or narrow. When you are asked to critically assess
a theory or concept, you should provide a descriptive list of what the theory or concept is
about. A critical assessment for a theory or concept should indicate how logically it is
derived and how well it fits into the real world.
• You should not regurgitate materials from the subject guide. Consequently, you may be
giving either descriptive or irrelevant material in your answer. Rather, you should carefully
consider what the examination question is in fact asking and respond accordingly.
• Candidates often spot questions and focus narrowly on a few topics in the hope that these
topics cover enough material to pass the examination. However, the empirical evidence
shows that this tactic often backfires badly. As corporate financial theories are often
inter-related, the examination questions will also cover materials from different chapters in
the subject guide. For example, when evaluating a real life project, we need to know which
discount rate to use and how to identify the relevant cash flows. The choice of the
appropriate discount rate depends on how the project is funded and how risky it is.
Therefore a question on capital budgeting can easily involve materials covered in Chapters
1, 2, 3 and 6.

Question spotting
Many candidates are disappointed to find that their examination performance is poorer
than they expected. This can be due to a number of different reasons and the Examiners’
commentaries suggest ways of addressing common problems and improving your performance.
We want to draw your attention to one particular failing – ‘question spotting’, that is,
confining your examination preparation to a few question topics which have come up in past
papers for the course. This can have very serious consequences.
We recognise that candidates may not cover all topics in the syllabus in the same depth, but
you need to be aware that Examiners are free to set questions on any aspect of the syllabus.
This means that you need to study enough of the syllabus to enable you to answer the required
number of examination questions.
The syllabus can be found in the ‘Course information sheet’ in the section of the VLE dedicated
to this course. You should read the syllabus very carefully and ensure that you cover sufficient
material in preparation for the examination.
Examiners will vary the topics and questions from year to year and may well set questions that
have not appeared in past papers – every topic on the syllabus is a legitimate examination
target. So although past papers can be helpful in revision, you cannot assume that topics or
specific questions that have come up in past examinations will occur again.
If you rely on a question spotting strategy, it is likely you will find yourself in
difficulties when you sit the examination paper. We strongly advise you not to
adopt this strategy.

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 Examiners’ commentaries 2014

Examiners’ commentaries 2014

FN3092 Corporate finance

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2013–14. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refers to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.

Comments on specific questions – Zone A

Candidates should answer FOUR of the following EIGHT questions: ONE from Section A, ONE
from Section B and TWO further questions from either section. All questions carry equal marks.

Section A

Answer one question and no more than two further questions from this section.

Question 1

(a) According to Modigliani and Miller, capital structure policy and payout policy
are irrelevant. Explain.
(9 marks)

(b) One reason capital structure policy may be relevant is due to taxes. Discuss
another alternative reason.
(8 marks)

(c) One reason payout policy may be relevant is due to taxes. Discuss an
alternative reason.
(8 marks)

Reading for this question

The subject guide, Chapter 6, pp. 91–99.

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FN3092 Corporate finance

Approaching the question

(a) Both payout and capital structure policy are irrelevant because they are purely financial
transactions, they neither create nor destroy value. As long as the firm invests in all positive
NPV projects, the firm will maximise value and payouts. Capital structure just determines
how the total investment necessary is split among different investors, while payout
determines how the total payout is split among different investors.
(b) There are multiple reasons why M&M fails in the real world. Among them are risk shifting,
debt overhang, insufficient effort, perks and diversion of cashflows, and asymmetries of
information. Candidates should explain whichever reason they give and not just give its
name.
(c) Dividends may be used as a costly signal to inform the market of the firms quality. Only
good firms can afford to pay high dividends due to either bankruptcy costs or high taxes.
Bad firms would not imitate.

Question 2

(a) Many valuable takeovers may not occur due to the free-rider problem. Explain.
(10 marks)
(b) What are the empirical facts regarding the stock returns of the participants in
the takeover (bidder and target). Is this consistent with the free-rider problem?
(6 marks)
(c) Describe one possible solution to the free-rider problem.
(9 marks)

Reading for this question

The subject guide, Chapter 10, pp. 135–144.

Approaching the question

(a) The free-rider problem is that when a raider who can raise firm value makes a bid on a firm,
the current shareholders know that if they do not sell and the bid is successful they will
benefit from the value added. Thus many refuse to sell their shares unless the price is very
high. However, if the price is very high than the raider does not benefit so no raid occurs.
Thus efficient, NPV rising raids may not occur.
(b) The free rider problem suggests that after a takeover announcement the bidder’s returns are
negative and the acquired firm positive; this is consistent with the data. In the data
shareholders of target firms gain from takeovers as they receive a high premium on the
shares when they are sold/taken over. For bidding firms – results are mixed. Cash offer
appears to have no significant impact on the bidder’s return. Share exchange on the other
hand seems to suggest a decline in the bidder’s share price and return.
(c) Grossman and Hart (1980) suggested a dilution mechanism: any mechanism that would
allow the raider to take value away from any shareholders who held out and did not sell
their shares if the raider was successful in acquiring enough shares to buy a controlling stake
in the firm. For example, allowing the raider to force any holdouts to sell shares to him at a
low price once he is in control is a dilution mechanism. The reason this works is that old
shareholders know that if they hold out and do not sell their shares during the raid, they
may suffer after the raid. Thus they choose to sell their shares and the efficient raid occurs.
Another potential solution to the free-rider problem is to accumulate shares in secret. It
works because prior to the raid becoming public information, the firm price is low as it is an
inefficient firm. If the raider can acquire a lot of shares at this time, secretly, he does not
need to pay a high price for most shares. After the raid becomes public, the free-rider

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 Examiners’ commentaries 2014

problem will still occur and he will have to pay a premium for the remaining shares.
However, he does not need to buy very many more shares to get to a majority, therefore the
raid may still be worth it.

Question 3

(a) Briefly explain the intuition behind the CAPM. According to the CAPM, which
characteristic explains whether an asset should have a high or a low return?
(9 marks)
(b) Discuss empirical evidence regarding the CAPM. Are there certain assets for
which the CAPM appears wrong?
(8 marks)
(c) One possible explanation for (b) is Roll’s critique. Explain.
(8 marks)

Reading for this question

The subject guide, Chapter 2, pp. 26–40.

Approaching the question

(a) The CAPM is an equilibrium model based on certain assumptions about preferences about
risk. The intuition is that the average agent holds the market portfolio, therefore any asset
with a positive covariance with the market portfolio does poorly when the agent does poorly
and is therefore bad insurance. Such assets should have low prices and high returns. Thus,
according to the CAPM, the only characteristic that matters for asset pricing is an asset’s
covariance with the market, or equivalently its beta. Assets with high beta should have high
expected returns.
(b) There are multiple anomalies discussed in the subject guide for which the CAPM does not
seem to work. Among these are the small stock premium, the value premium, and
momentum. Candidates should give some details about them, rather than simply listing
their names.
(c) The CAPM says that the only thing that matters is covariance with the market portfolio.
However, according to Rolls critique, we do not actually observe the true market portfolio.
We observe the return on a public equity market such as the S&P500, whereas the true
market portfolio may contain private equity, corporate debt, real estate, and labour income.
Thus, we cannot really determine that the anomalies discussed in (b) disprove the CAPM.

Question 4

(a) Which forms of efficiency are satisfied and/or violated in the following
hypothetical situations:
i. Jill Crener, the host of TV show Crazy Cash, gives stock recommendations
every day and insists following these recommendations will beat the market.
ii. Inintech announces that it has discovered a cure for colon cancer. Its share
price rises by 45%.
iii. If a firm’s stock price falls by more than 2% on any given day, the return is
typically positive the following day.
iv. The difference between the best performing and worst performing London
hedge funds was 86% in 2013.
(12 marks)

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FN3092 Corporate finance

(b) Describe the Net Present Value and the Internal Rate of Return decision rules.
Compare the two, does one have advantages over another?
(13 marks)

Reading for this question

The subject guide, Chapter 5, pp. 73–85.

Approaching the question

(a) i. If Jill’s strategies are indeed profitable than the market is not efficient since everyone has
access to them. However, more likely she is just crazy and the recommendations are not
profitable.
ii. It appears that the market responds swiftly to an announcement, suggesting that it is
consistent with the semi-strong form efficiency. The market is unlikely to be strong form
efficient as the privately held information is not already in the price.
iii. This is negative autocorrelation which implies that past returns are not fully
incorporated in the stock price. This is a violation of weak form efficiency.
iv. If managers have superior or private information then this may be a violation of strong
form efficiency. However, this may simply be due to luck.
(b) The NPV rule is the right rule for discounting cash flows. It takes every possible cash inflow
and outflow at future dates and values them as of today by discounting. If the net is
positive, the project should be taken.
The IRR computes the discount rate which would make the NPV equal to zero. If the IRR
is above the true discount rate, the project should be taken.
For standard projects the two give identical answers. However, for non-standard projects,
where there are choices of size or magnitude, or only one project may be taken, the IRR
may give misleading answers.

Section B

Answer one question and no more than two further questions from this section.

Examiner’s note: this is largely a numeric section, and so requires candidates to write equations and
to solve them. Examiners allocate partial marks for carried mistakes.

Question 5

As the procurement manager for a factory producing Slap Wrap bracelets, you are
charged with finding a machine to expand capacity. You have found a machine
available to be leased. The lease would start one year from now and would last four
years at a cost of $200,000 per year. At the end of the four year lease you must
compensate the machine’s owner for any aging damage to the machine, which you
estimate to be $225,000 due to natural wear and tear.

You project that you will incur additional labour expenses of $100,000 per year to
operate this machine; there are no other significant expenses to be considered. The
bracelets produced by the machine will result in revenues of $350,000 per year.

The tax law is such the entity in a procession of a machine (ie the lessee as opposed
to the owner) can claim depreciation, which can be evenly distributed over the
length of the lease. Your tax rate is 25% and the discount rate is 10% per year.

(a) Would you take on the lease described above? Explain and show your
calculations.
(20 marks)

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 Examiners’ commentaries 2014

(b) Suppose the lease additionally contained an option for you to keep the machine
indefinitely by paying an additional $300,000. Explain how you would
incorporate this into your calculation (there is no need for explicit calculations).
(5 marks)

Reading for this question

The subject guide, Chapter 1, pp. 10–23.

Approaching the question

(a) There are two solutions that were acceptable, depending on the treatment of tax credits. In
the first solution below, we do not assume that there are further operations that tax credits
are valued. As such, the deprecation offset shields the entire income from tax, so there is no
tax payable.
Year 0 1 2 3 4
Rent −200 −200 −200 −200
Expenses −100 −100 −100 −100
Revenue 350 350 350 350
Wear/Tear −225
Pre-Tax CF 50 50 50 −175
Depreciation Shield 56.25 56.25 56.25 56.25
Tax 0 0 0 0
Post-Tax CF 50 50 50 −175
PV 45.5 41.3 37.6 −119.5
NPV 4.8
In the second version below, we have assumed that tax credits are valuable to this firm,
therefore they are part of the calculation. It is easy to see therefore that the NPV of the
project increases, especially when you receive a lot more tax credits in time 4.
Year 0 1 2 3 4
Rent −200 −200 −200 −200
Expenses −100 −100 −100 −100
Revenue 350 350 350 350
Wear/Tear −225
Pre-Tax CF 50 50 50 −175
Depreciation Shield 56.25 56.25 56.25 56.25
Tax Credit 1.25 1.25 1.25 46.25
Post-Tax CF 51.25 51.25 51.25 −128.75
PV 46.6 42.4 38.5 −87.9
NPV 40
In both cases, the NPV is positive therefore you would take the project.
(b) You should discuss computing the present value of the additional cash flows with something
like the Gordon Growth model and comparing the total cost to the total revenue. Even
better (though unnecessary for full marks) if you discuss the additional value of the option
to decide whether to keep the machine or not by knowing the demand four years from now.

Question 6

Cyberdyne systems creates robotic stuffed toys, remote controlled cars, and toy
guns, which make up 60%, 25%, and 15% of its market value. You are interested in
estimating the required rate of return to discount Cyberdyne’s cash flows.

You found a stand-alone stuffed toy maker whose historic return volatility is 30%
and whose historic correlation with the market is 0.6.

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FN3092 Corporate finance

You have found a stand alone remote controlled car maker whose historic return
volatility is 35% and whose historic correlation with the market of 0.7.

There are no stand-alone toy gun makers, however a firm which derives half of its
value from producing toy guns, and half from remote controlled cars, has a historic
return volatility of 50% and a historic correlation with the market of 0.85.

The historic stock market expected return and volatility are 10% and 20% while the
average risk free rate was 4%.

(a) Estimate Cyberdyne’s beta.

(12 marks)
(b) Compute Cyberdyne’s discount rate?
(5 marks)
(c) Cyberdyne plans to raise debt in amount equal to half of Cyberdyne’s market
value. What is Cyberdyne’s equity beta if the yield on the debt is 5%?
(8 marks)

Reading for this question

The subject guide, Chapter 2, pp. 28–30 and Chapter 3, pp. 44–52.

Approaching the question

(a) The beta for stuffed toys is:

Cov[R, Rm ] Corr[R, Rm ] × StD[R] 0.6 × 0.3

= = = 0.9.
Var[Rm ] StD[Rm ] 0.2

The beta for remote controlled cars is:

Cov[R, Rm ] Corr[R, Rm ] × StD[R] 0.7 × 0.35
= = = 1.225.
V ar[Rm ] StD[Rm ] 0.2

The beta for the car/gun firm is:

0.85 × 0.50
= 2.125.
0.2

The estimated beta for guns alone is:

2.125 = 0.5βg + 0.5βt = 0.5βg + 0.5 × 1.225 ⇒ βg = 3.025.

Cyberdyne’s beta is:

0.6 × 0.9 + 0.25 × 1.225 + 0.15 × 3.025 = 1.3.

(b) We have:
R = 4 + 1.3 × (10 − 4) = 11.8%.

(c) The beta of debt is:

5−4
= 0.167.
10 − 4
The beta for equity satisfies:
1.3 − 0.5 × .167
βall = 0.5βd + 0.5βe ⇒ βe = = 2.433.
0.5

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 Examiners’ commentaries 2014

Question 7

Crudgington Brewery is considering adding a new ale to its product list. Adding the
ale would require an investment of £0.5 million today, and would result in a cash
flow of £0.6 million in one year.

Crudgington’s assets consist of £0.5 million in cash, as well as facilities to produce

ales and ciders. Next year these facilities will produce cash flows of £5 million if UK
demand is high, but only £2 million if it is low. The probability of high demand is
70%.

Crudgington’s only liability is debt with face value £2.5 million due in one year.
The appropriate discount rate is 0% and you can ignore all cash flows more than one
year in the future.

(a) Just for parts (a) and (b) suppose that Crudgington has no debt outstanding.
What is the expected net worth of Crudgington’s owners if they do not add the
new ale but rather pay the cash to themselves as a dividend?
(3 marks)
(b) Just for parts (a) and (b) suppose that Crudgington has no debt outstanding.
What is the expected net worth of Crudgington’s owners if they choose to add
the new ale?
(3 marks)
(c) Now redo (a) with debt. What is the expected net worth of Crudgington’s
owners if they do not add the new ale but rather pay the cash to themselves as
a dividend?
(6 marks)
(d) Now redo with debt. What is the expected net worth of Crudgington’s owners
if they choose to add the new ale?
(6 marks)
(e) (a) – (d) illustrate the debt overhang problem. Explain it.
(7 marks)

Reading for this question

The subject guide, Chapters 2, 3 and 7, and pp. 128–133 for dividends.

Approaching the question

(a) We have:
0.5 + 0.3 × 2 + 0.7 × 5 = 4.6.

(b) We have:
0 + 0.3 × 2 + 0.7 × 5 + 0.6 = 4.7.

(c) We have:
0.5 + 0.3 × 0 + 0.7 × (5 − 2.5) = 2.25.

(d) We have:
0 + 0.3 × 0.1 + 0.7 × (5.6 − 2.5) = 2.2.
Note that in the bad state of the world, there is still a small positive payoff for equity; that
is, the firm does not default.

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FN3092 Corporate finance

(e) This is an example of debt overhang. Note that the firm has a positive NPV project
available to it and positive NPV projects should always be taken to maximise value. Indeed
in (a) and (b), when there is no debt, the firm prefers to take the positive NPV project as
we would expect.
On the other hand, in (c) and (d) the firm has a high amount of debt outstanding. In other
words, the firm is distressed and likely to default next year. If equity holders choose to take
the project instead of paying themselves a dividend, they will be incurring the full cost of
the project but receiving only part of the benefit. Note that in the bad state of the world,
they receive 0 if there is no project, and only 0.1 if there is a project; the creditors receive
an additional 0.5 from the project. Thus equity holders choose to not take a positive NPV
project.

Question 8

Beverage maker Black & Tan is currently worth A C70 per share with one million
shares outstanding. Depending on demand, one year from now it will be worth
either A
C105 or A
C40 per share. The risk free rate is 1%.

(a) What is the price of a European call option on Black & Tan with a strike price
of A
C60 that expires in one year?
(5 marks)
(b) How does volatility affects call option prices? Explain.
(6 marks)
(c) Suppose Black & Tan has outstanding debt with face value AC50 million due in
one year. What is the value of the equity of Black & Tan?
(7 marks)
(d) Explain how volatility affects equity prices when equity is close to default? Does
this have any implications for optimal capital structure?
(7 marks)

Reading for this question

The subject guide, Chapter 10, pp. 136–141.

Approaching the question

(a) Setting up a replication portfolio:

105X + 1.01B = 105 − 60
40X + 1.01B = 0
65X = 45
Therefore X = 0.6923, B = −27.4178 and C = 70X + B = 21.043.
You can also calculate the risk-neutral probabilities.
(b) Volatility increases the value of call options. This is because call option payoffs are convex
in the underlying. As the underlying is worth more, the payoff is higher; however, if the
underlying is worth less (below the strike) the payoff is still the same – zero. Thus
increasing volatility increases the probability of very low and very high payoffs of the
underlying. Low and very low payoffs are equally painful as they result in zero; however,
high payoffs are not as good as very high payoffs.
(c) The key in this problem was to note that equity is just a call option on the firm with the
face value of debt being the strike price. In this case, the solution follows the same strategy
as in (a).

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 Examiners’ commentaries 2014

105X + 1.01B = 105 − 50

40X + 1.01B = 0
65X = 55
Therefore X = 0.8462, B = −33.5129 and C = 70X + B = 25.7211.
(d) Just as with call options, volatility increases the value of equity when equity is close to
default. The intuition is the same as in (b); taking on more risk has little cost on the
downside and large benefits on the upside. This is referred to as risk shifting or asset
substitution, which is one of several potential distress costs. Firms susceptible to risk
shifting are better off using equity rather than debt financing.

Black–Scholes’ Option Pricing Formula

C = S[N (d1 )] − X[N (d2 )]e−rt

ln(S/X) 1 √
d1 = √ + σ t
σ t 2
√
and d2 = d1 − σ t

Capital Assets Pricing Model (CAPM)

E(Ri ) = Rf + βi [E(Rm ) − Rf ]

Modigliani and Miller

Proposition I (no tax): VL = VU

Proposition II (no tax): Re = Ra + (Ra − Rd ) D

E

Proposition I (with corporate tax): VL = VU + Tc D

Proposition II (with corporate tax): Re = Ra + (Ra − Rd )(1 − Tc ) D

E

Miller (1977)

 
(1 − Tc )(1 − Te )
VL = VU + 1 − D
1 − Td

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FN3092 Corporate finance

Examiners’ commentaries 2014

FN3092 Corporate finance

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2013–14. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refers to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.

Comments on specific questions – Zone B

Candidates should answer FOUR of the following EIGHT questions: ONE from Section A, ONE
from Section B and TWO further questions from either section. All questions carry equal marks.

Section A

Answer one question and no more than two further questions from this section.

Question 1

(a) What are some examples of financial signals discussed in the course? What is
necessary for a signal to be effective?
(9 marks)
(b) What did Modigliani and Miller mean when they said financial policy is
irrelevant? Explain.
(8 marks)
(c) Is NPV a better appraisal technique than the Internal Rate of Return? Explain.
(8 marks)

Reading for this question

The subject guide, Chapter 8, pp. 112–123. Also, Chapter 1.

Approaching the question

(a) We have discussed signalling with dividends and signalling with debt. For a signal to be
effective ‘bad’ firms must find it more costly to use the signal than ‘good’ firms. If this is the

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 Examiners’ commentaries 2014

case, good firms can use the signal and bad firms would not imitate. At the same time, the
signal should not be too costly for good firms, otherwise they would rather do nothing and
be grouped with bad firms.
(b) Both payout and capital structure policy are irrelevant because they are purely financial
transactions, they neither create nor destroy value. As long as the firm invests in all positive
NPV projects, the firm will maximise value and payouts. Capital structure just determines
how the total investment necessary is split among different investors, while payout
determines how the total payout is split among different investors.
(c) For standard projects the two give identical answers. However, for non-standard projects,
where there are choices of size or magnitude, or only one project may be taken, the IRR
may give misleading answers whereas the NPV is correct.

Question 2

(a) Discuss three motives for corporate takeovers.

(9 marks)
(b) What empirical evidence do we have in regard to value creation following a
takeover for:
i. the bidder firm’s shareholders, and
ii. the acquired firms shareholders.
(7 marks)
(c) Can the free rider problem explain the pattern in (b)? Explain.
(9 marks)

Reading for this question

The subject guide, Chapter 10, pp. 136–143.

Approaching the question

(a) In this question, students should explain the three motives for takeover: Financial, Strategic
and Conglomerate. In each case, talk about the inefficiency that was exploited and how the
improvement would benefit the shareholders of the acquiring firm. In this case, you are
expected to describe the inefficiencies of management, economies of scale and economies of
scope as reasons for the acquisition.
(b) In the data shareholders of target firms gain from takeovers as they receive a high premium
on the shares when they are sold/taken over. For bidding firms – results are mixed. Cash
offer appears to have no significant impact on the bidder’s return. Share exchange on the
other hand seems to suggest a decline in the bidder’s share price and return.
(c) The free rider problem suggests that after a takeover announcement the bidder’s returns are
negative and the acquired firm positive; this is consistent with the data. The free-rider
problem is that when a raider who can raise firm value makes a bid on a firm, the current
shareholders know that if they dont sell and the bid is successful they will benefit from the
value added. Thus many refuse to sell their shares unless the price is very high.

Question 3

(a) Linter (1958) characterized dividend behaviour. Based on his observations, if a

firm’s earnings increase by $0.05/share, the firm’s dividends are likely to
increase by less than $0.05, $0.05, or more than $0.05? Explain your answer.
(9 marks)

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FN3092 Corporate finance

(b) Explain the tax clientele theory for the existence of dividends.
(8 marks)
(c) Explain the signalling theory of dividends.
(8 marks)

Reading for this question

The subject guide, Chapter 9, pp. 128–133.

Approaching the question

(a) Linter (1958) finds that firms like to keep dividends steady even if earnings are moving
around. Thus if a firm’s earnings increase by $0.05/share, the firm is unlikely to increase
dividends by $0.05/share. Most likely dividends will stay constant or increase by some
amount less than $0.05/share. Here you should highlight the model, explain the equation
and talk a little about the motives, like dividend smoothing.
(b) The tax clientele theory says that there are many different types of investors. Some of these
investors are in low tax brackets and therefore do not pay much (if any) taxes on dividend
income. For these investors there is no advantage from capital gains because even though
they are taxed at a lower rate than dividends it makes no difference to these investors since
their tax rate is already low. On the other hand, issuing dividends carries lower transaction
costs than buying back shares. Thus to attract this class of investors some firms will issue
dividends. Low tax investors are not just poor people, they include tax exempt entities such
as universities and certain pension funds. On the other hand, for most investors dividends
are much more costly than capial gains in terms of taxes. These investors prefer to be paid
through repurchases and other firms will issue less dividends and do more repurchases to
attract this class of investor.
(c) Good firms want the markets to know that they are good so that they can have cheaper
access to financing. Generally, a signal needs to be less costly for the good type than the
bad type in order to discourage the bad type from imitating the signal. Dividends are one
such potential signal. Note that dividends are an expensive way to pay investors. Dividends
are taxed at the corporate rate inside the firm, rather than at the personal rate outside the
firm. Capital gains are also taxed at the corporate rate inside the firm but at the capital
gains rate (lower than personal) outside the firm. Interest is not taxed inside the firm and is
taxed at the personal rate outside the firm. Thus the good firm, which benefits from
investors knowing that it is good because it can raise capital for positive NPV projects, does
not mind paying investors in a more expensive way because the benefit outweighs the cost.
The bad firm has fewer good projects and is less interested in cheap financing; it would
rather just pay its investors as cheaply as possible.

Question 4

(a) Discuss the risk shifting (asset substitution) problem. What kind of capital
structure does it favour?
(9 marks)
(b) Discuss the debt overhang problem. What kind of capital structure does it
favour?
(8 marks)
(c) Discuss the agency problem of managers not putting in enough effort or using
up firm resources for personal gain. What kind of capital structure does it
favour?
(8 marks)

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 Examiners’ commentaries 2014

Reading for this question

The subject guide, Chapter 8, pp. 112–123.

Approaching the question

(a) When a firm is close to default, equity holders want to take on more risk than optimal. This
is because they are ‘gambling for resurrection’ → the downside is not going to get any worse
due to limited liability. On the upside, the bigger the gamble, the bigger the potential
payoff. This may only happen if the firm has taken on too much debt; thus this problem
favours equity in the capital structure.
(b) With debt overhang the firm chooses not to invest in positive NPV projects. This occurs
when a firm is distressed and likely to default soon. If equity holders choose to take the
project instead of paying themselves a dividend, they will be incurring the full cost of the
project but receiving only part of the benefit since most of the benefit goes to creditors
(equity holders are unlikely to receive anything). Thus equity holders choose to not take a
positive NPV project.
(c) When managers are not properly incentivised, they may not work very hard, or may waste
the firm’s resources. To prevent them from doing this we can set proper incentives by giving
managers compensation which is highly dependent on how well the firm does – in this case
the manager wants to work hard and would not want to waste firm resources. Equity is one
form of such compensation. Thus we want the equity of the firm to be highly concentrated
in the hands of the manager. But to do that, most of the firm’s financing needs must be met
by debt (if they are met by outside equity, then the manager cannot hold a large fraction of
the equity). Thus this friction favours lots of debt in the capital structure and a small
amount of equity that is held by the insiders.

Section B

Answer one question and no more than two further questions from this section.

Examiner’s note: this is largely a numeric section, and so requires candidates to write equations and
to solve them. Examiners allocate partial marks for carried mistakes.

Question 5

This historic risk free rate is 3%, the historic market return is 8%, and the historic
market volatility is 18%.

Atlantic Southern Railroad is an all equity firm valued at $500 million. Its historic
volatility is 15% and its correlation with the market is 0.5.

(a) What is the expected return and the beta of Atlantic Southern Railroad?
(5 marks)
(b) Atlantic Southern just raised $300 million of debt with a yield of 4%. It plans to
keep the $300 million as cash to allow it to make acquisitions in the future.
What is Atlantic Southern’s new equity beta?
(10 marks)
(c) Atlantic plans to some of that cash to buy the troubled Dannager Coal
Company and to pay off its debt. Dannager’s debt has a market value of $150
million and a yield of 6%. Dannager’s equity is worth $50 million and has an
expected return of 13%. What will be Atlantic Southern’s equity beta after this
transaction?
(10 marks)

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FN3092 Corporate finance

Reading for this question

The subject guide, Chapters 7 and 3, pp. 101–108 and 43–52, respectively.

Approaching the question

(a) We have:

Cov[R, Rm ] Corr[R, Rm ] × StD[R] 0.5 × 0.15

Beta = = = = 0.42.
Var[Rm ] StD[Rm ] 0.18

The expected return is 3 + 0.42 × (8 − 3) = 5.08%.

(b) In this question and the following, you must: (i) first calculate the beta of the assets; and
(ii) secondly calculate the beta of the equity (namely, one part of the liability side). We
assume that cash has a beta of 0, thus the left hand side of the balance sheet has a beta of
(5/8)βa + (3/8) × 0 where βa = 0.42 is the beta of the original assets we found in (a).
On the right hand side of the balance sheet we have (5/8)βe + (3/8)βd . We can find βd using
the yield:
4−3
βd = = 0.2.
8−3
The left- and right-hand sides must be equal:

(5/8)βe + (3/8) × 0.2 = (5/8) × 0.42 ⇒ βe = 0.3.

(c) Dannager’s beta is:

(150/200)βd + (50/200)βe
where βd = (6 − 3)/(8 − 3) = 0.6 and βe = (13 − 3)/(8 − 3) = 2. Thus Dannager’s beta is
0.95.
Atlantic’s assets will now be: (a) Railroad worth 500 with a beta of 0.42; (b) Dannager
worth 200 with a beta of 0.95; (c) cash of 100 with a beta of 0. Therefore:

β = (500/800) × 0.42 + (200/800) × 0.95 + (100/800) × 0 = 0.5.

On the liability side it still has 300 of debt with a beta of 0.2.

(5/8)βe + (3/8) × 0.2 = 0.5 ⇒ βe = 0.68.

Question 6

American automaker TMCO is an all equity firm with current share price $10 per
share and one billion shares outstanding. It is introducing a new fleet of efficient
electric cars. Some analysts project the share prices falling to $8 per share due to
low oil prices and lack of demand for electric cars, while others project it rising to
$12.5 per share because of the high quality of TMCOs engineering. The risk free
rate is 4%.

(a) What is the price of a European call option on TMCO with a strike price of $10
that expires in one year?
(5 marks)
(b) How does volatility affects call option prices? Explain.
(6 marks)
(c) Suppose TMCO has outstanding debt with face value $9 billion due in one year.
What is the value of the equity of TMCO?
(7 marks)

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 Examiners’ commentaries 2014

(d) Explain how volatility affects equity prices when equity is close to default? Does
this have any implications for optimal capital structure?
(7 marks)

Reading for this question

The subject guide, Chapter 4, pp. 55–64.

Approaching the question

(a) Setting up a replication portfolio:

12.5X + 1.04B = 12.5 − 10
8X + 1.04B = 0
4.5X = 2.5
Therefore X = 0.5555, B = −4.2735 and C = 10X + B = 1.282.
Candidates can also attempt this question by calculating the risk neutral probabilities.
(b) Volatility increases the value of call options. This is because call option payoffs are convex
in the underlying. As the underlying is worth more, the payoff is higher; however, if the
underlying is worth less (below the strike) the payoff is still the same – zero. Thus
increasing volatility increases the probability of very low and very high payoffs of the
underlying. Low and very low payoffs are equally painful as they result in zero; however,
high payoffs are not as good as very high payoffs.
(c) The key in this problem was to note that equity is just a call option on the firm with the
face value of debt being the strike price. In this case, the solution follows the same strategy
as in (a) above.
12.5X + 1.04B = 12.5 − 9
8X + 1.04B = 0
4.5X = 3.5
Therefore X = 0.7778, B = −5.9829 and C = 10X + B = 1.795.
(d) Candidates must realise and comment on the similarities between an equity with a fixed
income component and a call option with a strike price. Just as with call options, volatility
increases the value of equity when equity is close to default. The intuition is the same as in
(b); taking on more risk has little cost on the downside and large benefits on the upside.
This is referred to as risk shifting or asset substitution, which is one of several potential
distress costs. Firms susceptible to risk shifting are better off using equity rather than debt
financing.

Question 7

Your factory owns an old machine which has four more years of life remaining. Its
current book value is £14 million and straight line depreciation can be used to
compute any tax breaks. The tax rate is 20% and the discount rate is 11% per year.

You receive revenues of £11 million per year from this machine’s production, and it
costs you £3 million per year to employ this machine’s operators. Assume that all
cash flows are end of year, so that you must discount the first cash flow.

Another factory has offered to buy this machine from you for £23 million, would
you agree? Show your work.

Reading for this question

The subject guide, Chapter 1, pp. 10–17.

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FN3092 Corporate finance

Approaching the question

The NPV calculation is as follows:

Year 0 1 2 3 4
Rent 0 0 0 0
Expenses 3 3 3 3
Revenue 11 11 11 11
Wear/Tear 0
Pre-Tax CF 8 8 8 8
Depreciation Shield 3.5 3.5 3.5 3.5
Tax 0.9 0.9 0.9 0.9
Post-Tax CF 7.1 7.1 7.1 7.1
PV 6.396396 5.762519 5.191459 4.67699
NPV 22.02736

Given the NPV, candidates must calculate the taxes they will need to pay. Given the book value
of 14, this is 1.8M in taxes. The net gain due to the sale is therefore 23 − 1.8 = 21.2 < 22.03.
Thus you are better off keeping the machine.

Question 8

The RAMJAC corporation has productive assets in place which will be worth $5
million or $10 million next year with equal probability. It also has cash in amount
$2 million. Additionally, it is considering an investment project which requires an
investment of $2 million and will payout $3.1 million with certainty next year.
Assume that the appropriate discount rate is 5%.

(a) Compute the payout to RAMJAC’s shareholders if the CEO does not take on
the investment project but rather pays the cash out as a one-time dividend.
(3 marks)
(b) Compute the payout to RAMJAC’s shareholders if the CEO uses the cash to
invest in the project.
(3 marks)
(c) Now suppose that RAMJAC also has outstanding debt with face value $8
million due next year. Compute the payout to RAMJAC’s shareholders if the
CEO does not take on the investment project but rather pays the cash out as a
one time dividend.
(6 marks)
(d) Continue the assumption about debt as in (c). Compute the payout to
RAMJAC’s shareholders if the CEO uses the cash to invest in the project.
(6 marks)
(e) Parts (a) – (d) illustrate the debt overhang problem. Explain it.
(7 marks)

Reading for this question

The subject guide, Chapters 2, 8 (for the empirical part) and 9 (for the final component of debt
overhang).

Approaching the question

(a) We have:
2 + (0.5 × 5 + 0.5 × 10)/1.05 = 9.143.

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 Examiners’ commentaries 2014

(b) We have:
0 + (0.5 × 5 + 0.5 × 10 + 3.1)/1.05 = 10.095.

(c) We have:
2 + (0.5 × 0 + 0.5 × (10 − 8))/1.05 = 2.952.

(d) We have:
0 + (0.5 × 0.1 + 0.5 × (13.1 − 8))/1.05 = 2.476.
Note that in the bad state of the world, there is still a small positive payoff for equity; that
is, the firm does not default.
(e) This is an example of debt overhang. Note that the firm has a positive NPV project
available to it and positive NPV projects should always be taken to maximise value. Indeed
in (a) and (b), when there is no debt, the firm prefers to take the positive NPV project as
we would expect.
On the other hand, in (c) and (d) the firm has a high amount of debt outstanding. In other
words, the firm is distressed and likely to default next year. If equity holders choose to take
the project instead of paying themselves a dividend, they will be incurring the full cost of
the project but receiving only part of the benefit. Note that in the bad state of the world,
they receive 0 if there is no project, and only 0.1 if there is a project; the creditors receive
an additional 3.4 from the project. Thus equity holders choose to not take a positive NPV
project.

Black–Scholes’ Option Pricing Formula

C = S[N (d1 )] − X[N (d2 )]e−rt

ln(S/X) 1 √
d1 = √ + σ t
σ t 2
√
and d2 = d1 − σ t

Capital Assets Pricing Model (CAPM)

E(Ri ) = Rf + βi [E(Rm ) − Rf ]

Modigliani and Miller

Proposition I (no tax): VL = VU

Proposition II (no tax): Re = Ra + (Ra − Rd ) D

E

Proposition I (with corporate tax): VL = VU + Tc D

Proposition II (with corporate tax): Re = Ra + (Ra − Rd )(1 − Tc ) D

E

Miller (1977)

 
(1 − Tc )(1 − Te )
VL = VU + 1 − D
1 − Td

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