The Chinese University of Hong Kong

CUHK Business School

FINA3070 Corporate Finance: Theory and Practice

Name:
Student ID:
Lecture: 3070A (Wed) / 3070B (Tue)

DO NOT TAKE AWAY

Midterm Quiz (Two Hours Closed Book)

Instructions:
1. Please answer all questions in the answer book. Any answers written on this
question paper will not be graded.

2. There are 4 questions and the total mark of this midterm is 90.

3. You are allowed to bring ONE A4 formula sheet.

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Question 1 (25 Marks)

(a) In a world with no taxes, no transaction costs, and no costs of financial distress,
is the following statement true, false, or uncertain? If a firm issues equity to
repurchase some of its debt, the price per share of the firm’s stock will rise
because the shares are less risky. Explain. (10 marks)

False. In the absence of taxes, transaction costs, and costs of financial distress,
the stock price will not change. The decrease in financial leverage will
decrease the risk of the cash flow to equity, but is offset by a lower required
return on equity.

4 marks for correct “true/false”; 6 marks for explanations.

(b) Do you agree or disagree with the following statement? A firm’s shareholders
will never want the firm to invest in projects with negative net present values.
Why? (10 marks)

Disagree. When the firm is close to bankruptcy, the shareholders may feel they
have little to lose; this may bring them into conflict with the bondholders, and
lead them to make inefficient decisions. For example, if a project has a high
variance, but a negative NPV, the shareholders might choose this project,
because they get the upside gains but do not bear the downside losses. Taking
this project would cause the value of the equity to rise, but the value of the firm
to fall.

4 marks for correct “true/false”; 6 marks for explanations.

(c) When managers are better informed than outside investors, the pecking order
theory predicts that there would be a price drop at equity issue announcement.
How would you suggest the managers to minimize the adverse effect if they
must issue equity? (5 marks)

Korajczyk et al (1992) found that the price drop at issue announcement increases
with the time since the last information release. The managers can therefore
issue equity right after results announcement in order to take advantage of the
time-varying asymmetric information as the price drop will be less severe at that
time.

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Question 2 (30 Marks)

Jason is the CEO of CU Café. Jason is considering opening a new café. He has
examined the potential for the company’s expansion and determined that the success
of the new café will depend critically on the state of the economy over the next few
years.

CU Café has a bond issue outstanding with a face value of $25 million that is due in
one year. Covenants associated with this bond issue prohibit the issuance of any
additional debt. The restriction means that the expansion will be entirely financed
with equity at a cost of $9 million. Jason has summarized his analysis in the
following table, which shows the value of the firm in each state of the economy next
year, both with and without expansion:

Economic Growth Probability Without Expansion With Expansion

Low 30% $20,000,000 $24,000,000
Normal 50% $34,000,000 $45,000,000
High 20% $41,000,000 $53,000,000

(a) What is the expected value of the firm in one year (i.e., at t = 1), with and
without expansion? (4 marks) Would the firm’s shareholders be better off with
or without expansion? (2 marks) Why? (2 marks)

The expected value of the firm in one year with expansion: (2 marks)
V with  0.3  24, 000, 000   0.5  45, 000, 000   0.2  53, 000, 000 
 40,300, 000

The expected value of the firm in one year without expansion: (2 marks)
V without  0.3  20, 000, 000   0.5  34, 000, 000   0.2  41, 000, 000 
 31, 200, 000

The firm’s shareholders appear to be better off with expansion since the expected
NPV of the project is positive ($100,000). (2 marks) The difference in the
expected value of the firm with and without expansion is $40,300,000 -
$31,200,000 = $9,100,000. If the required investment is $9,000,000, the
expansion creates a positive increase in expected value for current shareholders.
(2 marks)

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(b) What is the expected value of the firm’s debt in one year, with and without
expansion? (4 marks)

The value of the firm’s debt with low economic growth is the value of the firm
because the firm value is less than the face value of the debt. In both other
economic states, the value of the debt is the face value of the debt.

The expected value of the debt in one year with expansion: (2 marks)
VDwith  0.3  24, 000, 000   0.5  25, 000, 000   0.2  25, 000, 000 
 24, 700, 000

The expected value of the debt in one year without expansion: (2 marks)
VDwithout  0.3  20, 000, 000   0.5  25, 000, 000   0.2  25, 000, 000 
 23,500, 000

(c) One year from now, what is the firm’s equity with and without expansion? (4
marks) Do you think Jason would expand the café or not? (3 marks) Why? (3
marks)

The value of the firm’s equity with low economic growth is zero both with and
without expansion since the firm value will be less than the face value of the
debt.

The expected value of the equity in one year with expansion: (2 marks)
VEwith  0.3  0   0.5  20, 000, 000   0.2  28, 000, 000 
 15, 600, 000

The expected value of the equity in one year without expansion: (2 marks)
VDwithout  0.3  0   0.5  9, 000, 000   0.2 16, 000, 000 
 7, 700, 000

The shareholders’ gain if the firm expands: (2 marks)

 E  VEwith  VEwithout
 15, 600, 000  7, 700, 000
 7,900, 000

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 The shareholder value increases by $7.9 million, but the expansion was funded
entirely by equity, so the expected NPV of expansion for shareholders is actually:
(1 mark)
NPVshareholders  9, 000, 000  7,900, 000
 1,100, 000

The shareholder would not expand. If the firm expands, the bondholders will
gain $24,700,000 - $23,500,000 = $1,200,000. Such bondholders’ gain is the
amount sacrificed by the shareholders. This is a typical debt overhang problem.
(3 marks)

(d) If the firm announces that it is not expanding, what do you think will happen to
the price of its bonds? (2 marks) What will happen to the price of the bonds if
the company does expand? (2 marks) Briefly explain in words.

Assuming bondholders are fully informed and they act rationally, they will expect
the shareholders to act in their best interest and not expand, so the price of the
bond will not change. (2 marks)

If the expansion is announced, the price of the bonds will increase. (2 marks)

(e) If the firm opts not to expand, what are the implications for the firm’s future
borrowing needs? (2 marks) What are the implications if the firm does expand?
(2 marks) Briefly explain in words.

If they don’t expand, nothing will happen since it is already priced into the bond.
(2 marks) If the firm announces the expansion, they signal they are willing to
sacrifice for the bondholders, so the firm will receive a lower interest rate in the
future. (2 marks)

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Question 3 (15 Marks)

A firm has debt with both a face value and a market value of $3,000. This debt has a
coupon rate of 7% and the interest is paid annually. The expected earnings before
interest and taxes is $1,200, the tax rate is 34%, and the unlevered cost of capital is
12%.

(a) Assume perpetual cash flows, what is the value of this firm? (8 marks)

The value of the unlevered firm:

EBIT 1  Tc 
VU 
RU
1, 200 1  0.34 

0.12
 6, 600

3 marks for the steps; 1 mark for the correct answer.

The value of the levered firm:

VL  VU  D  Tc
 6, 600  3, 000  0.34
 7, 620

The value of this firm is $7,620.

2 marks for the steps; 2 marks for the correct answer.

(b) What is the firm’s cost of equity? (7 marks)

The value of equity:

VE  VL  VD
 7, 620  3, 000
 4, 620

2 marks for the steps; 1 mark for the correct answer.

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The cost of equity:
D
RE  RU   RU  RD 1  Tc 
E
3, 000
 0.12   0.12  0.07 1  0.34 
4, 620
 0.1414
 14.14%

3 marks for the steps; 1 mark for the correct answer.

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Question 4 (20 Marks)

The WHAT Company and the WHY Company are identical in every respect except
that WHAT is not levered. The market value of WHY Company’s 6% bonds is $1
million. Financial information for the two firms appears here. All earnings streams
are perpetuities. Neither firm pays taxes. Both firms distribute all earnings
available to common shareholders immediately.

WHAT WHY
Projected Operating Income $300,000 $300,000
Year-end Interest on Debt --- $60,000
Market Value of Stock $2,400,000 $1,714,000
Market Value of Debt --- $1,000,000

(a) What are the values of WHAT Company and WHY Company? (2 marks) Do
you think the results violate the MM Propositions? (1 mark)

V WHAT  VEWHAT
 2, 400, 000

V WHY  VEWHY  VDWHY

 1, 714, 000  1, 000, 000
 2, 714, 000

The MM Proposition suggests the value of the two firms are the same as they
have same amount of cash flows. However, the results violate the propositions.

1 mark for each correct answer; 1 mark for correct explanation.

(b) An investor who can borrow at 6% per year wishes to purchase 5% of WHY’s
equity. Can he increase his dollar return by purchasing 5% of WHAT’s equity if
he borrows so that the initial net costs of the two strategies are the same? (13
marks)

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 To purchase 5% of WHY’s equity, the investor would need: (2 marks)
$1,714,000  5%  $85,700

To purchase 5% of WHAT without borrowing would require: (2 marks)

$2, 400,000  5%  $120,000

In order to compare dollar returns, the initial net cost of both positions should be
the same. Therefore, the investor will need to borrow the difference between the
two amounts: (2 marks)
$120,000  $85,700  $34,300

An investor who owns 5% of WHY’s equity will be entitled to 5% of the firm’s

earnings available to common stockholders at the end of each year. While
WHY’s expected operating income is $300,000, it must pay $60,000 to
debtholders before distributing any of its earnings to shareholders. So the
amount available to this shareholder will be:

Cash flow from WHY to shareholder: (2 marks)

 300,000  60,000  5%  12,000

WHAT will distribute all of its earnings to shareholders, so the shareholder will
receive:

Cash flow from WHAT to shareholder: (2 marks)

300,000  5%  15,000

However, to have the same initial cost, the investor has borrowed $34,300 to
invest in WHAT, so interest must be paid on the borrowings. The net cash flow
from the investment in WHAT will be:

Net cash flow from WHAT investment: (3 marks)

15,000  34,300  6%  12,942

(c) Given the two investment strategies in part (b), which will investor choose?
When will this process cease? (4 marks)

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Both of the two strategies have the same initial cost. Since the dollar return to
the investment in WHAT is higher, all investors will choose to invest in WHAT
over WHY. The process of investors purchasing WHAT’s equity rather than
WHY’s will cause the market value of WHAT’s equity to rise and/or the market
value of WHY’s equity to fall. Any differences in the dollar returns to the two
strategies will be eliminated, and the process will cease when the total market
values of the two firms are equal.

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