FN2191 Commentary 2022

Examiners’ commentaries 2022

FN2191 Principles of corporate finance
Important note
This commentary reflects this course’s examination and assessment arrangements in the
academic year 2021–22. The format and structure of the examination may change in future years;
see the virtual learning environment (VLE) for such changes.
Information about the subject guide and the Essential reading

references
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2018).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary, online reading list, 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(s).
General remarks
Learning outcomes
At the end of the course and having completed the essential reading and activities, you should be
able to:
explain how to value projects, and use key capital budgeting techniques (for example, NPV
and IRR)
understand and apply real options theory as an advanced technique of capital budgeting
understand and explain the relevance, facts, and role of the payout policy, and calculate how
payouts affect the valuation of securities
understand the trade-off firms face between tax advantages of debt and various costs of debt
calculate and apply different costs of capital in valuation
understand and explain different capital structure theories, including information

asymmetry and agency conflict
understand how companies issue new shares and calculate related price impact in security
offerings
discuss why merger and acquisition activities exist, and calculate the related gains and losses
understand risk, hedging, and numerous financial securities as tools to manage risk.
1
What are the examiners looking for?
The examination questions typically cover a wide range of topics from the syllabus. They aim to test
exam candidates’ understanding of corporate finance concepts and techniques and their ability to
apply them in different scenarios. The examiners generally look for solid evidence that the
candidates have attained the learning outcomes.
Candidates should read widely about each topic covered in the subject guide. Essential and
supplementary readings are vital if you wish to achieve high grades. Typical weaknesses which
examiners have identified in this examination are as follows.
Answers that are too general or too narrow. When asked to assess a theory or concept
critically, you should go beyond describing the theory or concept. You should indicate how
logically it is derived and how well it fits into the real world.
You should not repeat material from the subject guide without analysing or comprehending
it, as this may result in a descriptive or irrelevant answer. Rather, you should carefully
consider what the examination question is asking and respond accordingly.
Avoid writing excessively long, rambling answers. Keep your discussion relevant and
focused. Tailor your answer to the specific requirements of the examination question. The
inclusion of irrelevant material suggests a lack of understanding.
Candidates often spot questions and focus narrowly on revising 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 interrelated, the examination questions usually cover materials from different chapters
in the subject guide. For example, when evaluating a real-life project, we need to know what
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 involve topics covered in Chapters 1, 2, 3,
and 4.
Examination revision strategy
Many candidates are disappointed that their examination performance is poorer than expected.
It may be due to several reasons, but one significant reason is ‘question spotting’, i.e., limiting
your examination preparation to a few questions and/or topics that have appeared in past papers
for the course. This strategy can have serious consequences.
We recognise that candidates might not cover all topics in the syllabus in the same depth, but you
must be aware that examiners are free to set questions on any aspect of the syllabus. Although
past papers can be helpful during your revision, you cannot assume that topics or specific questions
covered in past examinations will re-occur.
You will find the syllabus in the Course information sheet available on the VLE. Read the syllabus
carefully and ensure you cover sufficient material when preparing for the examination.
If you rely on a question-spotting strategy, you will likely find yourself in

difficulties when you sit the examination. We strongly advise you not to
adopt this strategy.
2

Important note

references
Comments on specific questions – Zone A
Candidates should answer FOUR of the following SIX questions. Note that if you attempt more
than the required number of questions, the first four answers will be marked, not the best ones. This
discourages ‘hedging’ of solutions by attempting more questions than required.
Question 1
Rani Corporation expects cash flows from its risky assets in one year of either $150 million or
$20 million, with equal probability. The firm also has debt with a face value of $45 million due in
one year.
Rani is considering a new project that would require an investment of $28 million today and
would result in a certain cash flow of $34 million in one year. Rani has $28 million in cash, which
it can invest in the project. If the cash is not used for financing the project, it will be distributed
now to equityholders as a dividend.
Investors are all risk neutral, and the risk-free discount rate is 3%. There are no taxes.
(a) What are the expected present values of Rani’s equity and debt without the new project?
(4 marks)
(b) What are the expected present values of the firm’s equity and debt if the firm decides to
accept the new project? What is the incremental value to the equity holders? Will Rani’s
managers accept the project? Explain.
(6 marks)
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Assume now that Rani negotiates with the debtholders to write off part of the debt. The face value
of the debt reduces to $35 million on restructuring, on the condition that Rani accepts the new
project.
(c) What are the expected present values of Rani’s debt and equity if this restructuring occurs?
(5 marks)
(d) Will both debtholders and equityholders be willing to go ahead with this restructuring?
Explain.
(4 marks)
(e) From your answers to parts (a) to (d), what conclusions can you make about the relationship
between debt financing, project value, and firm value? (max. of 160 words)
(6 marks)
(Total = 25 marks)
Reading for this question
Subject guide, Chapter 5.
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston, MA; London:
McGraw–Hill, 2016) Chapters 12, 17, and 18.
Approaching the question
$m
(a) If no new project
Payment to debtholders, good state 45
bad state 20
Expected 32.5
PV 31.553
Payment to shareholders, good state 105
bad state 0
Expected 52.5
PV 50.9709
And they have dividend 28
Total 78.9709
(b) Undertake new project
bad state 45
Expected 45
PV 43.68932039
4

bad state 9
Expected 74
PV 71.8447
Incremental value to shareholders from the project
-7.12622
Incremental value to debtholders from the project

12.1359
Shareholders will reject the project as all the benefits go to the debtholders and part of
the existing equity value.
(c) With debt restructuring

If no project
bad state 20
Expected PV 27.5

bad state 0
Expected 57.5
PV 55.8252

Total 83.8252
Undertake new project

bad state 35
Expected 35
PV 33.9806

bad state 19
Expected 84
PV 81.5534
5
(d) Incremental value to shareholders from project AND restructuring

81.5534 – 78.9709 = 2.5825
Incremental value to debtholders from project AND restructuring

33.9806 – 31.5534= 2.4272
Both equityholders and debtholders will be happy to accept the project.
(e) At a certain level of debt, the debtholders benefit from an incremental project’s
expected returns while the shareholders do not, due to the structure of the payoffs to
debt and equity holders – the debt overhang problem.
The project’s positive NPV is unaffected by how the payoffs are split, but managers
acting for the benefit of shareholders will reject it.
Reducing the debt’s face value can lead to positive returns for both parties if the project
is guaranteed to be accepted.
Question 2
The firm, Amber, plans to acquire Benn, another firm in the same industry. Both firms are
financed entirely by equity and have the same required return on equity of 14%.
Table 1 shows relevant financial information for the two firms.
Table 1
Amber Benn
Price per share, $ 25.70 12.80
Number of shares 3,320,000 1,625,000
The acquisition will result in an instant cash flow benefit for the merged (post-acquisition) firm
with a total present value of $25 million.
Amber’s CEO wants at least 80% of the synergy from the merger to benefit his company’s
shareholders. The CEO of Benn has indicated she will agree to the merger for a premium of at
least 20% of Benn’s current share price.
Amber is considering two possible acquisition methods: a share exchange or a cash acquisition
financed by borrowing.
Suppose Amber offers new shares in itself in exchange for Benn’s entire 1.625 million shares.
(a) How many shares should Amber offer to give its existing shareholders 80% of the synergy
gain? What will be Amber’s post-acquisition share price?
(5 marks)
(b) What cash offer would give Amber’s existing shareholders 80% of the synergy gain? What
will be Amber’s post-acquisition share price?
(5 marks)
(c) Can the merger succeed? Explain.

(3 marks)
Suppose for parts (d) and (e) that, following negotiation, the two firms agree that Amber will
acquire the entire 1.625 million shares of Benn at $15.60 each. Amber will pay for the acquisition
by issuing risk-free perpetual debt at an interest rate of 5%. The corporation tax rate is 30%, and
there are no other market imperfections.
In the first year following the acquisition, the earnings per share of Amber are expected to be
$4.78.
(d) What are Amber’s post-acquisition share price and its weighted average cost of capital?
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(8 marks)
(e) Are Amber shares more attractive to buy now than before the acquisition? Explain. (max. of
100 words)
(4 marks)
(Total = 25 marks)
(a) Value of former Benn with a share of synergy gain = 25,800,000

Firm Amber’s equity = 85,324,000+20,800,000+25,000,000 = 131,124,000
Proportion of equity given up by Amber = 25,800,000 /131,124,000 = 0.1968
Proportion of merged firm shares held by former Benn stockholders
= New shares issued/(old shares+ new shares issued) = 0.1968
New shares = 813,262
Total shares after merger = 4,133,262
Price per share in merged firm = 131,124,000 /4,133,262 =31.7241
(b) Increase for Amber = 20,000,000

Increase for Benn = 5,000,000
Offer for Benn =25,800,000
Offer per share of Benn = 15.88
Share value (all Amber) = 105,324,000
Share price of Amber = 31.7241
(c) Yes, the merger can succeed. The two firms’ objectives are compatible. Either method of financing will
lead to an equally acceptable outcome.
(d) Suppose Amber pays for Benn, per share 15.6

Total 25,350,000
Issues debt of face value 25,350,000
Interest rate on debt 0.05
Market value of debt 25,350,000
MV of combined firm 131,124,000
Plus debt tax shield 7,605,000
Total 138,729,000
Less MV of debt 25,350,000
MV of equity 113,379,000
Share price 34.1503012
Gearing ratio 0.193328452

ke= eps/share price = 4.78/34.15 = 14%
Post-merger WACC of A = 0.8067(0.14) + 0.1933(0.05(1-0.30)) = 0.1197 or
7
12% approximately
(e) The shares are not more (or any less) attractive to buy now; they are fairly priced for their risk and
return both before and after the acquisition (under the specified market assumptions).
The new financial risk does not matter since an investor can undo the firm’s debt financing themselves
costlessly if they wish.
Question 3
Driver plc is fully financed by 2.5 million equity shares with a current (cum-div) market value of
£2.29 each. The current dividend of £0.16 per share is about to be paid. The firm has been paying
a constant dividend of £0.16 per share for several years.
The finance director of Driver has proposed that the firm invests £1 million now in more efficient
machinery, which will save the firm £227,500 per year in perpetuity.
The first saving will be in one year. To obtain the funds for investment, Driver can make a one-
time reduction in the current dividend to £0.06 per share. Alternatively, Driver could raise
external finance through a rights issue. Issue costs associated with the rights issue will be
£25,000.
The market is semi-strong form efficient, and there are no taxes.
(a) Demonstrate that the total present value of the cash inflows from the project is £3.25
million.
(3 marks)
(b) If the firm funds the project by reducing the current dividend, what will be the ex-div price
per share after the project acceptance?
(4 marks)
(c) If the firm funds the project by a 1 for 5 rights issue priced at £2 per share, what will be the
ex-div equilibrium price per share after the project acceptance?
(5 marks)
(d) A representative shareholder concerned only about her wealth owns 250 shares in Driver
before the rights issue. What change in her wealth will result from:
(i) taking up the rights and receiving a full dividend?
(ii) receiving a reduced dividend with no rights issue?
Are the two wealth outcomes the same? Explain why or why not.
(6 marks)
(e) Assume now that Driver chooses to fund the project by cutting the current dividend to £0.06
per share. All income from capital gains is taxed at a rate c; all income from dividends is
taxed at a rate d. Assume also that the rates c and d are the same, and the inflation rate is
zero. There are no other market imperfections.
For next year and the foreseeable future, Driver can pay a constant dividend of either £0.06
or £0.16 per share. Will the shareholder in part (d) be indifferent between the two payout
policies? Carefully explain your reasoning.
(7 marks)
(Total = 25 marks)
8
McGraw–Hill, 2016) Chapters 14,15, and 16.
(a) Annual cash flows 227,500 in perpetuity

Cost of equity (div/share price) 0.07
The total present value of the project cash flows is 3,250,000
(b) What will be the ex-div price per share if it reduces the current dividend?
Original shares value 5,725,000
Dividends 2.5*0.06=-150,000
Invest -1,000,000
PV of inflows 3,250,000
Ex-div valuation 7,825,000
Ex-div share price 3.13
(c ) What is the ex-rights ex-div price per share?

Current shares value 5725,000
Dividends = 2.5*0.16=-400,000
Raise in rights issue 1,000,000
Invest in project -1,000,000
Issue costs -25,000
Value of firm ex-rights 8,550,000
No of shares after RI 3,000,000

Share price (ex-rights) 2.85
(d)
(i) Shareholder with existing 250 shares
Before RI Value of shares 572.5
Dividend 40
Pays for new shares -100
after RI has 300 shares
Value of shares 855
Value of wealth after taking rights and receiving dividends
795
Change in their wealth 222.50
(ii) Retention
Original shares value 5,725,000
Dividends -150,000
Invest -1,000,000
Ex-div valuation 250*3.13=7,825,000
Share price 3.13

Dividend 0.06
Cum-div price 3.19
After receiving a reduced dividend, the shareholder with existing 250 shares has a
wealth of 797.5
Change in their wealth 225
Difference -2.5
The two outcomes are not quite the same. The rights issue has a neutral effect on shareholder
9
wealth, but the shareholders bear the issue costs.
(e) The shareholder is not indifferent because capital gains tax is paid only on the disposal of
the shares, while dividend tax is payable annually. See study guide, p. 102.
Question 4
You are the founder of Couture, a designer clothing and homewares firm. Suppose you made an
initial investment of $2 million and received 2 million shares five years ago. Two years ago, you
raised funding from a venture capitalist who invested $14.1 million in the firm in exchange for
30% of the firm’s capital (the venture capitalist still owns today 30% of the firm’s capital).
(a)
(i) How many shares did the venture capitalist receive in Couture in exchange for their
investment? What was the implied price per share?
(3 marks)
(ii) What was Couture’s value following the venture capitalist funding (the post-money
valuation)?
(2 marks)
You now decide to take the firm public through an initial public offering (IPO) to raise funds to
expand the firm. You issue 2 million IPO shares priced at $16 each. Issuance costs are 7% of the
gross amount raised. Assume that the share price at the end of the first trading day is $20.
(b)
(i) How much did your firm raise for investment from the IPO? What is the market
value of the firm immediately after the IPO?
(5 marks)
(ii) What is the implied market valuation of Couture before the IPO?
(4 marks)
(iii) What is the cost to you of taking your firm public?
(3 marks)
(iv) Comparable publicly listed firms have a prospective price/earnings multiple of 17.
What is the implied market anticipation of Couture’s total earnings in its first year
following the IPO?
(3 marks)
(c) Explain what market imperfections can account for the difference between Couture’s implied
pre-IPO share price and its share price at the end of the first trading day. (max. of 120 words)
(5 marks)
(Total = 25 marks)
10
(a)
(i) 2,000,000 founder shares will be 0.70 of total
Total 2,857,143
VC must buy 857,143 shares for 14,100,000
The implied price per share is 16.45
(ii) Post money valuation?

2,857,142 x 16.45=47,000,000
(b)
(i) Raised from the IPO per share = 14.88
Total raised for investment = 29,760,000
Gross amount raised: 32,000,000
Market value of firm after IPO = 97,142,840 including 29,760,000 raised in IPO
(ii) Market value of assets pre-IPO = market value after IPO – net amount raised in IPO
= 69,328,916
Market’s view of value per share pre-IPO = 24.2655
(iii) Issuance cost = 0.07*16*2,000,000 =2,240,000

Cost to you of taking firm public = share of issuance costs
= 0.70 * 2,240,000 = 1,568,000
(iv) Suppose the market values the firm according to the p/e ratio, and the comparable
p/e ratio is 17. What is the implied market anticipation of Couture’s total earnings in
its first year following the IPO?
17 = 20/EPS
EPS = 20/17 = 1.1765
No. of shares post-IPO = 4,857,143
Total anticipated earnings = 5,714,286.
(c) Market imperfections include information asymmetry between investors inside and
outside the firm and between different types of investors.
While the issuance costs typically constitute the largest direct costs for a company
undergoing an IPO, there are other costs, including legal, accounting, and tax costs.
The existing shareholders bear the transaction costs.
11
Question 5
Mere Ltd, a UK company, expects cash flows of £1.71 million from its UK operations in one year.
In one year, it will need to make a payment to a supplier in the United States of $780,000. Mere
also has debt of £1.1 million due in one year. If the firm goes bankrupt, the bankruptcy costs will
be £80,000. The exchange rate for one US dollar in one year is forecast to be £0.70 (probability
30%), £0.75 (probability 40%), or £0.82 (probability 30%).
Assume the firm has no other cash flows, all investors are risk-neutral, and the discount rate is
zero.
(a) What are the expected values of the equityholders’ and debtholders’ stakes in Mere and the
firm’s total value?
(7 marks)
(b) Suppose Mere can hedge its dollar exposure with a forward exchange contract at $= £0.76.
What will be the expected cash flows to debtholders and equityholders? What will be the
firm’s total value?
(6 marks)
(c) Suppose now that Mere can hedge its dollar exposure with a call option with an exercise price
of £0.76 and a premium of £0.02 per dollar. What will be the expected cash flows to
debtholders and equityholders? What will be the firm’s total value?
(6 marks)
(d) Who is better off with hedging, and who is worse off? What will Mere’s managers choose to
do? Explain what, if any, agency cost is occurring in this case. (max. of 150 words)
(6 marks)
(Total = 25 marks)
(a) Firm forecasts 0.7 0.75 0.82

Possible exchange rates t=1 0.7 0.75 0.82
Probability 0.3 0.4 0.3
Net exposure to $ (payable) -780 -780 -780

Payable in £ -546 -585 -639.6
Net cash from UK sales 1,710 1,710 1,710
Total inflows, £ 1,164 1,125 1,070.4
Bankruptcy? No No Yes
Debt due for repayment t=1 1,100
Bankruptcy costs 80
Cash flows to debtholders 1,100 1,100 1,070.4

less Bankruptcy cost 0 0 80
1,100 1,100 990.4
Expected value to debtholders 1,067.12
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Cash flows to equityholders 64 25 0

Expected value to equityholders 29.2
Total firm value 1,096.32
(b) Forward hedge

Forward rate of 0.76
Buy $780 at the forward rate
Net £ payment for $ -592.8 -592.8 -592.8
Add £ inflows 1,710 1,710 1,710
Total 1,117.2 1,117.2 1,117.2
Bankruptcy? No No No
Cash flows to debtholders 1,100 1,100 1,100

1,100 1,100 1,100
Expected value to debtholders 1,100
Cash flows to equityholders 17.2 17.2 17.2


Difference from no hedge 20.88
Increase/decrease in shareholders’ wealth from hedging
-12
(c) What if Mere uses a call option?

Exercise price 0.76
Premium 0.02
Exercise option? No No Yes
Buy $ at 0.7 0.75 0.76
Payment for $ -546 -585 -592.8
Add £ inflows 1,710 1,710 1,710
Option premium -15.6 -15.6 -15.6
Total 1,148.4 1,109.4 1,101.6
Cash flows to debtholders 1,100 1,100 1,100

1,100 1,100 1,100
Expected value to debtholders 1,100

Difference from no hedge 22.44

Increase/decrease in shareholders’ wealth from hedging
13
-10.44
(d) In this case, the firm value is increased by both types of hedge because the expected cost of
hedging is less than the expected bankruptcy cost.
Debtholders are better off, shareholders worse off.
Managers acting in shareholders’ interests will not hedge because their expected payoff is
higher in the more risky unhedged scenario. There is an agency cost here because the
managers’ actions result in suboptimal firm values.
The three strategies are analogous to 3 mutually exclusive projects with differing risk and
return. Managers acting on behalf of the shareholders choose the riskiest, least valuable
‘project’.
Question 6
Sunny plc, a firm in the leisure industry, is considering buying a plot of land to develop as a
holiday park. The purchase price of the land is £1.8 million. Sunny would now need to spend an
additional £6 million to build the site’s facilities. The cash flows from this project will be either
£850,000 every year (probability 0.7) or £140,000 every year (probability 0.3) in perpetuity,
depending on whether the success of the holiday park is high or low. The first cash flow will occur
in one year, and at that time, Sunny will know whether the park’s success is high or low.
Assume that 10% is a suitable discount rate for all cash flows.
(a) What is the expected net present value of the project?

(5 marks)
Suppose that Sunny can sell the developed site, if it chooses to do so, after one year, for £6
million.
(b) What is the expected value now of this abandonment option? Is the project worthwhile?
(5 marks)
Assume now that if the site is not sold, the firm can instead choose to extend it by investing a
further £1.5 million in one year. The cash flows from this expansion will be either £30,000 yearly
(probability 0.5) or £400,000 yearly (probability 0.5) in perpetuity, depending on whether a
competitor firm builds a site nearby. The first cash flow from the expansion will occur in two
years.
(c) What is the expected value now of the expansion option?

(5 marks)
(d) Suppose that the project cannot be delayed, but Sunny can purchase the land and own it
without further investment for up to one year by paying a fee to the local government. If
Sunny believes it could sell the land for £3.5 million in one year, what is the maximum fee the
firm would pay now?
(5 marks)
(e) Explain how a real option to delay investment could be analogous to an American call option
on a dividend-paying stock. (max. of 120 words)
(5 marks)
(Total = 25 marks)
14
(a)
NPV, high success t=0
Cash flows -1,800,000
-6,000,000
-7,800,000
Cash flow perpetuity 8,500,000 = 0.85/0.1
NPV 700,000
NPV, low success t=0

-6,000,000
-7,800,000
Cash flow perpetuity 1,400,000 = 0.14/0.1
NPV -6,400,000
ENPV - 1,430,000
(b) Compare the sale value with the cash flow perpetuities from t=1.
In the high success state, the abandonment option has zero value (6m<8.5m).
In the low success state, the selling price of 6m > the perpetuity of 1.4m from future cash
flows.
The option value is 6m –1.40m = 4.46 with probability 0.3.
Present value = 0.3(4.6m)/1.10 = 1.255m.
The project is still not worthwhile with the option. 1.255m < 1.43m so ENPV is negative.
(c) Competitor firm does not build nearby (probability 0.5)

Outlay at t=1 = £1,500,000
Annual inflow starting at t=2 = £400,000
PV at t=1 of expansion cash inflow stream starting at t=2 =£4,000,000
NPV at t=1 = £2,500,000
NPV at t=0 = £2,272,727
Competitor firm builds nearly (probability 0.5)

Outlay at t=1 = £1,500,000
Annual inflow starting at t=2 = £30,000
PV at t=1 of expansion cash inflow stream starting at t=2 = £300,000
The option value is zero.
The value now at t=0 of the option is £2,272,727 x probability competitor does not build
(0.5) x probability of site is not sold (0.7) = £795,455.
The expansion option will be chosen only in the ‘good’ state from part (a). In the ‘bad’ state
the expansion option will not be chosen as the abandonment option is preferable. (At t=1,
the sale price of £6 million exceeds the payoffs from keeping the business (£1.4 million) and
expanding (£2.5 million)).
15
(d) The overall project ENPV with both options is -£1,430,000 + £1,254,545 + £795,455 =
£620,000.
Since the project cannot be delayed, land purchase and subsequent sale without
development is an alternative.
The land value in 1 year is £3,500,000.

£
Present value at t=0 of land sale = 3,181,818
Cost of land purchase at t=0 = 1,800,000
NPV 1,381,818
Holiday park project ENPV 620,000
Difference = 761,818
The firm would pay up to a maximum fee of £761,818 to the local government.
(e) The option to delay investment is an option to buy (call) the investment at a known
purchase price (the exercise price). It is an American option if the firm can exercise the
option to delay at any time.
The investment’s discounted cash flows are analogous to the stock price of a financial asset.
The option will be in the money if the purchase price < the sum of the discounted future
cash flows and should be exercised; otherwise, the option will be out of the money and does
not pay to exercise it.
16

Important note

references
Comments on specific questions – Zone B
Candidates should answer FOUR of the following SIX questions. Note that if you attempt more
than the required number of questions, the first four answers will be marked, not the best ones. This
discourages ‘hedging’ of solutions by attempting more questions than required.
Question 1
Dash plc, a property development and investment company, is considering purchasing a disused
airfield site to develop as a retail park. The purchase price of the land is £2.3 million. Dash would
need to spend an additional £6 million now to develop the site. The project will generate cash
flows from rental income every year in perpetuity. If the local government builds a new road
nearby, the yearly cash flows will be £1.1 million (probability 0.5). If the new road is not built, the
yearly cash flows will be £180,000 (probability 0.5). The first cash flow will occur in one year.
Assume that 8% is a suitable discount rate for all cash flows.
(a) What is the expected net present value of the project?

(5 marks)
Suppose that Dash can sell the developed site, if it chooses to do so, after one year for £10 million.
(b) What is the expected value now of this abandonment option? Is the project worthwhile?
(5 marks)
Assume now that, if the site is not sold, Dash can instead choose to invest £3 million in one year
to expand its retail space. The expansion will result in additional rental cash flows of either
£168,000 every year (probability 0.25) or £354,000 every year (probability 0.75) in perpetuity,
depending on whether a large department store chooses to occupy the new space after it is built.
The first cash flow from the expansion will occur in two years.
17
(c) What is the expected value now of the expansion option?

(5 marks)
(d) Suppose that the project cannot be delayed, but Dash can purchase the land now and own it
without further investment for up to one year by paying a fee to the local government. If Dash
believes that it could sell the land for £4.5 million in one year, what is the maximum fee the
firm would pay now?
(5 marks)
(e) Explain how a real option to abandon a project could be analogous to an American put
option, identifying the specific components of the option. (max. of 120 words)
(5 marks)
(Total = 25 marks)
(a) NPV, good state t=0

-6,000,000
- 8,300,000
Cash flow perpetuity 1.1/0.08 = 13,750,000
NPV 5,450,000
NPV, bad state

-6,000,000
- 8,300,000
Cash flow perpetuity 0.18/0.08 = 2,250,000
NPV -6,050,000
ENPV - 300,000
(b) Compare the sale value with the cash flow perpetuities from t=1.
In the high success state, the abandonment option has zero value (10m<13.75m).
In the low success state, the selling price of 10m > the perpetuity of 2.25m from future
cash flows.
The option value is 10m –2.25m = 7.75m (with probability 0.5).
Present value = 0.5(7.75m)/1.08 = 3.588m.
The project is worthwhile with the option. 3.588m > 0.3m so ENPV is positive.
18
(c) Expansion option at t=1

With department store (p = 0.75)
Outlay at t=1= £3,000,000
The perpetual annual inflow from expansion is £354,000 with the first inflow at t=2
PV at t=1 of this future cash inflow perpetuity = £354,000/0.08 = £4,425,000
NPV at t=1 = £4,425,000 – £3,000,000 = £1,425,000
NPV at t=0 = £1,425,000/1.08 = £1,319,444.
Without department store (p = 0.25)

Outlay at t=1= £3,000,000
The perpetual annual inflow from the expansion is £168,000 starting at t=2
PV at t=1 of this future cash inflow perpetuity = £168,000/0.08 = £2,100,000, less than the
initial outlay.
The option has value 0 in this state.
The expansion option’s value now at t=0 is £1,319,444 x probability of a department store
(0.75) x probability of site not being sold (0.5) = £494,792.
The expansion option will be chosen only in the ‘good’ state from part (a). In the ‘bad’ state
the expansion option will not be chosen as the abandonment option is preferable. (At t=1,
the sale price of £10 million exceeds the payoffs from keeping the business (£2.25 million)
and expanding (£1.425 million)).
(d) The overall project ENPV with both options is -£300,000 + £3,587,962 + £494,792 =
£3,782,754.
Since the project cannot be delayed, land purchase and subsequent sale without
development is an alternative.
The land value in 1 year is £4,500,000.

£
Present value at t=0 of land sale = 4,166,667
Cost of land purchase at t=0 = 2,300,000
NPV 1,866,667
The NPV is lower than the project ENPV of £3,782,754 so no fee is worth paying. The
'option' has a zero value.
(e) The option to abandon is an option to sell (put) the investment at a known sale price
(the exercise price).
It is an American option if the firm can exercise the option to abandon at any time.
The discounted cash flows of the investment are analogous to the stock price of a
financial asset.
The option will be in the money if the selling price > the sum of the discounted future
cash flows and should be exercised; otherwise, the option will be out of the money and
does not pay to exercise it.
Question 2
Genie Corporation expects cash flows from its risky assets in one year of either $100 million or
$16 million, with equal probability. The firm also has debt with face value of $29 million due in
one year.
Genie is considering a new project that would require an investment of $18 million today and
would result in a certain cash flow in one year of $22 million. Genie has $18 million in cash,
19
which it can use to invest in the project. If the cash is not used for financing the project, it will be
distributed to equityholders now as a dividend.
Investors are all risk neutral, and the risk-free discount rate is zero. There are no taxes.
(a) What are the expected present values of Genie’s equity and debt without the new project?
(4 marks)
(b) What are the expected present values of the firm’s equity and debt if the firm decides to
accept the new project? What is the incremental value to the equityholders? Will Genie’s
managers accept the project? Explain.
(6 marks)
Suppose that Genie proposes to sell half its risky assets for $29m, use the sale proceeds to pay off
the debt entirely, and undertake the new project.
(c) What would be the expected present values of Genie’s debt and equity after implementing the
proposal?
(5 marks)
(d) Will both debtholders and equityholders be willing to go ahead with this proposal? Explain.
(4 marks)
(e) From your answers to parts (a) to (d), what conclusions can you make about the relationship
between debt financing, project value, and firm value? (max. of 160 words)
(6 marks)
(Total = 25 marks)
McGraw–Hill, 2016) Chapter 12, 17, and 18.
(a) If no new project

bad state 16
Expected 22.5
Payment to shareholders, good state 71 (=100-29)

bad state 0
Expected 35.5
Total 53.5
(b) Undertake new project

bad state 29
Expected 29
Payment to shareholders, good state 93 (=122-29)

bad state 9 (=38-29)
20
Expected 51
Incremental value to shareholders from the project -2.5
Incremental value to debtholders from the project 6.5
Shareholders will reject the project as all the benefits go to the debtholders and part of
the existing equity value.
(c) Assets in place Value Probability

Good 50 0.5
Bad 8 0.5
By selling half of the risky assets

Undertake new project
bad state 0
Expected 0
Payment to shareholders, good state 72 (=50+22)

bad state 30 (=8+22)
Expected 51
(d) Incremental value to shareholders from the project

AND selling half of the risky assets -2.5
Incremental value to debtholders from

project AND selling half of the risky assets -22.5
plus debt paid off now 29.0
6.5
Incremental values to shareholders and debtholders are the same as (b).
Shareholders will STILL reject the project as all the benefits go to the debtholders and
part of the existing equity value.
(e) At a certain level of debt, the debtholders benefit from an incremental project’s expected
returns while the shareholders do not, due to the structure of the payoffs to debt and
equity holders – the debt overhang problem.
The project’s positive NPV is unaffected by how the payoffs are split, but managers acting
for the benefit of shareholders will reject it.
Question 3
In one year, Raby Ltd, a UK company, expects cash flows of £160,000 from its UK operations and
€480,000 from its European Union (EU) sales. Raby also has debt of £550,000 due in one year.
If the firm goes bankrupt, the bankruptcy costs will be £80,000. The exchange rate for one euro
in one year is forecast to be £0.75 (probability 30%), £0.85 (probability 40%), or £0.90
(probability 30%). Assume the firm has no other cash flows, all investors are risk-neutral, and the
discount rate is zero.
21
(a) What are the expected values of the equityholders’ and debtholders’ stakes in Raby and the
total value of the firm?
(8 marks)
(b) Suppose Raby can hedge its euro exposure with a forward exchange contract at € = £0.84.
What will be the expected cash flows to debtholders and equity holders? What will be the
total value of the firm?
(6 marks)
(c) Suppose now that Raby can hedge its euro exposure with a put option with an exercise price
of £0.85 and a premium of £0.025 per euro. What will be the expected cash flows to
debtholders and equityholders? What will be the total value of the firm?
(6 marks)
(d) Which of the three strategies in (a), (b), or (c) maximises the value of the firm? What strategy
will Raby’s managers choose? Are they the same? Carefully explain why/why not. (max. of
150 words)
(5 marks)
(Total = 25 marks)
McGraw–Hill, 2016) Chapter 20, 21, and 26.
Possible exchange rates t=1 0.75 0.85 0.9

Probability 0.3 0.4 0.3
Cash flows, € 480 480 480

Value in £ 360 408 432
Cash from UK ops 160 160 160
Total inflows, £ 520 568 592
(a) Bankruptcy? Yes No No
Debt due for repayment t=1 550

Bankruptcy cost 80
Cash flows to debtholders 520 550 550

440 550 550
Expected value to debtholders 517
Total firm value 536.8
(b) Hedging
Sell 480 forward at 0.84
Net £ income from € 403.2 403.2 403.2
add £ inflows from UK ops 160 160 160
22
Total 563.2 563.2 563.2


550 550 550

Increase/decrease in firm value from hedging

26.4
Increase/decrease to shareholders from hedging
-6.6
(c) What if Raby uses a put option?

Exercise price of 0.85
Premium 0.025
Exercise option? Yes Yes/No No
Sell € at 0.85 0.85 0.9
Receive for € 408 408 432
Add £ inflows from UK ops 160 160 160
Less option premium -12 -12 -12
556 556 580


550 550 550
Increase/decrease in firm value from hedging
26.4
Increase/decrease to shareholders from hedging
-6.6
23
(d) Both types of hedge increase the firm value because the expected cost of hedging is less than
the expected bankruptcy cost.
Hedging benefits debtholders at the expense of equityholders. Managers acting in

shareholders’ interests will not hedge because their expected payoff is higher in the more
risky unhedged scenario. The payoffs reflect the option-like nature of equity (call option on
the firm’s assets), with the downside limited to zero. Choosing not to hedge shifts risk to the
debtholders.
Question 4
Walker plc is fully financed by 26 million equity shares with a current (cum-div) market value of
£4 each. The current dividend of £0.65 is about to be paid. The dividend was £0.63 per share one
year ago and £0.6125 per share two years ago.
The finance director of Walker has proposed that the firm invests £16.9 million now in
technologically updated equipment which will save the firm £4.665 million per year in
perpetuity. The first saving will occur in one year. The funds for investment will be available if the
firm does not pay the current dividend (dividends will restart in one year at £0.65(1+g) per share,
where g is the average dividend growth rate). Alternatively, Walker could raise external finance
through a rights issue.
The market is semi-strong form efficient, and there are no taxes.
(a) Estimate the average dividend growth rate for Walker plc and its cost of capital, both to the
nearest whole percentage point.
(5 marks)
For questions (b) to (e), assume the dividend growth rate and cost of capital will remain the same
in the future.
(b) If the current dividend is not paid, what will be the price per share after project acceptance?
(4 marks)
(c) If the firm funds the project by a 1 for 4 rights issue priced at £2.60 per share and pays the
current dividend, what will be the ex-rights equilibrium price per share?
(5 marks)
(d) Demonstrate that a shareholder who is concerned only about her wealth and owns 50 shares
in Walker before the rights issue should be indifferent to
(i) taking up the rights and receiving a full dividend, and
(ii) forgoing the current dividend if no rights issue is made.
(5 marks)
(e) Assume now that there are personal taxes. All income from capital gains is taxed at a rate c;
all income from dividends is taxed at a rate d. Assume also that the rates c and d are the
same, the inflation rate is zero, and that the shareholder in part (d) plans to hold her shares
in Walker for another two years and then sell them.
Does the shareholder remain indifferent between the two methods of financing the new
project? Carefully explain your reasoning.
(6 marks)
(Total = 25 marks)
24
25
(a) Dividend growth rate?

t-1 0.031746032
t-2 0.028571429
Estimate 3%
Estimate the cost of equity capital:
From dividend growth model P0 = D0(1+g)/(ke-g)

where
P0 = current ex-div price = 4 – 0.65 = 3.35
D0 = 0.65
g = 0.03
ke = (0.65*1.03/3.35) + 0.03 = 0.2299
Estimate 23%
(b) What is the price per share after project acceptance, assuming no dividend is paid?
NPV of project 3,379,058
Share price increases by 0.13
New share price 4.13
(c) Ex-rights equilibrium price per share

Rights issue is 1 for 4
Rights issue price is 2.6
Value of firm
Original shares 104000000 (=26,000,000*4)
Rights issue funds 16900000 (=26,000,000/4 * 2.60)
Capital outlay for project -16900000

PV of project inflows 20,279,058 (=3,379,058+16900000)
Dividend payment -16,900,000

Value of firm ex-rights 107,379,058
Number of shares after issue 26000000+6500000 (26/4) = 32,500,000
Ex-rights equilibrium price per share = 3.304
(d) The shareholder with 50 shares

Dividend 32.5 (=50*0.65)
Gets rights shares 12.5 (=50/4)
Cost of rights -32.5 (=12.5*2.6)
No of shares post-RI 62.5 (=50+12.5)
Value of shares = 62.5*3.304 =206.50
or
has 50 shares
Value per share 4.13
Value of shares 206.50
Identical outcomes.
26
(e) The shareholder is no longer indifferent because capital gains tax is paid only on the disposal
of the shares, while dividend tax is payable annually. See subject guide, p. 102.
Question 5
The firm, Turf, plans to acquire Fence, another firm in the same industry. Both firms are financed
entirely by equity and have the same business risk. There are no taxes or other market
imperfections.
The table below shows relevant financial information for the two firms.
Turf Fence
Price per share, $ 9.00 4.40
Number of shares 20,000,000 10,000,000
Turf is considering two possible acquisition methods: a share exchange or a cash acquisition
financed by borrowing. The acquisition will result in expected operating cost savings for the
merged (post-acquisition) firm with a total present value of $45 million. Reorganisation costs for
the merged business will have a present value of $10 million, regardless of the acquisition
method.
Suppose Turf offers new shares in itself in exchange for Fence’s entire 10 million shares.
(a) What will be the value of the merged firm? What is the maximum number of shares that Turf
should offer, so its existing shareholders will not be worse off?
(5 marks)
(b) How many new shares should Turf issue to Fence’s shareholders to enable both firms’
individual shareholders to experience the same proportional increase in their wealth from the
acquisition? What is the merged firm’s share price?
(7 marks)
(c) What cash offer would give both firms’ individual shareholders the same proportional
increase in their wealth?
(4 marks)
Suppose for parts (d) and (e) that the two firms agree that Turf will acquire the entire 10 million
shares of Fence for a price of $4.90 each. Turf will pay for the acquisition by issuing risk-free
perpetual debt at an interest rate of 5%. There are no taxes.
Assume you are an institutional investor with a 1% shareholding in Turf before the merger.
(d) What is the difference in the value of your investment after the merger compared to its pre-
merger value?
(3 marks)
(e) After the merger, how could you restore the pre-merger risk associated with your
shareholding? Explain the specific actions you would take. (max. of150 words)
(6 marks)
(Total = 25 marks)
27
(a) Value of merged firm = (9*20m) + (4.40*10m) + 45m – 10m = 259m.

Max number of shares to issue is where Turf’s share price is the same.
Total value after merger = 259,000,000
Max number of shares post-acquisition = 28,777,778 = 259,000,000 / 9.00
of which Turf has 20,000,000
Issue to Fence: 8,777,778 = 28,777,778 - 20,000,000
(b) What share exchange would give a proportionate increase in wealth for Turf and Fence
shareholders?
Proportion of equity given up by Turf =44/(180+44) =0.1964
Proportion of merged firm shares held by former Fence stockholders

= New shares issued/(old shares+ new shares issued)
New shares/(20m + new shares) = 0.1964
New shares = 4,888,889
Total shares after merger =24,888,889
Price per share in merged firm =259,000,000 /24,888,889 =10.4063
(c) Increase for Turf = 28,125,000 = 35,000,000 (180,000,000/ (180,000,000+ 44,000,000))
Increase for Fence = 6,875,000 = 35,000,000 (44,000,000 / (180,000,000 +44,000,000 )
Offer for Fence = 50,875,000 = 6,875,000 + 44,000,000
Share value (all Turf post merger) = 208,125,000 = 180,000,000 + 50,875,000
Share price of Turf post merger = 10.4063 = 208,125,000 / 20,000,000
(d) MV of firm =259m

of which debt = 49m
MV of equity = 210m
Share price = 210m/20m =10.50.
An institutional investor has 1% of A shares

Value before merger = 1.8m
After = 2.1m
(Explanation: MM1)
(e) Shareholding is riskier now due to financial risk.
To restore original risk, undo the firm’s gearing at a personal level. Gearing ratio of A after
merger = 49m/259m = 18.92
Sell 0.1892 of shareholding = 0.3973m
Invest this in A’s debt.
28
Question 6
You are the founder of Epic Arts, a video game firm. Suppose you made an initial investment of
$1 million and received 1 million shares four years ago. Two years ago, you raised funding from a
venture capitalist who invested $6.5 million in the firm. Following the venture capitalist’s
funding, the firm’s value was $18.6 million (the post-money valuation).
(a)
(i) How many shares did the venture capitalist receive in Epic Arts in exchange for their
investment? What was the implied price per share?
(3 marks)
(ii) What proportion of the firm does the venture capitalist hold?
(2 marks)
You now plan to take the firm public through an initial public offering (IPO). You wish to raise
$40 million, net of issuance costs, for investment into the firm. Issuance costs will be 5% of the
gross amount raised. In the first year as a public firm, the expected earnings of Epic Arts will be
$2 million.
(b) Suppose that similar technology firms with publicly traded shares have a prospective
price/earnings multiple of 16. What is the implied market value of a share in Epic Arts?
(3 marks)
You set the IPO price to imply a price/earnings multiple of 16.
(c)
(i) Assuming the IPO is successful, what are the firm’s post-IPO net market value and
share price? How many shares are issued in the IPO?
(6 marks)
(ii) What is the change in the value of your shareholding from taking your firm public?
(3 marks)
(iii) Assume now that the IPO shares need to be priced at $15 per share for the IPO to be
successful. How many shares must be issued? What is the change in the value of your
shareholding compared to before the IPO?
(3 marks)
(d) Explain what market imperfections can account for the difference in your answers in parts
c(ii) and c(iii) above. (max. of 120 words)
(5 marks)
(Total = 25 marks)
(a)
(i) Founder’s shares are worth 18.6m – 6.5m = 12.1m
Implied price per share = 12.1/1million = $12.1
Venture capitalist holds 6.5m/12.1 = 537,190 shares
(ii) Proportion of firm the venture capitalist holds = 537,190/1,537,190 = 34.95%, since
29
founder holds 1 million shares (=12.1m/$12.1).
(b) Number of shares now 1,537,000
Earnings next year 2,000,000
Comparative PE ratio 16
Value per share (using PE) BEFORE the IPO 20.82

(c)
(i) Value of firm BEFORE the IPO 32,000,000
Want to raise (net) 40,000,000
Issuance costs 0.05 of gross proceeds
Gross proceeds from IPO must be 42,105,263 = Pnew x N
Net market value after IPO must be 72,000,000
1,537,000(Pnew) + N(Pnew) =32,000,000 + 40,000,000
1,537,000(Pnew) + 42,105,263 =72,000,000
Pnew = 19.45
N = 2,164,789
(ii) Value of founders' shares post IPO 29,894,737 =original value - issuance costs
Value of new investors' shares =42,105,263
Loss to existing shareholders = 2,105,263
From a(ii), the founder had 65.05% of shares, loses 0.6505*2,105,263 = 1,369,474
Existing shareholders bear the issue costs.
(iii) Issue underpriced at 15
Need to raise 42,105,263
Number of shares to issue is 2,807,018 (=42,105,263/15)
Loss to existing shareholders = (20.82 - 15)*2,807,018 = 16,336,845
Founder’s loss = 10,627,118.
(d) Information asymmetry exists between investors inside and outside the firm and between
different types of investors.
While the issuance costs typically constitute the highest direct costs for a company
undergoing an IPO, other costs include legal, accounting, and tax costs.
The existing shareholders bear the transaction costs.
30

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Examiners’ commentaries 2022

Examiners’ commentaries 2022

Information about the subject guide and the Essential reading

calculate and apply different costs of capital in valuation

understand and explain different capital structure theories, including information

What are the examiners looking for?

Examination revision strategy

If you rely on a question-spotting strategy, you will likely find yourself in

Examiners’ commentaries 2022

Information about the subject guide and the Essential reading

Comments on specific questions – Zone A

Reading for this question

Subject guide, Chapter 5.

Approaching the question

Payment to shareholders, good state 139

Incremental value to debtholders from the project

(c) With debt restructuring

Payment to shareholders, good state 115

And they have dividend 28

Undertake new project

Payment to debtholders, good state 35

Payment to shareholders, good state 149

(d) Incremental value to shareholders from project AND restructuring

Incremental value to debtholders from project AND restructuring

Table 1 shows relevant financial information for the two firms.

(c) Can the merger succeed? Explain.

Reading for this question

Subject guide, Chapter 8.

Approaching the question

(a) Value of former Benn with a share of synergy gain = 25,800,000

(b) Increase for Amber = 20,000,000

(d) Suppose Amber pays for Benn, per share 15.6

Gearing ratio 0.193328452

The market is semi-strong form efficient, and there are no taxes.

Reading for this question

Subject guide, Chapter 7.

McGraw–Hill, 2016) Chapters 14,15, and 16.

Approaching the question

(a) Annual cash flows 227,500 in perpetuity

(c ) What is the ex-rights ex-div price per share?

No of shares after RI 3,000,000

Share price 3.13

wealth, but the shareholders bear the issue costs.

Reading for this question

Subject guide, Chapter 6.

Approaching the question

(ii) Post money valuation?

(iii) Issuance cost = 0.07*16*2,000,000 =2,240,000

The existing shareholders bear the transaction costs.

Reading for this question

Subject guide, Chapter 9.

Approaching the question

(a) Firm forecasts 0.7 0.75 0.82

Net exposure to $ (payable) -780 -780 -780

Cash flows to debtholders 1,100 1,100 1,070.4

Cash flows to equityholders 64 25 0

Total firm value 1,096.32

(b) Forward hedge

Cash flows to debtholders 1,100 1,100 1,100

Cash flows to equityholders 17.2 17.2 17.2

(iii) Issuance cost = 0.07162,000,000 =2,240,000