92 Corporate finance

Examiners report 2007

Zone A General remarks
Students were expected to draw on a range of skills outlined in this unit particularly skills involving asset pricing, how to apply asset pricing theory to evaluate investment projects, and knowledge of the effect of agency considerations and informational asymmetry on the decision-making process for managers, investors and lenders to corporations.

Specific comments on questions

Section A Question 1 The risk free rate of return is 5% and the expected rate of return on the market index is 10%. The variance of the return on the market index is 20%. (a) Two portfolios A and B have expected return 7% and 12.5%, and variance 20% and 50%, respectively. Work out the portfolios beta coefficients. Students were expected to draw on the material in Chapter 2 of the subject guide on the CAPM model and apply this model to derive the answers. (b) The risk of a portfolio can be decomposed into market risk and idiosyncratic risk. What are the proportions of market risk and idiosyncratic risk for the two portfolios A and B? Students were here expected to draw on the single index model, which is covered in Chapter 2 under the heading Systematic and unsystematic risk as well as in Chapter 3. However, the question contained a typing error which made it impossible to get sensible answers for asset B. Using the single index model for asset B, we find that the market risk exceeds the total risk for the asset, which is of course impossible. Students who had made a correct approach to this question were awarded full marks. (c) Assume the two portfolios have uncorrelated idiosyncratic risk. What is the covariance between the return on the two portfolios? Students were expected to apply the formula for covariance, and by using the expressions of a single factor model in Chapter 3 (max 2.5 marks). The result, after eliminating terms which are uncorrelated (i.e. the error terms), is that the covariance depends on the betas of the two assets and the standard deviation of the market index (max 7.5 marks).

Examination papers and Examiners reports 2007

Question 2 The price of a stock is currently 100 and each year the price either goes up by 30% or down by 10%, each equally likely. The risk free rate of return is 5% and the expected rate of return on the market index is 10%. (a) What is the expected return on the stock? What is the beta of the stock? Students were expected to work out the expected return on the stock using the probabilities given in the question. They were then expected to apply the CAPM (Chapter 2) equation to arrive at a beta estimate. (b) Derive the price of a one-year call option on the stock with exercise price 100 using an arbitrage argument. Students were expected to apply option pricing techniques in a binomial setting (Chapter 4, under Binomial option pricing) to work out a portfolio of the stock and the risk free asset which is replicating the behavior of the call option. The procedure is explained in detail in the subject guide. (c) Using put-call parity, derive the price of a corresponding put option with exercise price 100. Students were expected to apply put-call parity outlined in Chapter 4 of the subject guide, to arrive at the answer. Note that it is common to use an annual return in the binomial option pricing model, so students needed to give the present value of the exercise price as the discounted exercise price using the annually compounded rate instead of the continuously compounded rate that is used in the subject guide. Marks were deducted from students who approached this question mixing between the two compounding methods. (d) Explain what would happen to your answers in (b) and (c) if the risk of the stock is increased (i.e. keeping the expected return constant, the return in the up state is greater than 30% and the return in the down state is less than minus 10%). Students were expected to draw on the explanation of the effects of an increase in volatility given in the section on BlackScholes option pricing in Chapter 4 of the subject guide (max 2 marks). They were also expected to use put-call parity to explain that any effect on the call price that does not involve the underlying stock price, the exercise price, or the risk free discount rate will have exactly the same effect on the put price, since put-call parity must hold at all times (max 3 marks). Question 3 You observe that the average return for three stocks A, B, and C is 7%, 9%, and 13%, respectively, and you find that when regressing the stock returns on a zero-mean random variable X you find: r(A) = 0.07 + 0.5X + e(A) r(B) = 0.09 + 1.0X + e(B) r(C) = 0.13 + 2.0X + e(C) Where r(i) and e(i) are the returns and the regression residuals on stock i=A,B,C, respectively. (a) Assume the residuals in the regressions above and all regressions of this type are uncorrelated across time and across stocks. Work out the risk free rate of return and the risk premium for the X-factor in an arbitrage free market. Students were expected to draw on the material in Chapter 3 on APT in answering this question. Students should have derived the APT equation for each stock, which depends on the risk free rate, the factor loadings and

92 Corporate finance

the risk premium for the single factor (max 8 marks). Since students had three equations of this type but only two unknown, the risk free rate and the risk premium, they should have found that the third expression is always a linear combination of the other two (max 4.5 marks). The information regarding one of the assets is redundant. (b) Now assume the residuals in regressions of the type above are correlated across stocks, but if you introduce a second random variable Y (also zero mean) you find that the residuals of the regressions r(A) = 0.07 + 0.2X + 0.3Y + e(A) r(B) = 0.09 + 0.5X + 0.5Y + e(B) r(C) = 0.13 + 1.2X + 0.8Y + e(C) are uncorrelated across all stocks. Work out the risk free rate of return and the risk premium for the X-factor and the Y-factor in an arbitrage free market. Students were expected to draw on the same material for this question as for (a) (max 8 marks). Now the information for all assets is relevant, as there are three equations and three unknowns. The answer should give the same number for the risk free rate of return as in (a) (max 4.5 marks). Question 4 Consider a strategic (i.e. value enhancing) merger/takeover between two firms A and B. Firm A has 100,000 shares outstanding priced at $2 each, and firm B 200,000 shares priced at $1 each. If a merger takes place, the new firm could make cost savings in production and marketing of $4,000 each year indefinitely. The cost of capital is 10%. (a) Suppose firm A proposes a bid for firm Bs shares worth $1.2 each, and also suppose the bid is going to be accepted for sure by all of Bs shareholders. Work out the price-response to the bid announcement by a rational market who take the announcement as a complete surprise. Do you think firm A is overpaying for firm Bs shares? Explain your answer. Students were expected to draw on Chapter 9 in answering this question. There are several parts to this question: first, students needed to work out the value of the firms prior to the announcement, which is just the number of shares times the share price (max 3 marks), and second, they needed to identify the synergy gains, which are equal to the discounted cost savings cash flow (max 3 marks). This makes it possible to work out the value of the merged firm after the announcement (max 3 marks). Then students needed to work out firm Bs value after the announcement, which is equal to the total value of firm As bid, and firm As value after the announcement, which is equal to the value of the merged firm less the total value of its bid (max 3 marks). The price responses can be obtained as the difference between what the shareholders expect to receive after the announcement and what their firms were worth prior to the announcement (max 0.5 marks). (b) Suppose now that the two firms have agreed to a merger where each share in firm A will be converted into 2 shares in the merged firm, and each share in firm B will be converted into 1 share in the merged firm. Work out the price-response to the announcement of the merger, making similar assumptions as in (a). This question also draws on Chapter 9. What is essential here is to work out the division of the merged firm, which can be obtained by calculating the total number of new shares that go to firm As shareholders and the total number of new shares that go to firm Bs shareholders (max 8

Examination papers and Examiners reports 2007

marks). Since the value of the merged firm is known (part (a)), it is just a matter of working out how the merged firm is divided between firm A and firm Bs shareholders (max 4 marks). This would enable the student to work out the price-response to the announcement (max 0.5 marks). Section B Question 5 (a) What are the stylised facts with respect to dividend policy? Review briefly the existing evidence. Students were expected to draw on Chapter 8, which has a section on stylised facts surrounding dividend policy. This section also contains a critical evaluation of the existing empirical evidence which the students were supposed to apply in their answers. (b) Is the empirical evidence for strategic mergers/takeovers conclusive? Review briefly the existing evidence from accounting and event studies. Students were here expected to draw on Chapter 9, which contains a section on empirical evidence. This section makes the distinction between accounting-based studies and event studies, and students were expected to outline the differences in approach between these two types of studies. Students were expected to quote the important empirical evidence that emerged, and to comment on whether they believed current knowledge is sufficient to draw conclusions about the value-enhancing effect of strategic mergers and takeovers. (c) Describe the NPV-rule, the internal rate of return criterion, and the payback rule for investment. What are the relative advantages and disadvantages of these rules? Students were expected to draw on the material in Chapter 1 of the subject guide, which contains an outline of the three methods and a careful discussion of how these methods differ in their conclusions and the appropriateness of their use. Question 6 (a) Outline three different types of mergers, and explain in what circumstances you expect to see each type occurring. This question draws on the material in Chapter 9, which outlines three different types of mergers according to their motivation. Students were expected to comment on what conditions produce a merger of the various types, and were rewarded for mentioning examples. (b) An efficient takeover is defined as a merger in which the value of the synergy gains of the merger exceeds the cost. Explain why, in theory, efficient takeovers may not always succeed. Students should again have used Chapter 9 as a basis for answering this question. A good answer would contain an explanation of the free-riding problem associated with takeovers, followed by an algebraic outline of the impossibility. Note that this analysis does not imply that efficient mergers never happen: in fact it implies that efficient mergers must happen some of the time but not all of the time. (c) Outline two ways which, in theory, can increase the likelihood of efficient takeovers succeeding. This is a follow-up question to (b) and draws on the sections in Chapter 9 that follow those which deal with the free-rider problem. A good answer would outline exactly how the inefficiency is eliminated from the analysis in (b).

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Question 7 (a) Explain what is meant by Myers debt overhang problem. What type of firm is most likely to suffer from this particular problem, and how do you think such a firm seeks to protect itself against it? Students should here have drawn on material from Chapter 7 of the subject guide. They were expected to explain what the debt overhang problem is (max 3 marks), and what type of firm is likely to suffer from this type of problem (it would be good to mention characteristics other than just high borrowing here for instance that the firm has little worth of tangible assets that can act as security for high borrowing, and that it is a high-growth firm whose assets may still be investment projects due to be started rather than actual investments) (max 3 marks). Students should also have commented on how the firm could protect itself from this type of problem via debt management policy, and mentioned the key ingredients in such a policy (max 2 marks). (b) Jensen and Meckling argue there are agency costs associated with outside equity. Explain carefully the nature of these costs. Students should also here have drawn on Chapter 7, where the agency costs of outside equity are carefully explained. (c) Given that there are agency costs of issuing outside equity as in (b), is issuing debt the answer? Explain. Students were again drawn to Chapter 7, and needed to explain that issuing debt may be a partial answer but certainly not a full answer, as there are also agency costs of debt (max 5 marks). Students were also expected to explain the nature of these costs, and finally to draw conclusions as to optimal capital structure, as outlined in the subject guide (max 4 marks). Question 8 (a) Are there agency costs associated with dividend policy for a company that has debt? Explain why this may be the case, and explain also how such agency costs can be prevented. Students should have drawn on Chapter 7 for an overview of agency costs (max 2 marks), and Chapter 6 for an overview of the features of the debt contract, to arrive at the conclusion that the fixed payment plan of debt can make this claim vulnerable to large dividend payments going out from the firm before debt payments are due (max 3 marks). Thus, dividend policy can undermine a fixed debt claim. Students were also expected to explain how such costs could be prevented, for instance by the use of short-term debt or debt covenants triggering foreclosure if large dividend payments are made (max 3 marks). (b) Explain why, assuming firms have better information than the market, dividend policy may be an important factor determining market prices. What are the empirical predictions regarding dividend policy and firm value? Students needed to draw on Chapter 8 on asymmetric information and dividend policy. They were expected to outline the key features of the Ross dividend signaling model (max 4 marks), and explain what main empirical implications emerge from this model (max 4 marks). (c) Explain why your answer in (a) and (b) have completely different empirical predictions for debt values. Students should have here contrasted the effect high dividends have on the debt claim when driven by agency considerations (negative from (a)) (max 4 marks) and the debt claim when driven by asymmetric

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Examination papers and Examiners reports 2007

information (positive from (b)) (max 4 marks) and explained how the effect of high dividend payments of debt can discriminate between these two explanations. If we look at equity values these may be positively related to high dividend payments in either case, and will therefore not discriminate between the two explanations in the same way (max 1 mark).

Key steps to improvement

A number of students could have improved their marks by providing a more careful explanation of their answers. This was particularly the case for numerical questions, where a clear structure and good explanation throughout make it very clear to the Examiner that the student has understood the question.

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