Examiners’ commentaries 2008

Examiners’ commentary 2008

92 Corporate finance

Specific comments on questions Zone A

Section A
Question 1
(a) Factor models describe the return on assets as a relationship to one or
more factors. Specify this relationship (for k factors, say), and explain what
can be said about the expected returns on assets for this specification? (5
marks)
Three marks in total are available for the first part. If you can come up
with the factor structure equation:
ri = ai + bi1 f1 + bi2 f2 + ... + bik fk + ek,
you will get one mark. If you explain further that a factor structure
implies a pricing relationship where
Eri (= ai) = rF + bi1 λ1 + bi2 λ2 + ... + bik λk
for some factor risk premia λi, i=1,…,k, you get a further two marks.
The final two marks are for further explanations about the APT model,
e.g. that expected returns on assets will adjust such that there are no
arbitrage profits to be made between broad portfolios, and that
portfolios that have loading on a single factor must have expected
return equal to the risk free asset plus the beta-weighted risk premium
for that factor.
(b) The one factor model is the simplest of factor models. In what ways does
this model differ from the CAPM model, and in what ways is it similar?
Explain Roll’s critique of the CAPM model. Finally, explain how well the
CAPM equation fits real data when using the market index as proxy for the
market portfolio. (10 marks)
Two marks are available for explaining that the CAPM model is similar
to a one-factor model since the only source of risk is the return on the
market index, and it is different in the sense that it explains directly
what the risk premium is.
Roll’s critique is that all tests of the CAPM is a joint hypothesis with the
one that the market index is the market portfolio – thus a rejection
may just indicate that the market index is not the market portfolio – it
doesn’t follow that the CAPM is rejected. Failure to reject may similarly
just mean the market index is efficient – it doesn’t follow that the
market portfolio is. Four marks are available for this argument.
The final part is also worth four marks. Asset returns should be linear
in the return on the market index with the intercept related to beta and
the risk free rate – it is flatter than that in practice. Another prediction
is that beta is the only factor explaining risk premia – it is not: firm
size, book to market, P/E ratios and dividend yields also matter.

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(c) Explain how Fisher separation implies that the owners of a firm can agree
to delegate the job of investing the firm’s money to a manager, even though
the owners may have different preferences from each other and from the
manager. What rule should the manager use for optimal investment? Finally,
explain why Fisher separation breaks down if the borrowing rate differs from
the lending rate. (10 marks)
The first part is worth four marks. The reason differences in
preferences can be overcome is that private borrowing and lending on
the part of the investors as a method of evening out differences is
superior to using the firm’s investment plan – you would probably use
a diagram to illustrate this. Differences in preferences between the
owners and the manager can be managed by an incentive scheme that
awards the manager for using a certain rule for evaluating projects.
The second part outlines this rule (which is the NPV-rule). It follows
from the diagram of Fisher separation – the marginal project has zero
NPV and all projects with positive NPV are accepted and those with
negative NPV are rejected. Three marks are available here.
The last part should explain that if the borrowing rate is different from
the lending rate in general there will be some degree of residual
disagreement about the investment plan. You would probably use
another diagram illustrating the relevant area. There is no way of
resolving this. The marginal project is now ambiguous as there are two
rates for working out the NPV. Three marks are available here.
If you just provide a diagram of Fisher separation with little or no
explanation on the first part, you would only receive only two of the
four marks. A full explanation without a diagram is still worth four
marks.
Question 2
(a) Derive the Gordon Growth Model, and explain how you can use this
model to work out the required rate of return for an investment project in
terms of the dividend yield of the project. (5 marks)
The first part requires a derivation of the stock price as next year’s
dividend plus price: P(0) = (D(1) + P(1))/(1+r), repeating
successively we find P(0) = D(1)/(1+r) + D(2)/(1+r)2 + ... and if we
assume a constant growth rate g in dividends we find eventually P(0)
= D(1)/(r−g) (4 marks). Note that if you write next year’s dividend as
D(0)(1+g) – current dividend inflated with the annual growth rate –
this is fine.
The final part comes from turning the return around to:
r = D(1)/P(0) + g
= dividend yield plus growth rate (this is worth one mark).
(b) Suppose the underlying asset does not pay dividends. Derive the upper
and lower bounds on European call and put option prices. Derive put-call
parity for European options. Do you expect put-call parity holds also for
American options? Explain. (10 marks)
For calls: the payoff max(s−X,0) is dominated by the payoff of s,
therefore the stock price s is always greater than or equal to the call
price c. Similarly, the payoff max(s−X,0) dominates the stock price
minus the present value of X (or zero, whichever is greatest) (worth

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three marks). The payoff max(X−s,0) is dominated by the payoff of X,

therefore the present value of X is always greater than or equal to the
put price p. Similarly, max(X−s,0) dominates the present value of X
minus the stock price (or zero, whichever is greatest) (worth three
marks).
The portfolio c + PV(X) has payoff max(X,s) and the portfolio p + s
has also payoff max (X,s), therefore the price must be the same: c +
PV(X) = p + s (worth two marks).
Put-call parity will hold only if early exercise is not optimal (one mark
for this point). Early exercise may be optimal for puts, since the upper
bound on put prices is PV(X) which may be exceeded by an American
put whose payoff max(X−s,0) is greater (one mark for this point).
Discussed and agreed at the standardisation meeting: if you just state
put-call parity without derivations you would receive zero marks
(applies to the second part above). If you produce a table
demonstrating the equivalence of the payoffs of the two portfolios but
fail to make the final arbitrage argument you would receive only one
mark.
(c) The Black-Scholes price of a European call is C = SN(d1) – PV(X)N(d2),
where C is the call price, S is the stock price, and PV(X) is the present value of
the exercise price paid at maturity. The function N(.) is the normal
distribution function, and d1 and d2 are parameters that depend on the time
to maturity, the stock and exercise prices, the risk free rate of return, and the
volatility of the stock price. Use put-call parity to derive the price of a
European put option. Suppose you invest a fraction x of you money in calls
and the remaining fraction 1-x in puts. Work out the value of x for which your
portfolio is no longer sensitive to small movements in the stock price. (10
mars)
Put call parity is c + PV(X) = p + s (one mark available for stating
this) and from this we can work out
sN(d1) – PV(X)N(d2) + PV(X) = p + s
and solve with respect to p to find
p = PV(X)(1−N(d2)) – s(1−N(d1)) (5 marks available for this).
The portfolio in the second part is worth
x(sN(d1) – PV(X)N(d2)) + (1−x)(PV(X)(1−N(d2)) – s(1−N(d1))
= s(xN(d1) – (1−x)(1−N(d1))) – PV(X)(xN(d2) − (1−x)(1−N(d2))).
Putting
xN(d1) – (1−x)(1−N(d1))
equal to zero yields
x = (1−N(d1)) and (1−x) = N(d1). (4 marks available for this)
Question 3
(a) Let F be the k-period forward price, and S the current spot price of the
underlying. The risk free interest rate is r. Derive the expression for the k-
period forward price. (5 marks)
Consider the following portfolios. P1: long position in forward
contract. P2: long position in the stock and borrowing F/(1+r)k. Both
portfolios generate a pay-off equal to Sk – F in k periods. Both

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portfolios should hence have identical costs. As the cost of P1 is nil, it

follows that S = F/(1+r)k. Five marks in total available for this part.
If you just state the final conclusion you would only be awarded one
mark overall.
(b) Event studies are important for evaluating the semi-strong form of the
efficient market hypothesis, as well as studying the effects of key corporate
announcements. Explain what the semi-strong form of the efficient market
hypothesis means. Next, explain how you would design an event study to
examine the price impact of earnings announcements. (10 marks)
The semi-strong form of the EMH states that all public information is
embedded in asset prices (two marks available).
The study should contain an announcement, e.g. earnings
announcements, then an announcement window (including a period
leading up to the announcement and a period after the
announcement), and investigate the abnormal returns over the
announcement window (worth four marks).
The test consists of looking at the pattern of abnormal returns. It
should have a large jump around the announcement date, and small
abnormal returns in the period leading up to the jump and small
abnormal returns in the period following the jump. The public
announcement should dictate the price jump (worth four marks).
(c) Consider a firm that has expected free cash flow of £100,000 each year
for 5 years. At the end of year 5 the value of the firm is equal to the expected
resale value of its assets, which is £800,000. You believe it would be
appropriate to use a discount rate corresponding to a beta of 1. The
expected return on the market index is 12%, and the risk free return is 5%.
Work out the current value of the firm. (10 marks)
First we need the cost of capital: r
E = rF + βE [E(rM) – rF] =5% +1*7% = 12% (worth four marks).
Then we need to discount the cash flow plus the scrap value:
PV = 814.4 (worth six marks).
Question 4
You consider an investment project which has a cost of $100,000. The cash
flow of the project is $10,000 per year, growing at a rate of 1% per year. The
cash flow is expected to continue indefinitely. The assets of the project has
unknown beta, but they are very similar to the assets of a company which
has already a stock market listing. This company has 50% debt and 50%
equity, and the equity has a beta of 1.2. The expected return on the market
index is 12% and the risk free rate is 5%.
(a) If the project has a beta of 1, what is the net present value of the project?
(5 marks)
The cost of capital is rE = rF + βE [E(rM) – rF] =5% +1*7% = 12%
(worth two marks) and the value is just the NPV where we’re using the
constant growth formula NPV = −100 + [10/(12%−1%)] = −9.1
(worth three marks).

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(b) Use the listed company as a basis for working out the beta of the project.
What is the net present value of the project using this beta estimate? (10
marks)
You need to work out the average beta on the liability side: (E/V) βE +
(D/V) βD (worth two marks), and need to make an assumption about
βD – can accept a reasonable number – for instance zero (worth two
marks). This yields: βA = (E/V) βE + (D/V) βD = 50%*1.2 = 0.6
(assuming βD =0) (two marks for this).
Then the cost of capital is rE = rF + βE [E(rM)−rF] =5% +0.6*7% =
9.2% (worth two marks) and the value is NPV = -100 +
[10/(9.2%−1%)] = 21.95 (worth two marks).
(c) Suppose the listed company also own valuable growth opportunities
(these are new projects which have not yet been invested in – the assets of
these projects will therefore not be visible on the current balance sheet). You
estimate that 20% of the current value consists of growth opportunities with
beta 1, and 80% consists of assets similar to the assets in your investment
project. Would this change your conclusion in (b)? An explanation suffices –
there is no need to work out the new V. (10 marks)
The advice here is to realise that the asset beta of 0.6 from b is a
weighted average of the beta of assets in place and the growth
opportunities (worth two marks). The formula is:
0.6 = βA
= 20%* βAGO + 80% * βAS
= (E/D+E) βE + (D/D+E) βD (worth one mark)
and the calculation yields
βAS = [(E/D+E) βE + (D/D+E) βD − 20%* βAGO ]/80%
= (0.6−0.2*1)/0.8 = 0.5 (worth four marks).
The NPV of the project becomes even more positive so there is no
change in the decision (worth three marks).

Section B
Question 5
(a) Explain how corporate debt and equity can be thought of as asset
combinations of risk free debt and call and put options on the firm’s assets.
(8 marks)
The equity has the payoff profile of a call option (i.e. max(s−X,0))
(worth four marks) and the debt is equal to the value of the firm minus
the equity: s – max(s−X,0) = X – max(X−s,0), which is a risk free
payoff minus the payoff of a put option (worth four marks).

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(b) Suppose corporate earnings are taxed at the corporate level (tax rate tC)
and that earnings distributed to investors as income on equity are taxed
privately (tax rate tE) and earnings distributed to investors as income on debt
are also taxed privately (tax rate tD) but such income is tax deductible at the
corporate level. Explain that in this case the value of a levered firm VL is
equal to the value of an unlevered firm VU plus the value of corporate debt D
times a factor measuring the tax benefits of borrowing 1 – (1-tC)(1-tE)/(1-tD).
(8 marks)
The value of an unlevered firm is the discounted value of the earnings
less corporate and private taxes: PV(y(1−tC)(1−tE)) (worth two
marks). The value of a levered firm is the discounted value of the
earnings minus interest less corporate and private taxes, plus the value
of interest payments less debt tax: PV((y−i)(1−tC)(1−tE)) +
PV(i(1−tD)) = PV(y(1−tC)(1−tE)) + PV(i(1−tD) – i(1−tC)(1−tE))
(worth four marks). Putting it all together gives the value of a levered
firm as the value of unlevered firm plus the value of debt times
(1−(1−tC)(1−tE)/(1−tD)) (worth two marks).
(c) Suppose the firm can choose one of two mutually exclusive projects A and
B, each with a investment cost of $100,000. There is 50% chance project A is
has present value $150,000 and 50% chance it has present value $80,000.
Similarly, there is 50% chance project B has present value $200,000 and 50%
chance it has present value 0. The firm has a debt liability redeemable right
after the investment is made, and with contractual value of $50,000. Assume
risk neutrality, and assume the shareholders cannot observe the present
value before making the investment. Which project has the highest NPV?
Suppose shareholders fund the new project with new equity – which project
is the best for them in this case? Explain why you may get different
conclusions to these questions. (9 marks)
Which project has the highest NPV?
NPVA = −100 + 50%*(150 + 80) = +15 (two marks for stating this)
and
NPVB = −100 + 50%*(200 + 0) = 0 (two marks for stating this) so A
B

has highest NPV.

When it comes to the second part, assumptions about the default
probability of the debt must be made, since project A as a stand-alone
project is safer than project B (worth two marks).
However, if we make the extreme assumption that the firm has no
other assets, then there is no way we can feasibly invest in project A,
since what can be offered to the new shareholders is 100,000 with
probability 50 per cent and 30,000 with probability 50 per cent, which
has value 65,000. There is no way we can invest in project B either,
since what can be offered to the new shareholders is 150,000 with
probability 50 per cent, or 75,000 (worth two marks).
Once we start adding existing assets to the firm’s asset base we find
that investment will be feasible, and it is project B that becomes
attractive first. The reason is the higher default probability of project B
– and therefore the lower debt value (worth one mark).

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Question 6
(a) Outline Ross’ (1977) signalling argument for debt. There is no need to
reproduce algebra – an intuitive exposition suffices. (8 marks)
You should explain that if the manager’s objective function is
increasing in expected firm value but decreasing in expected
bankruptcy costs we can construct a debt signalling mechanism (three
marks available for this). You do need to stress this point to be
awarded the three marks.
The story is based on the fact that high cash flow firms can afford to
borrow more without increasing expected bankruptcy costs whereas
low cash flow firms cannot. Therefore, by setting leverage sufficiently
high that the low cash flow firm’s manager cannot increase his utility
from pretending the firm is a high cash flow firm (the higher firm value
gives the manager higher utility but this is offset by disutility from the
increased likelihood of bankruptcy), the high cash flow firm can use
leverage to communicate its true nature to the uninformed investors
(worth five marks).

(b) Myers (1977) argues that when firm’s assets consist of growth
opportunities as well as projects that have already been initiated, debt policy
may be relevant even in the absence of bankruptcy costs. Explain Myers’
argument. (8 marks)
The Myers model assumes that some corporate assets are growth
opportunities, and that the investment decision is delayed to the point
where the profitability of these growth opportunities can be evaluated
more closely (worth two marks).
If the company also has debt, the investment decision can affect the
value of the debt contract, since debt has seniority over other claims.
This implies that the present value of the investment needs to cover not
only the investment cost it also needs to cover the debt payment. This
may create underinvestment. This implies that debt carries a cost
associated with underinvestment – the debt-overhang problem (worth
six marks).
(c) Dividend policy is sometimes explained by the so called dividend clientele
theory. Explain this theory. What are the implications of the dividend
clientele theory? Do you expect firm values to be affected by dividend policy
under the dividend clientele theory? Explain. (9 marks)
You should point out there are three classes of investors: those who
pay higher taxes on dividends than on capital gains (typically
individuals); those who pay lower taxes on dividends than on capital
gains (typically corporations); and those who are indifferent (typically
zero tax payers) – three marks available for outlining these investor
classes.
Some stocks paying high dividends will attract corporations and zero
taxpayers – some stocks paying low dividends will attract individuals
and zero tax payers. This is the clientele argument – three marks for
explaining this.
Finally, we need to put it all together in equilibrium: when there is too
strong a demand for low dividend paying stocks some firms will

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switch; when there is too strong a demand for high dividend paying
stocks some firms will switch. In equilibrium no firm has an incentive
to switch dividend policy – three marks for this argument.
Question 7
(a) What is the asset substitution (or risk-shifting) problem? What can be
done to prevent asset substitution? Who bears the cost of asset substitution?
(8 marks)
Asset substitution is associated with debt financing: when swapping its
less risky assets for more risky ones, the company doesn’t create or
destroy value – its balance sheet remains the same. However, on the
liability side there will in general be a negative effect on debt values as
corporate debt and a negative put option component. Thus the equity
holders gain (worth three marks).
One way of preventing asset substitution is to restrict restructuring on
the asset side of the balance sheet – if the assets change too much or if
there is a material increase in the risk of the company, debt covenants
may be triggered which demand immediate repayment of the loan or
the bond (two marks available for this).
Finally, whereas debt holders bear the asset substitution costs ex post,
it is reasonable to assume the debt holders realise ex ante the nature of
these costs, so demand a discount in the debt value when lending to
the company. Therefore, it is likely the shareholders are the true
bearers of asset substitution costs (worth three marks).
(b) Outline the Myers-Majluf (1984) pecking order theory of finance. Explain,
in particular, why it can be more costly to issue equity than to issue debt for
corporations? Do you think that a share buyback scheme financed by
retained earnings (which is the opposite of issuing equity) could be profitable
by reversing Myers-Majluf’s argument? Explain. (8 marks)
Pecking order theory dictates that firms first use retained funds, then
external debt, and they issue new equity only as a last resort (worth
one mark).
You should make it clear that the firm has two incentives for issuing
equity: it may raise funds for a positive NPV project, or it may profit
from issuing overpriced equity. The first has a positive effect (given the
NPV is positive), but the second has a negative effect since it sends a
signal the market is overvaluing the stock. Both are recognised by the
market (worth two marks).
Managers who issue overpriced equity may do so if the NPV is low or
even negative; managers who issue underpriced equity will only do so
if the NPV is large enough to make up for the financing cost. Therefore,
issuing equity leads to distortions in investment policy and signals
overpricing – this leads to a fall in current equity values (worth two
marks).
Issuing debt mitigates this problem as debt is safer and hence the
mispricing effect is smaller – the distortions are therefore less and the
effect on current equity prices smaller (worth one mark).

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A share buyback scheme has two effects – it can signal underpricing

and therefore be a positive signal – but it also reduces the pool of
retained earnings that can reduce future financing costs (worth two
marks).
(c) Suppose the firm has assets currently valued at $100,000, which next year
are worth either $200,000 or $50,000. The risk free rate is 5%. The firm also
own an investment project which needs a $50,000 investment right now, and
will be worth $70,000 for sure next year. The firm has currently no debt.
Suppose the firm issues new equity to finance the investment. Determine the
payoff after investment to the new equity holders and the old equity holders.
Suppose a manager – who may have better information than the market –
makes the investment decision. Can you think of a reason why he would
issue debt rather than equity in this situation? Explain. (9 marks)
The current value is 100,000, the new project has value 70,000/1.05 =
66,667, so the total value is 166,667 (worth two marks).
The new equity holders hold a claim worth 50,000, so they hold
50,000/166,667 = 30 per cent of the equity (worth three marks). This
implies the new and the old equity holders get 30 per cent and 70 per
cent of 270,000 or 120,000 (worth one mark).
In the second part you should explain the Myers-Majluf story – if
funding a risky project with risky equity it may be that the financing
cost in the high state exceeds the NPV of the project and will be cut. If
issuing risk-free debt this problem disappears (worth three marks).

Question 8
(a) Option pricing theory tells us that increasing risk has a positive impact on
option prices. Explain why. We also know that equity can be thought of as a
call option on the firm’s equity. However, in equity markets increasing risk is
often taken to have a negative impact on prices. Explain why we reach
opposite conclusions in the two cases. (8 marks)
You should make it clear that increasing risk is assumed, keeping the
current value of the underlying constant. Since options carry upside
risk they tend therefore to become more valuable when risk is
increased (worth two marks).
Risk has a negative impact on equity values because, in this case, risk
may affect the value of the firm’s assets negatively, i.e. the value of the
underlying goes down at the same time as the risk goes up. Since call
values are positively related to both the value of the underlying as well
as risk, there may be a negative impact of increasing risk for equity
(worth four marks).
The effect on equity is, however, ambiguous. It could be that the
reduction in debt values is greater than the reduction in the value of
the firm’s assets – in which case the equity holders would gain (worth
two marks).

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(b) We normally distinguish between three types of mergers – outline briefly

these three types. We can think of a ‘spinoff’ as a reverse merger in the sense
that a large company is split into two new companies. In the light of the
merger literature you have reviewed, can you think of reasons why ‘spinoffs’
may be profitable? Can you also think of an agency argument for profitable
‘spinoffs’? Explain. (8 marks)
The types are financial mergers (takeover is motivated by inefficiency
so target is undervalued); strategic merger (takeover is motivated by
synergy gains); and conglomerate mergers (takeover motive is often
unclear – may be tax related or may demonstrate neutral use of
retained free cash flow where the alternative is inefficiency) (worth
three marks).
It is hard to imagine synergy losses or tax savings arising from a
spinoff, but of course we can imagine inefficiency in a large company
that may be reduced if the company is broken up (worth three marks).
In particular, we can imagine that it is easier to incentivise managers of
smaller, more streamlined units than managers of large conglomerates.
Therefore, spinoffs are often motivated by agency considerations
driven by streamlining the operations (worth two marks).
(c) Explain why, in the framework of Jensen and Meckling, there are agency
costs of outside equity, and explain why there are agency costs of outside
debt. What conclusion about capital structure can you draw from this
analysis? Suppose the circumstances of the firm change such that it becomes
easier to incentivize the manager. An example is that the firm is restructured
to focus on only core activities where managerial failures are easier to
identify so that bonus schemes have greater effect on managerial behaviour.
Given such a change, do you expect that there may be a change in the capital
structure of the firm? Explain. (9 marks)
The argument of agency costs of outside equity rests on effort: if the
manager is the sole owner he puts more effort into the running of the
firm since he receives all the benefits; when he shares these benefits
with outside shareholders it is optimal for him to reduce the effort
investment. The outside equity holders demand a discount, therefore,
when buying the equity (worth two marks).
The argument of agency costs of debt is the risk-shifting argument, that
ex post is optimal for the equity holders to increase the risk as this
reduces debt values and increases equity values. The debt holders
demand a discount when buying the debt (worth two marks).
The optimal capital structure balances the two concerns to minimise
the overall agency costs of financing (worth one mark).
If it becomes easier to incentivise the manager, we expect that the
agency costs of outside equity is reduced (since these involve the effort
investment of the manager) but that the agency costs of outside debt
remains the same (since they involve risk shifting) (worth three
marks).
Therefore, outside equity becomes cheaper and the firm may be
inclined to reduce the leverage to take advantage of this (worth one
mark).

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