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Corporate Finance

SS 2012 July 20, 2012

THIS SHEET IS PART OF THE EXAM AND HAS TO BE HANDED IN TOO!

Last name: First name: Matriculation nr.: Subject: Semester:

Time limit: 120 minutes General instructions: You have to solve all problems. All answers must be written either

completely in English or completely in German. The maximum number of points is specified for each problem. Taken together, the maximum number of points is 120. Please make sure your handwriting is legible. You should give brief and precise answers. Explain your calculations and symbols not mentioned in the text. In case of missing specifications, please make appropriate economic assumptions.

**Allowed auxiliary means: Non programmable calculator
**

Problem 1 /15 2 /20 3 /20 4 /25 5 /10 6 /10 7 /10 8 /10 /120

Good luck!

Problem 1: Valuation

[15 points]

Consider a company with expected earnings before interest and taxes of €2000. The market expects these earnings to grow at an annual rate of 3% thereafter. Furthermore, all future investments by the company are expected to equal depreciation. Changes in net working capital are expected to be zero as well. The company plans to keep its debt-equity ratio constant in the future, so that on average the company’s debt will grow by 3% per year. Right now, the company has €5000 in risk-free debt and its asset beta is given by 1.11. The risk-free rate equals 5% and the expected return of the market portfolio equals 11%. The corporate tax rate equals 40%. a) Determine the company’s market value if it were an all-equity firm! [3 points]

b) Assuming the company’s debt is fairly priced, what is the amount of interest the company will pay next year? At what rate are the company’s interest payments expected to grow? [2 points] c) Assuming the company’s debt-equity ratio is updated continuously, determine the present value of the company’s tax shield! [3 points] d) Determine the value of the company and the value of the company’s equity! [2 points]

e) What is the company’s weighted average cost of capital (WACC)? (Hint: If you could not solve part d), suppose the company’s value is €15,000.) [2 points] f) Using the WACC, what is the company’s expected return on equity? g) Determine the company’s equity beta! [2 points] [1 point]

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Problem 2: Capital Structure

[20 points]

a) Consider a two-period model with two companies which both have expected free cash flows of €110 million in the second period. The companies differ only in their chosen capital structures. One firm is totally equity financed and the other firm has risk-free debt outstanding due in the second period with face value €42 million. Suppose that capital markets are perfect and that all market participants can lend and borrow at the risk-free rate of 5%. The value of the unlevered firm is €100 million while the value of the levered firm is €102 million. Show that these values imply an arbitrage opportunity! [6 points] b) How does the existence of taxes, financial distress costs, information costs, and agency costs affect Modigliani and Miller's irrelevance of capital structure theorem? [4 points] c) When a firm defaults on its debt, debt holders often receive less than 50% of the amount they are owed. Is the difference between the amount debt holders are owed and the amount they receive a cost of bankruptcy? [2 points] d) Consider the following two job offers. One firm offers to pay €85,000 per year for two years. A second firm offers to pay €90,000 for two years. Both jobs are equivalent. Suppose that the first firm’s contract is certain, but that the second firm has a 50% chance of going bankrupt at the end of the year. In that event, it will cancel the job contract and pay the lowest amount required for the employee to not quit. If the employee did quit, assume he would find a new job paying €85,000 per year, but he would be unemployed for 3 months while he searches for it. What is the least the second firm can offer to pay the next year in order to match what an employee would earn if he quit after the first year? Assuming that employees have a cost of capital of 5%, which offer pays a higher present value of expected wages? Based on this example, discuss one reason why firms with a higher risk of bankruptcy may need to offer higher wages to attract employees. [4 points] e) Consider the manager of a car manufacturer who wants to take on more debt to reduce the expected expense of car warranties. To quote the manager, “If we go bankrupt, we don’t have to service the warranties. We therefore have lower bankruptcy costs than most corporations, so we should use more debt.” Is he right? [2 points] f) Consider a company exploring a new line of business. While this new investment is expected to increase profits, it will also substantially increase the company’s risk. If the company is levered, would this investment be more or less attractive to equity holders than if the company had no debt? [2 points]

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Problem 3: Payout Policy

[20 points]

a) What options does a firm have to spend its free cash flow (after it has satisfied all interest obligations)? [2 points] b) La Porta, Lopez-de-Silanes, Shleifer, and Vishny (2000, Agency Problems and Dividend Policies around the World, Journal of Finance 55, 1-33) suggest that the legal environment a company operates in affects its dividend policy. Who are the parties involved in the agency conflict underlying the authors’ propositions? Give a brief description of the two competing theories articulated by the authors that link dividend payments and the legal environment a company operates in. What are both theories’ main empirical implications? [9 points] c) The authors mentioned in part b) test their theories empirically. What are the proxies used by the authors to measure the protection of minority shareholders? [2 points] d) Below is a table from the paper mentioned in part b). Summarize the authors’ main empirical findings! Which one of the two theories articulated in part b) do the results support? [4 points]

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e) According to the dividend signaling theory, a firm’s dividend choice contains information about the management‘s expectation of future earnings. Grullon, Michaely, and Swaminathan (2002, Are Dividend Changes a Sign of Firm Maturity?, Journal of Business 75, 387-424) test this theory and present the following figures. Are the results consistent with the dividend signaling theory? Explain your conclusions! [3 points]

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Problem 4: Mergers & Acquisitions

[25 points]

a) Consider perfect capital markets. Generally, diversification is good for shareholders. So why shouldn’t managers acquire firms in different industries to diversify a company? [3 points] b) Company A has announced plans to acquire company B. Company A is currently trading for €35 per share and company B is trading for €25 per share, implying a premerger value of company B of approximately €4 billion. If the projected synergies of the deal are €1 billion, what is the maximum exchange ratio company A could offer in a stock for stock deal and still generate a positive net present value? [3 points] c) What is meant by a toehold in the context of mergers and acquisitions? How might a toehold help overcome the free rider problem in tender offers? [3 points] d) Empirically, in many takeovers the price of the target rises if the takeover is successful whereas the price of the acquirer falls. The opposite can be observed for unsuccessful takeovers. Consider the following example: A bidder has announced its plans to acquire a target company. The bidder’s current share price is €30 whereas the target’s current share price is €60. It is expected that a successful takeover will lead to share prices of €29 for the bidder and €65 for the target. If the takeover fails, the bidder’s shares will be worth €33 whereas the target’s shares will be worth €45. A takeover arbitrageur estimates the probability of a successful takeover to be 80%. Find a profitable trading strategy for the arbitrageur if he is risk-neutral! Is this an arbitrage strategy in the sense that it is risk-free? If all market participants are risk-neutral, what is the market’s expected probability of a successful takeover? [10 points] e) Explain what is meant by a poison pill in the context of mergers & acquisitions! Discuss the pros and cons of poison pills from a shareholder’s perspective! [6 points]

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**Problem 5: Initial Public Offerings
**

a) What is initial public offering (IPO) underpricing?

[10 points]

[2 points]

b) Consider a company offering 100 new shares to the market. The value of the company’s shares is uncertain. With 50% probability the company’s shares will be worth €120. Otherwise, the company’s shares will be worth €80. Assume that there are two types of risk-neutral traders who bid for the company’s shares. Uninformed investors apply for 100 shares if their expected return on doing so is at least zero, and do not apply otherwise. Informed investors know the company value and apply for 50 shares if and only if the offer price is strictly below €120 and the company’s shares are worth €120. If more than 100 applications are received, rationing is pro rata. Finally, assume that the company’s management does not know the value of the shares with certainty. What is the maximum price the company can demand if a successful offering requires all of the 100 shares to be sold to investors? Does this offer price imply underpricing? [6 points] c) Suppose a model similar to the example from part b) is really the explanation for the underpricing phenomenon. Does a trading strategy that tries to buy shares in every IPO necessarily make money? [2 points]

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**Problem 6: Corporate Investment Decisions
**

Discuss the bright and the dark sides of internal capital markets!

[10 points]

[10 points]

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Problem 7: Behavioral Corporate Finance

[10 points]

a) Some researchers claim that there is evidence of successful “market timing”, i.e. firms seem to issue equity when its price is too high (cost of equity is low), and to repurchase shares when prices are too low (cost of equity is high). Name some of the empirical findings that support the hypothesis of successful market timing! [4 points] b) How do economic models typically incorporate the psychological concepts of overconfidence and optimism? [2 points] c) Name four potential consequences of overconfidence and/or optimism for the decisions of managers! [4 points]

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Problem 8: Optimization

[10 points]

a) Name four of the main problems that may arise when the Kuhn-Tucker conditions are used to identify the solution(s) to an inequality-constrained optimization problem! [4 points] b) Use the Kuhn-Tucker conditions to solve the following optimization problem: max f(x,y) = ln x + ln y sub2 2 ject to x + y = 1, x ≥ 0, and y ≥ 0! (Hint: You do not need to care about the problems asked for in part a)) [6 points]

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