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Examiners commentaries 2013

Examiners commentaries 2013


FN3092 Corporate finance
Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 201213. The format and structure
of the examination may change in future years, and any such changes
will be publicised on the virtual learning environment (VLE).

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 (2011). You should always attempt to use the most
recent edition of any Essential reading textbook, even if the commentary
and/or online reading list and/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.

General remarks
Learning outcomes
At the end of this course, and having completed the Essential reading and
activities, you should be able to:
explain how to value projects, and use the key capital budgeting
techniques (NPV and IRR)
understand the mathematics of portfolios and how risk affects the
value of the asset in equilibrium under the fundamental asset pricing
paradigms (CAPM and APT)
know how to use recent extensions of the CAPM, such as the Fama
and French three factor model, to calculate expected returns on risky
securities
explain the characteristics of derivative assets (forward, futures and
options), and how to use the main pricing techniques (binomial
methods in derivatives pricing and the BlackScholes analysis)
discuss the theoretical framework of informational efficiency in
financial markets and evaluate the related empirical evidence
understand the trade-off firms face between tax advantages of debt and
various costs of debt
understand and explain the capital structure theory, and how
information asymmetries affect it
understand and explain the relevance, facts and role of the dividend
policy
understand how corporate governance can contribute to firm value
discuss why merger and acquisition activities exist, and calculate the
related gains and losses.
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FN3092 Corporate finance

What are the Examiners looking for?


In general, the Examiners are looking for a solid demonstration of
understanding of the above learning outcomes from candidates. Typically,
the examination questions cover a wide range of topics from the syllabus.
They are often set in such a way as to enable students to be tested on their
understanding of the concepts and techniques and their ability to apply
them in scenarios.
Candidates should read widely around each topic covered in the subject
guide. Essential and supplementary readings are important if you wish to
achieve high grades.
Typical weaknesses that Examiners have identified in this examination are as
follows:
1. Candidates answers are often too general or narrow. When they
are asked to critically assess a theory or concept, they often provide
a descriptive list of what the theory or concept is about. A critical
assessment for a theory or concept should indicate how logically it is
derived and how well it fits into the real world.
2. Candidates often regurgitate materials from the subject guide without
carefully considering what the examination question is in fact asking.
Consequently, they are giving either descriptive or irrelevant materials
in their answer.
3. Candidates often spot questions and focus narrowly on 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
inter-related, the examination questions will also cover materials from
different chapters in the subject guide. For example, when evaluating
a real life project, we need to know which 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 easily involve materials
covered in Chapters 1, 2, 3 and 6.

Examiners commentaries 2013

Question spotting
Many candidates are disappointed to find that their examination
performance is poorer than they expected. This can be due to a number
of different reasons and the Examiners commentaries suggest ways
of addressing common problems and improving your performance.
We want to draw your attention to one particular failing question
spotting, that is, confining your examination preparation to a few
question topics which have come up in past papers for the course. This
can have very serious consequences.
We recognise that candidates may not cover all topics in the syllabus in
the same depth, but you need to be aware that Examiners are free to
set questions on any aspect of the syllabus. This means that you need
to study enough of the syllabus to enable you to answer the required
number of examination questions.
The syllabus can be found in the Course information sheet in the
section of the VLE dedicated to this course. You should read the
syllabus very carefully and ensure that you cover sufficient material in
preparation for the examination.
Examiners will vary the topics and questions from year to year and
may well set questions that have not appeared in past papers every
topic on the syllabus is a legitimate examination target. So although
past papers can be helpful in revision, you cannot assume that topics
or specific questions that have come up in past examinations will occur
again.
If you rely on a question spotting strategy, it is likely
you will find yourself in difficulties when you sit the
examination paper. We strongly advise you not to adopt
this strategy.

FN3092 Corporate finance

Examiners commentaries 2013


FN3092 Corporate finance Zone A
Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 201213. The format and structure
of the examination may change in future years, and any such changes
will be publicised on the virtual learning environment (VLE).

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 (2011). You should always attempt to use the most
recent edition of any Essential reading textbook, even if the commentary
and/or online reading list and/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.

Comments on specific questions


Candidates should answer FOUR of the following EIGHT questions: ONE
from Section A, ONE from Section B and TWO further questions from
either section. All questions carry equal marks.
A list of formulas is given at the end of the paper.
A calculator may be used when answering questions on this paper and
it must comply in all respects with the specification given with your
Admission Notice. The make and type of machine must be clearly stated
on the front cover of the answer book.

Section A
Answer one question from this section and not more than a further
two questions. (You are reminded that four questions in total are to be
attempted with at least one from Section B.)
Question 1
a. Briefly explain the concept of risk shifting and what implications it has for
optimal capital structure.
(9 marks)
Reading for this question
Subject guide, Chapter 8, pp.11223.
Approaching the question
When a firm has a large amount of debt outstanding, it is optimal for
equity holders to take on too much risk, even if that risk is a negative
NPV proposition. Note that higher risk increases the probability of both
the upside and the downside. This is because increasing the probability of
the downside does not hurt equity very much they have limited liability

Examiners commentaries 2013

and their worst case scenario is zero. On the other hand, increasing the
probability of the upside helps equity holders because they receive the
residual after all payments to debt, which are fixed.
Since it is the CEOs job to represent equity holders, she will take on too
much risk. This means the firm will not be acting optimally (taking the
highest NPV projects), and will therefore be valued below maximum.
Ex-ante this actually hurts the equity holders.
b. Personal taxes result in the Modigliani and Miller 1st proposition being
violated. Briefly explain why.
(8 marks)
Reading for this question
Subject guide, Chapter 6, pp.9199.
Approaching the question
Since different payouts are taxed in different ways, it is optimal for the
firm to structure its financing so as to minimise the tax liability. Therefore
capital structure is not irrelevant and M&M1 is violated.
In particular, personal taxes on equity payouts are typically lower than on
debt payouts. Equity payouts are either capital gains (share repurchases)
or dividends; debt payouts are interest. Capital gains are taxed at the
capital gains tax rate while interest is taxed at the personal tax rate,
which is typically higher than capital gains. Depending on the tax regime,
dividends are taxed at the same rate as interest, or lower. Thus, overall,
if we just consider personal taxes (and other frictions), equity is cheaper
than debt and firms should issue as much equity as possible.
c. Briefly explain the Modigliani and Miller 1st proposition and discuss some
of the other reasons (not including (a) and (b)) which may cause it to be
violated.
(8 marks)
Reading for this question
Subject guide, Chapter 6, pp.9199.
Approaching the question
M&M1 says that capital structure is irrelevant if certain conditions hold.
This means that it does not matter how the firm finances its investment
the value for the shareholders will be unchanged. This is because financial
decisions do not affect value, they only determine how this value is split
among the different stakeholders.
Among the other reasons that M&M1 can be violated:
corporate taxes make debt cheaper (implies more debt in the capital
structure)
high amounts of debt leading to debt overhang and underinvestment
(implies less debt in the capital structure)
high amounts of outside equity leading to too little effort by managers
(implies more debt in the capital structure)
asymmetric information leading to only bad firms issuing risky
securities and good firms underinvesting in positive NPV projects,
this is referred to as pecking order (implies more debt in the capital
structure)
asymmetric information leading to good firms signalling with certain
types of securities, for example a firm can signal with debt, because
debt is risky and costly (implies more debt in the capital structure),
or a firm can signal with dividends because they are costly from a tax
perspective (implies less debt in the capital structure).
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FN3092 Corporate finance

Question 2
a. Explain pecking order theory. According to pecking order theory, how do
bad firms tend to finance investment? How do good firms tend to finance
investment?
(9 marks)
Reading for this question
Subject guide, Chapter 8, pp.11223.
Approaching the question
If the market does not know which firms are good and which firms are
bad, it will value all firms as average. A good firm that is valued as average
does not want to issue equity because its equity is undervalued it will be
giving up too large a fraction of its equity for too little of a cash infusion.
On the other hand, bad firms dont mind since their equity is over valued.
If a firm has a new, NPV>0 project which requires financing, if it knows
it is a good firm (so that it is undervalued), and if it has no option but to
finance it by equity, it may choose to not finance this project at all. This
is because the cost of giving away too many shares is higher than the
benefit of the project. This problem is more severe if the NPV is small
relative to the value of the firm, and if the firm is more undervalued. This
problem can even occur with risky debt, because it is priced in a similar
way to equity. However, if the firm has cash, it is not worried about outside
valuations and will finance all positive NPV projects.
The pecking order theory states that in the presence of asymmetric
information, firms will finance investment with the most informationally
insensitive securities, such as cash or safe debt, and then move up the
pecking order to risky debt and equity if they have no choice.
b. A recent research study found that firms run by CEOs who have family
problems (such as a seriously sick child) tend to underperform. You are aware
that your cousin, who is married to the CEO of NORNE LLC, is likely to file
for divorce. As a result you expect NORNEs stock price to fall and you short
it. Which kind of efficiency must be violated for your expectations to be
correct? Explain your reasoning.
(7 marks)
Approaching the question
Note that a CEOs family problems are typically private information,
therefore this gives us no evidence that either the weak form or the
semi-strong form efficiency are violated. However, if you expect to profit
from this trade, you must believe that this market is not strong-form
efficient in that private information about the CEOs personal life is not yet
incorporated into prices.
c. Suppose that starting next year you will receive a cash flow D, which will
grow at a rate g per year. The appropriate discount rate is r. Derive the
Gordon Growth Model for the present value of this cash flow.
(9 marks)
Approaching the question
The cash flow pattern is:
0, D, D(1 + g), D(1 + g)2
The discount factor is:
1, 1/(1 + r), 1/(1 + r)2, 1/(1 + r)3
Let X = (1 + g)/(1 + r). Then the NPV can be written as:

Examiners commentaries 2013

NPV = D/(1 + r) + X * D/(1 + r) + X2 * D/(1 + r) +


= (1 + X + X2 + X3 +) * D/(1 + r)
Note that (1 + X + X2 + X3+) = 1/(1 X) so that:
NPV = D/[(1 + r) * (1 X)] plugging in the definition of X we get:
NPV = D/(r g)
Question 3
a. How does the price of a European put option change if the time to maturity
rises? If the price of the underlying rises? If the volatility of the underlying
rises? If the exercise price rises? Explain.
(9 marks)
Reading for this question
Subject guide, Chapter 4, pp.5570.
Approaching the question
If the volatility rises, the put option price rises. This is because with
options, the downside is limited (by zero) and the upside can be very high
(unlimited for call options). Increased volatility increases the probability of
both.
A rise in time to maturity has exactly the same effect as volatility there is
now more time for the underlying to reach very low or very high prices.
If the price rises, the put option price falls. This is because a put entitles
you to sell at a particular fixed price. If the actual price is now higher, the
option to sell at a fixed (relatively low) price is less valuable.
If the strike price rises, the put option price rises. This is because a put
option entitles the owner to sell the underlying for the exercise (strike)
price. Selling at a higher price is good.
b. What are the differences between the NPV and IRR approaches to project
evaluation? Is one of the approaches superior to the other?
(8 marks)
Reading for this question
Subject guide, Chapter 1, pp.1023.
Approaching the question
The NPV approach calculates the present value of all future cash flows
using some specified discount rate.
NPV = C1/R + C2/R2 + C3/R3 +
It then suggests investing any time the NPV is positive.
The IRR approach computes that discount rate which would make the
present value exactly zero.
0 = C1/IRR + C2/IRR2 + C3/IRR3 +
It then suggests investing any time the IRR is higher than the appropriate
discount rate.
Note that for standard projects IRR and NPV give exactly the same answer
since R>IRR implies that the discounted present value is above zero.
However, for non standard projects, they may give different answers. In
particular, when we must only choose one project out of many, when the
borrowing rate is different from the lending rate, when the discount rate is
changing through time, when cash flows are often changing from positive
to negative. See the textbook for detailed explanations of how each of
these can lead to different answers between NPV and IRR.

FN3092 Corporate finance

If we are able to properly estimate cash flows, growth rates, and discount
rates the NPV approach is superior. The NPV approach says to invest
whenever a project is increasing firm value anything else would be
wrong! However, in the real world we may not always perfectly estimate
cash flows, growth rates, and discount rates. For this reason, IRR may
work better in practice even though NPV is theoretically better.
c. Describe the stylized facts about dividend payments which were listed in
Linter (1958).
(8 marks)
Reading for this question
Subject guide, Chapter 9, pp.12734.
Approaching the question
Managers seem to have a target dividend pay-out level. This is
determined as a proportion of long-run (sustainable) earnings of the
firm. Thus if there is a large temporary shock to earnings today, this
does not mean there will be a large change in dividends.
Managers seem to be more concerned with changes in dividends than
the actual level of dividends.
Managers prefer not to make changes that may be reversed. As a result,
dividends are relatively smooth and do not change often.
Linterns numerical model for dividends was dDIV(t) = L * (a * EPS(t)
DIV(t 1)) thus dividends adjust to earnings changes slowly.
Question 4
a. How does the empirical security market line compare to the one predicted by
the CAPM?
(7 marks)
Reading for this question
Subject guide, Chapter 2, pp.2540.
Approaching the question
The empirical line is flatter than the one predicted by theory. Stocks with
low betas tend to have higher returns than predicted by CAPM; stocks with
high betas tend to have lower returns than predicted by CAPM.
b. Discuss possible explanations for the differences between the empirical line
and the one predicted by theory.
(10 marks)
Approaching the question
This pattern may be due to mismeasurement of beta. Mismeasurement can
be due to Rolls critique, or for a host of other reasons.
If we are mismeasuring beta, then stocks we are calling high beta are
likely to have high beta but not quite as high as we are measuring (beta
is the sum of the true beta and an error). In which case, their expected
return should be lower than we would be predicting. Similar for low beta
stocks, their true beta is not as low as we are measuring. The result would
be a flatter line.
Another possible explanation is borrowing constraints. If low risk aversion
investors are unable to borrow in order to short low beta stocks and long
high beta stocks, they will just be forced to hold long positions in high
beta stocks. Thus high beta stocks will be overbought and overvalued
and have relatively low returns; low beta stocks will be underbought and
undervalued, with relatively high returns.

Examiners commentaries 2013

c. Suppose the CAPM does not hold, is this evidence of the violation of market
efficiency?
(8 marks)
Approaching the question
It is not necessarily inconsistent with market efficiency. The CAPM is
not necessarily the right model to describe all risk. Any firm with higher
loading on the true risk in the economy should have higher returns.
Multi-factor models attempt to capture the risks in the economy not
captured by the CAPM.

Section B
Answer one question from this section and not more than a further
two questions. (You are reminded that four questions in total are to be
attempted with at least one from Section A.)
Question 5
For this question assume that debt carries no tax advantage over equity. The
average return on the stock market is 8% per year, and the average risk free rate
is 2% per year.
Reading for this question
Subject guide, Chapter 2, pp.2540, Chapter 10, pp.13543.
a. Cyberdyne Systems is a robot manufacturer. It is an all equity firm whose
historic average annual return is 13%. Suppose the CAPM holds, calculate
Cyberdynes beta.
(5 marks)
Approaching the question
Beta = (R Rf)/(Rm Rf)=(0.13 0.02)/(0.08 0.02) = 1.833
b. Union Aerospace Corporation (UAC) has 1M shares of equity outstanding
with a price of $100 per share and a historic annual return of 15%, it also
has $50M of long term debt with an interest rate of 4%. Calculate UACs
weighted average cost of capital.
(6 marks)
Approaching the question
The equity value is 1M * $100 = $100M, the debt value is $50M.
Therefore the weights of equity and debt within UAC are wE = 100/(100
+ 50) = 0.67 and wD = 50/(100 + 50) = 0.33
The weighted average cost of capital is: WACC = wE * Re + wD * Rd =
0.67 * 0.139 + 0.33 * 0.04 = 13.9 per cent.
c. UAC consists of two divisions. The first division manufactures robots and
competes directly with Cyberdyne. It is very similar to Cyberdyne in terms
of its risk characteristics. The annual free cash flows (FCF) of this division
are $8M and its expected growth rate is 6% per year. UAC has a second
division which produces toy aeroplanes and its annual free cash flows (FCF)
are $6M. The expected growth rate of the toy aeroplane division is zero.
UAC is considering divesting and selling off the toy aeroplane division. Use
information from (A) and (B) to compute the fair value of this division and
the rate of return on a stand alone firm that produces toy aeroplanes.
Hint: Apply the Gordon Growth Model

(7 marks)

Approaching the question


Since the robot division is similar to Cyberdyne, we can assume they
have the same expected rate of return of 13 per cent. Note that this is the
unlevered or the asset rate of return.
We can use 13 per cent to compute the value of the robotics division as a
stand alone: V = FCF/(r g) = 8 /(0.13 0.06) = $114.3M
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FN3092 Corporate finance

Since UACs total value is $150M, it must be that the toy division is worth
150 114.3 = $35.7M. Its expected rate of return is 35.7 = 6/(r 0)
16.9 per cent/year
An alternative is to use the WACC from (b) to find this: WACC = wR * rR
+ wT * rT 13.9 = (114.3/150) * 13 + (35.7/150) * rT rT = 16.9
d. Suppose UAC was able to sell this division for the price you computed in (c),
and it then used all of the proceeds to repay as much of its outstanding debt
as it could. What is the value of the remaining debt? What is UACs expected
cost of equity? Briefly explain why the return on equity is different from
before.
(7 marks)
Approaching the question
UAC uses the cash from the sale to repurchase $35.7M of debt, leaving
it with $14.3M of debt; this debt still carries a 4 per cent interest rate.
The value of the capital employed (debt+equity) is $114.3M with the
weight of debt being wD = 14.3/114.3 = 0.125 and the weight of equity
being wE=100/114.3=0.875. Note that the risk of making robots has not
changed and is still the same as in (a), 13%. Again applying the formula
for the WACC: 13 = 0.125 * 4 + 0.875 * Re Re = 14.3 per cent.
If the return they got in (c) was 5.98 per cent, this should read:
The return on equity has fallen. Note that two things have happened, first
of all UAC sold one of its divisions, since this division was relatively safe
and had a low equity return, this made the remaining firm riskier. UAC has
also repurchased debt, which makes equity safer. The second effect was
stronger and the equity return decreased compared to what it was in (b).
If the return they got in (c) was 16.8 per cent, this should read:
The return on equity has fallen. Note that two things have happened; first
of all UAC sold one of its divisions, since this division was relatively risky
and had a high equity return, this made the remaining firm safer. UAC has
also repurchased debt, which makes equity safer. The second effect was
stronger and the equity return decreased compared to what it was in (b).
Question 6
There are two types of firms. Each firm has a project whose quality is known
by the firms CEO but not by outsiders (except for in (b)). Type G are good, their
project is worth $30 million. Type B are bad, their project is worth $18 million.
It is publically known that good firms are 40% of the total population of firms,
with the remainder being bad.
These firms can also finance an additional project. This new project requires an
initial investment of $20 million and next year will pay $24 million with 75%
probability or $18 million with 25% probability.
Assume risk neutrality and a discount rate of zero.
Reading for this question
Subject guide, Chapter 9, pp.12735.
Approaching the question
Students should look to approach these questions by using a combination
of basic probability theory and signalling theory outlined in the subject
guide.

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Examiners commentaries 2013

a. What is the NPV of the project? If the market does not know which firm is of
which type and therefore values all firms equally (not including the project),
what is a firms market value?
(3 marks)
Approaching the question
20 +.75 * 24 + .25 * 18 = 2.5
Avg firm: 0.4 * 30 + 0.6 * 18 = 22.8
b. Suppose the outside market knows each firms type. What is the payoff
to each firms original owners if they do not invest in this project? What
is the payoff to each firms original owners if each firm finances the new
project with equity. What fraction of equity must each type of firm offer to
outsiders? Which firms finance the project and which do not?
(5 marks)
Approaching the question
If the firms do not invest in this project the payoffs of each firm are just
their original values: 30 for G, 18 for B.
If a firm finances the project with equity then the cost of the project must
equal the expected payoff for outside investors, which is a fraction of the
firms total value promised to them. Let that fraction be .
For G: (30 + .75 * 24 + .25 * 18)= 52.5= 20 = 38.1 per cent.
The payoff to the original owners is (1 ) * 52.5 = 32.5 > 30 so they
finance the project.
For B: (18 + .75 * 24 + .25 * 18)= 40.5 = 20 = 49.4 per cent.
The payoff to the original owners is (1 ) * 40.5 = 20.5 > 18 so they
finance the project.
Approaching the question
c. Now consider a world of asymmetric information where the CEO knows her
own firm type but the outside market does not. Suppose outside investors
believe that all firms finance these projects with equity. What fraction of
equity will outside equity investors ask for? What will be the total value of
firm G? What will be the total value of firm B?
(6 marks)
The outside market does not know which firm is which so asks for fraction
that is the same for both firms. The market assumes it is getting an
average firm.
[0.4 * (30 + .75 * 24 + .25 * 18) + 0.6 * (18 + .75 * 24 + .25 * 18)]= 20
(0.4 * 52.5 + 0.6 * 40.5)= 45.3 = 20 = 44.2 per cent
Approaching the question
d. Compute the benefit to the original shareholders of each firm from following
the strategy in (c) and compare it to the strategy of not investing in this
project. What will each type do? Thus, what will the market believe about
firms who raise equity?
(6 marks)
G and invest: (1 0.442) * (30 + .75 * 24 + .25 * 18) = 29.3
G and not invest: 30 Good does not invest
B and invest: (1 0.442) * (18 + .75 * 24 + .25 * 18) = 22.6
B and not invest: 18 Bad invests, good does not
Approaching the question
e. If the market reacts rationally to the assumed strategies in (d), what does
the market assume about any firm that raises equity? What fraction of equity
does the market ask for? What is the market value of any firm that raises
equity? How does it compare to the original stock price in (a)?
(5 marks)
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FN3092 Corporate finance

Only bad firms raise equity, since the market is aware of this, the problem
of the bad firm becomes identical to (b). In particular = 49.4 per cent
and the firms value is 20.5, which is below 22.8 in (a). Thus bad firms
tend to raise equity and their value drops.
Question 7
Hotel California, a lovely place along the 101 Highway, last underwent an
upgrade in 1969. As a result of its dilapidated conditions it has plenty of extra
rooms. It is considering a major renovation.
The construction costs of the renovation are estimated to be $1 million, payable
at the end of construction. If the construction starts today, it will last one year.
During the renovation, the hotel will be closed to guests (however assume that
all of the hotels expenses, such as paying staff, are unchanged due to long term
contracts).
Hotel Californias capacity is 40 rooms and, on average, 60% of the rooms are
vacant on any single day. The daily profit per occupied room is $90.
The corporate tax rate is 20%, the appropriate discount rate is 9%, and
renovation can be depreciated at 33.3% per year.
Reading for this question
Subject guide, Chapter 1, pp. 1023.
Approaching the question
Students should practise NPV calculation questions to enable them to get
comfortable in aligning the cash flows, as well as the inputs.
a. Compute the average profit per occupied room a year. Then compute the
average profit for the hotel as a whole. Assume 365 days per year. (4 marks)
Approaching the question
Occupied room: 365 90 = $32,850
Hotel: $32,850 * (40 * 0.4) = $525,600 where 0.4 = 1 0.6 is the
occupancy rate.
b. Suppose Hotel California decides to begin renovation today. Assume that
after renovation, the vacancy rate will fall to 25%. Suppose that the hotel
will be sold exactly 3 years after the renovation is complete. Ignore the sales
price and everything that happens after the sale and compute the NPV of
renovation for cash flows from now until the sale (excluding the sale). Do
not forget depreciation and corporate taxes. Assume that Hotel California
has enough taxable profit to take advantage of any additional tax breaks
due to this construction. Assume no additional capital expenditures are made
between the end of renovation and the sale of the hotel.
(14 marks)
Approaching the question
Note that in the table below, everything is done in excess of what would
happen if the hotel did not undergo renovation.

Profit per room


Rooms in excess of no
renovation
Pre-tax profit in excess of
no renovation
Capital expenditures
Depreciation
12

2013

2014

2015

2016

32.85

32.85

32.85

32.85

16

14

14

14

525.6

459.9

459.9

459.9

333.3

333.3

333.3

1000

Examiners commentaries 2013

Taxable income

525.6

126.6

126.6

126.6

Tax

105.1

25.3

25.3

25.3

After-tax income

420.5

434.6

434.6

434.6

1420.5

434.6

434.6

434.6

0.917

0.842

0.772

0.708

PV

1303.2

365.8

335.6

307.9

NPV

294.0

FCF
Discount multiple

c. Explain how you would calculate the price at which the hotel is sold and how
you would use this number to augment the NPV calculation.
(7 marks)
Approaching the question
The sales price of the hotel is the present value of all future cash flows
after the sale.
To augment the NPV calculation you have to add the sales price but
subtract what the sales price would have been if the renovation was not
done. No marks for this part if they do not mention this.
There are several ways to compute the sales price. One would be to
assume a constant growth rate and discount rate and then plug the
FCF into the Gordon Growth Model: V = FCF/(r g). How to get FCF?
Could use the FCF for the last year: 434.6; however, this assumes that:
(i) no additional capital expenditures are made; (ii) there is no need to
account for additional depreciation; and (iii) includes the tax-shields
from depreciating the original investment, which should run out after
2015. The third assumption is clearly problematic, but the first two are
not unreasonable assumptions since it was specified that $90 is profit
per room (which may include costs of replacing depreciation). However,
a better answer would specifically say something about subtracting off
additional depreciation, and replacing depreciated capital with capital
expenditures.
Question 8
You currently have $50,000 in cash. You have access to a project which requires
an initial investment of $50,000. One year from now this project will pay either
$40,000 with probability 50% or $100,000 with probability 50%. After this, there
are no further cash flows.
Assume risk neutrality and an annual discount rate of 10%. This is also the risk
free rate.
Reading for this question
Subject guide, Chapter 6, pp. 8999.
Approaching the question
Students should look to approach these questions by using a combination
of basic probability theory and capital structure theory outlined in the
subject guide.
a. What is the NPV of this project?

(4 marks)

Approaching the question


NPV = 50 + (0.5 * 40 + 0.5 * 100)/1.1 = $13,636
Note that the cash you have is irrelevant for this calculation.

13

FN3092 Corporate finance

b. Suppose you decide to finance this project with your own cash. How much
money do you expect to have one year from now?
(6 marks)
Approaching the question
0.5 * 40 + 0.5 * 100 = $70,000
Note that this question was posed in terms of payoff one year from now;
however, if they do everything in terms of present values that is fine too.
c. You have found investors who will fund the full cost of the project through
equity. You will invest your cash at the risk free rate. What is the share of
equity they will ask for? How much money do you expect to have one year
from now?
(6 marks)
Approaching the question
Let be the fraction of equity promised to outsiders. It must be that:
50 = * (0.5 * 40 + 0.5 * 100)/1.1 = * 63.64 = 78.57 per cent.
Your payoff: (1 ) * (0.5 * 40 + 0.5 * 100) = 15
In addition you will have 50 * 1.1 = 55 from investing your cash.
In total you have 15 + 55=$70,000.
Note that this question was posed in terms of payoff one year from now;
however, if they do everything in terms of present values that is fine too.
d. You have found investors who will give you a loan for the full cost of the
project. You will invest your cash at the risk free rate. Assume in case of
default, these investors can claim all of the projects cash flows, but cannot
claim the cash you have invested outside of the project. What is the face
value of the loan and the interest rate? How much money do you expect to
have one year from now?
(6 marks)
Approaching the question
Loan calculation:
50 = (0.5 * 40 + 0.5 * F)/1.1 F=70 Interest rate = 40 per cent
Your payoff: 0.5 * 0 + 0.5 * (100 F) = 15
In addition you will have 50 * 1.1 = 55 from investing your cash.
In total you have 15 + 55 = $70,000.
Note that this question was posed in terms of payoff one year from now;
however, if they do everything in terms of present values that is fine too.
e. In light of your numerical answers above, discuss Modigliani and Millers 1st
proposition.
(3 marks)
Approaching the question
Note that in (b),(c) and (d) the payoff was always the same. Furthermore,
if you were to discount it to year 0 (divide by 1.1) and subtract the value
of your cash ($50,000), they are all equal to the NPV in (a). This is exactly
the point of M&M1, financing method (capital structure) is irrelevant. The
payoff to the firms owner will be the same regardless of which capital
structure is chosen, as long as the conditions stipulated by M&M hold
(which they do in this question).

14

Examiners commentaries 2013

Black-Scholes Option Pricing Formula


C = S[N(d1)] X[N(d2)]e-rt
d1 =

ln ( S / X )

1
+ t
2

and
d 2 = d1 t

Capital Assets Pricing Model (CAPM)


E(Ri) = Rf + i E (Rm) Rf
Modigliani and Miller
Proposition I (no tax): VL = VU
Proposition II (no tax): Re = Ra + (Ra Rd) D
E
Proposition I (with corporate tax): VL = VU + Tc D
Proposition II (with corporate tax): Re = Ra + (Ra Rd) (1 Tc) D
E
Miller (1977)
(1 Tc )(1 Te )
VL = VU + 1
D
1 Td

15

FN3092 Corporate finance

Examiners commentaries 2013


FN3092 Corporate finance Zone B
Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 201213. The format and structure
of the examination may change in future years, and any such changes
will be publicised on the virtual learning environment (VLE).

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 (2011). You should always attempt to use the most
recent edition of any Essential reading textbook, even if the commentary
and/or online reading list and/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.

Comments on specific questions


Candidates should answer FOUR of the following EIGHT questions: ONE
from Section A, ONE from Section B and TWO further questions from
either section. All questions carry equal marks.
A list of formulas is given at the end of the paper.
A calculator may be used when answering questions on this paper and
it must comply in all respects with the specification given with your
Admission Notice. The make and type of machine must be clearly stated
on the front cover of the answer book.

Section A
Answer one question from this section and not more than a further
two questions. (You are reminded that four questions in total are to be
attempted with at least one from Section B.)
Reading for this question
Subject guide, Chapter 5, pp.7389/Chapter 2, pp.2540.
Approaching the question
Question 1
a. Discuss evidence on anomalies such as size, book-to-market, and return
predictability.
(9 marks)
Approaching the question
Size: small firms tend to have higher returns than large firms.
Book-to-Market: value firms (firms with high Book/Market ratio) tend to
have higher returns than Growth firms (low Book/Market ratio).
At longer horizons stock returns are predictable by variables like P/E, say.
16

Examiners commentaries 2013

b. Are these anomalies consistent with the CAPM? How does Rolls critique
relate to this?
(8 marks)
Approaching the question
For anomalies such as these to be consistent with CAPM, the firms with
higher returns need to have higher betas. This does not seem to be the
case for small and value firms, at least not enough to explain the return
differences.
However, to compute a beta we need to have the markets return. In
practice, a beta is typically computed relative to some equity index. Rolls
critique is that the typical equity index is not necessarily equal to the true
market return. In which case, beta is mismeasured so we cannot confirm
that the CAPM fails.
c. Are these anomalies consistent with market efficiency?

(8 marks)

Approaching the question


These are not necessarily inconsistent with market efficiency. The CAPM
is not necessarily the right model to describe all risk. Any firm with higher
loading on the true risk in the economy should have higher returns. It
may be that small and value firms are indeed such firms. Multi-factor
models attempt to capture the risks in the economy not captured by the
CAPM.
Question 2
a. Corporate taxes result in the Modigliani and Miller 1st proposition being
violated. Briefly explain why.
(8 marks)
Reading for this question
Subject guide, Chapter 6, pp. 8999 and Chapter 9, pp.12733.
Approaching the question
Since different payouts are taxed in different ways, it is optimal for the
firm to structure its financing so as to minimise the tax liability. Therefore
capital structure is not irrelevant and M&M1 is violated.
In particular, at the corporate level any payments to creditors are not
taxed, while all other profit (which is eventually paid out to equity) is
taxed at the corporate tax rate. Therefore debt is cheaper than equity and
if we consider corporate taxes only, firms should issue as much debt as
possible.
b. Asymmetric information result in the Modigliani and Miller 1st proposition
being violated. Briefly explain why.
(9 marks)
Approaching the question
The answer can be either about pecking order theory, or signalling with
debt, or signalling with dividends.
Pecking order theory: When the market does not know firm type, good
firms may choose to not issue risky securities because good firms are
undervalued and will have to give away too much to the outside investors.
If they can, they will issue safer securities (this is the pecking order)
because safe security payoffs have less dependence on firm type. Or they
will finance investment with internal cash. However, if they cannot issue
safe securities, they will not use external financing at all, and therefore
will pass up positive NPV projects.

17

FN3092 Corporate finance

Signalling: When the market does not know firm type, good firms will
want to signal to the market that they are good. This is so that they can
get a better price for issuing securities. The signal must be more costly
for bad firms than for good firms; otherwise, bad firms would replicate
the signal and the market still would not be able to tell good from bad.
Two such signals are debt and dividends. Debt (as in Ross 1977) is costly
because it increases the probability of the firm going bankrupt (for this
to work the model also needs either bankruptcy costs, or disutility from
bankruptcy for manager). Dividends (as in Bhattacharya 1979) are costly
because they are taxed at a higher rate than other types of payouts.
c. Briefly explain the Modigliani and Miller 1st proposition and discuss some
of the other reasons (not including (a) and (b)) which may cause it to be
violated.
(8 marks)
Approaching the question
M&M1 says that capital structure is irrelevant if certain conditions hold.
This means that it does not matter how the firm finances its investment
the value for the shareholders will be unchanged. This is because financial
decisions to not affect value, they only determine how this value is split
among the different stakeholders.
Among the other reasons that M&M1 can be violated:
Personal taxes make equity cheaper (implies less debt in the capital
structure)
High amounts of debt leading to debt overhang and underinvestment
(implies less debt in the capital structure)
High amounts of debt leading to risk shifting; that is, managers take on
too much risk because upside is unlimited and downside has limited
liability (implies less debt in the capital structure)
High amounts of outside equity leading to too little effort by managers
(implies more debt in the capital structure).
Question 3
a. Explain debt overhang. Describe situations in which debt overhang is most
severe. What are some possible solutions to the debt overhang problem?
(9 marks)
Reading for this question
Subject guide, Chapter 8, pp.11124.
Approaching the question
When a firm has too much debt; that is, when the firm is close to
bankruptcy but not yet in default, it may bypass positive NPV projects. The
reason is that there is a high probability that the firm will default, in which
case creditors will receive all benefit from the new investment. Thus, in
expectation, equity holders receive only a fraction of the benefit from
investing (whenever the firm does not default), but pay the full cost. The
reason they pay the full cost is that if the firm did not invest, it could use
the cash to pay them a cash dividend.
Debt overhang is most severe for firms with high expectations of default,
and with low (but positive) NPV projects. Note that if the project has a
very high NPV, then the equity holders will want to take it because the
fraction they receive in expectation is still higher than the cost.
One possible solution is renegotiation. Since the firm is bypassing positive
NPV projects, in theory everyone could benefit if they could somehow
18

Examiners commentaries 2013

take the project and split the NPV between equity and debt holders.
Negotiation can involve a reduction of interest payments, or a deferral of
interest payments.
Another possible solution is issuance of new debt. However, this can only
work if the new debt is more senior than existing debt. Thus new creditors
know they are likely to be paid back and do not charge too high interest
rates. However, this is typically forbidden in the covenants of the existing
debt. If the firm files for bankruptcy, then issuing senior debt is allowed.
b. How does clientele theory explain the existence of dividends?

(9 marks)

Approaching the question


In most tax regimes dividends are taxed at a higher rate than capital
gains. Thus, if a firm chooses to issue equity, it would seem that it is best
to pay out equity investors with capital gains (repurchases) rather than
dividends.
However, not all investors are the same. There are some investors that are
in high tax brackets. Indeed, for them, dividends are a tax disadvantage
and they prefer to be paid through capital gains. However, there are other
investors who are tax exempt, or in low tax brackets. For them dividends
are no worse, and may be even better than capital gains. In order to attract
as many investors as possible to the market, some firms will choose to
cater to each of these types of investors. Indeed, empirically it is true that
low tax investors have portfolios that are tilted toward dividend paying
stocks.
c. Suppose you notice that subsequent stock returns are higher after warm and
sunny mornings; stock returns are lower after cold and rainy mornings. Is
this market efficient? Which forms of efficiency are violated according to this
observation.
(7 marks)
Approaching the question
This market is is not semi-strong form efficient because morning weather
is public information on which anyone can trade. Thus semi-strong-form
efficiency is violated, and strong-form efficiency is violated as well. We are
given no evidence that weak-form efficiency is violated.
Question 4
a. How does the price of a European call option change if the volatility of the
underlying rises? If the price of the underlying rises? If the interest rate
rises? If the strike price rises? Explain.
(9 marks)
Reading for this question
Subject guide, Chapter 4, pp.5571.
Approaching the question
If the volatility rises, the call option price rises. This is because with
options, the downside is limited (by zero) and the upside is unlimited.
Increased volatility increases the probability of both.
If the price rises, the call option price rises. This is because a call entitles
the owner to buy at a particular fixed price. If the actual price is now
higher, the option to buy at a fixed (relatively low) price is more valuable.
If the risk free rate rises the call option value rises. This is because it
decreases the present value of the exercise price.
If the strike price rises, the call option price falls. This is because a call
option entitles the owner to buy the underlying for the exercise (strike)
price. Buying at a higher price is bad.
19

FN3092 Corporate finance

b. Describe the NPV and IRR approaches to project evaluation. When do they
agree? Give an example of when they disagree.
(8 marks)
Reading for this question
Subject guide, Chapter 1, pp. 1023.
Approaching the question
The NPV approach calculates the present value of all future cash flows
using some specified discount rate.
NPV = C1/R + C2/R2 + C3/R3 + .
It then suggests investing any time the NPV is positive.
The IRR approach computes that discount rate which would make the
present value exactly zero.
0 = C1/IRR + C2/IRR2 + C3/IRR3 + .
It then suggests investing any time the IRR is higher than the appropriate
discount rate.
Note that for standard projects IRR and NPV give exactly the same answer
since R>IRR implies that the discounted present value is above zero.
However, for non standard projects, they may give different answers. In
particular, when we must only choose one project out of many, when the
borrowing rate is different from the lending rate, when the discount rate is
changing through time, when cash flows are often changing from positive
to negative. See the textbook for detailed explanations of how each of
these can lead to different answers between NPV and IRR.
If we are able to properly estimate cash flows, growth rates, and discount
rates the NPV approach is superior. The NPV approach says to invest
whenever a project is increasing firm value anything else would be
wrong! However, in the real world we may not always perfectly estimate
cash flows, growth rates, and discount rates. For this reason, IRR may
work better in practice even though NPV is theoretically better.
c. Do takeovers typically increase the value of the target? Do they tend
to increase the value of the acquirer? Briefly discuss the theory and the
empirical evidence.
(8 marks)
Reading for this question
Subject guide, Chapter 10, pp.13544.
Approaching the question
Grossman and Hart (1980) suggest that it is impossible (or at least
very difficult) for takeovers to occur due to the free-rider problem. The
shareholders of the target firm will refuse to sell for anything less than the
acquirers maximum valuation of the target. Thus the acquirer has nothing
to gain.
There are certain mechanisms which may make takeovers easier; for
example, if the acquirer is able to purchase many shares in secret, before
the market realises there is a takeover bid. However, even in this case, the
acquirer is likely to pay more than the target is worth.
The empirical evidence is consistent with the theory. The value of the

20

Examiners commentaries 2013

target firm typically rises during the sale. However, the evidence on the
acquirer and the total value is mixed. The gain to the acquirer may even
be negative, and the net gain may be negative as well.
Other studies look at operating performance of mergers, rather than
market values. Here the evidence too, is mixed. Some studies find
improvements in operating performance (namely, higher return on assets,
profit) but others find no improvement.

Section B
Answer one question from this section and not more than a further
two questions. (You are reminded that four questions in total are to be
attempted with at least one from Section A.)
Question 5
There are two types of firms. Each firm has a project whose quality is known
by the firms CEO but not by outsiders (except for in (b)). Type G are good, their
project is worth $40 million. Type B are bad, their project is worth $25 million.
It is publically known that good firms are 30% of the total population of firms,
with the remainder being bad.
These firms can also finance an additional project. This new project requires an
initial investment of $17 million and next year will pay $21 million with 50%
probability or $15 million with 50% probability.
Assume risk neutrality and a discount rate of zero.
Reading for this question
Subject guide, Chapter 9, pp.12735.
Approaching the question
Students should look to approach these questions by using a combination
of basic probability theory and signalling theory outlined in the subject
guide.
a. What is the NPV of the project? If the market does not know which firm is of
which type and therefore values all firms equally (not including the project),
what is a firms market value?
(3 marks)
Approaching the question
17 + .5 * 21 + .5 * 15 = 1
Avg firm: 0.3 * 40 + 0.7 * 25 = 29.5
b. Suppose the outside market knows each firms type. What is the payoff
to each firms original owners if they do not invest in this project? What
is the payoff to each firms original owners if each firm finances the new
project with equity? What fraction of equity must each type of firm offer to
outsiders? Which firms finance the project and which do not?
(5 marks)
Approaching the question
If the firms do not invest in this project the payoffs of each firm are just
their original values: 40 for G, 25 for B.
If a firm finances the project with equity then the cost of the project must
equal the expected payoff for outside investors, which is a fraction of the
firms total value promised to them. Let that fraction be .
For G: (40 + .5 * 21 + .5 * 15)= 58= 17 = 29.3 per cent. The
payoff to the original owners is (1 ) * 57 = 41 > 40 so they finance the
project.

21

FN3092 Corporate finance

For B: (25 + .5 * 21 + .5 * 15) = 43= 17 = 39.5 per cent. The


payoff to the original owners is (1 ) * 43 = 26 > 25 so they finance the
project.
c. Now consider a world of asymmetric information where the CEO knows her
own firm type but the outside market does not. Suppose outside investors
believe that all firms finance these projects with equity. What fraction of
equity will outside equity investors ask for? What will be the total value of
firm G? What will be the total value of firm B?
(6 marks)
Approaching the question
The outside market does not know which firm is which so asks for fraction
that is the same for both firms. The market assumes it is getting an
average firm.
[0.3 * (40 + .5 * 21 + .5 * 15) + 0.7 * (25 + .5 * 21 + .5 * 15)]= 17
(0.3 * 58 + 0.7 * 43)= 47.5 = 17 = 35.8 per cent
d. Compute the benefit to the original shareholders of each firm from following
the strategy in (c) and compare it to the strategy of not investing in this
project. What will each type do? What will the market believe about firms
who raise equity?
(6 marks)
Approaching the question
G and invest: (1 0.358) * (40 + .5 * 21 + .5 * 15) = 37.2
G and not invest: 30 Good does not invest
B and invest: (1 0.358) * (25 + .5 * 21 + .5 * 15) = 27.6
B and not invest: 25 Bad invests, good does not
e. If the market reacts rationally to the assumed strategies in (d), what does
the market assume about any firm that raises equity? What fraction of equity
does the market ask for? What is the market value of any firm that raises
equity. How does it compare to the original stock price in (a)?
(5 marks)
Approaching the question
Only bad firms raise equity, since the market is aware of this, the problem
of the bad firm becomes identical to (b). In particular = 39.5 per cent
and the firm value is 26, which is below 29.5 in (a). Thus bad firms tend
to raise equity and their value drops.
Question 6
Hotel California, a lovely place along the 101 Highway, last underwent an
upgrade in 1969. As a result of its dilapidated conditions it has plenty of extra
rooms. It is considering a major renovation.
The construction costs of the renovation are estimated to be $900,000, payable
at the end of construction. If the construction starts today, it will last one year.
During the renovation, the hotel will be closed to guests (however assume that
all of the hotels expenses, such as paying staff, are unchanged due to long term
contracts).
Hotel Californias capacity is 25 rooms and, on average, 50% of the rooms are
vacant on any single day. The daily profit per occupied room is $80.
The corporate tax rate is 25%, the appropriate discount rate is 10%, and
renovation can be depreciated at 33.3% per year.
Reading for this question
Subject guide, Chapter 1, pp.1023.
Approaching the question
22

Examiners commentaries 2013

Students should practise NPV calculation questions to enable them to get


comfortable in aligning the cash flows, as well as the inputs.
a. Compute the average profit per occupied room a year. Then compute the
average profit for the hotel as a whole. Assume 365 days per year. (4 marks)
Approaching the question
Occupied room: 365 80= $29,200
Hotel: $29,200 * (25 * 0.5) = $365,000 where 0.5 = 1 0.5 is the
occupancy rate.
b. Suppose Hotel California decides to begin renovation today. Assume that
after renovation, the vacancy rate will fall to 20%. Suppose that the hotel
will be sold exactly 3 years after the renovation is complete. Ignore the sales
price and everything that happens after the sale and compute the NPV of
renovation for cash flows from now until the sale (excluding the sale). Do
not forget depreciation and corporate taxes. Assume that Hotel California
has enough taxable profit to take advantage of any additional tax breaks
due to this construction. Assume no additional capital expenditures are made
between the end of renovation and the sale of the hotel.
(14 marks)
Approaching the question
Note that in the table below, everything is done in excess of what would
happen if the hotel did not undergo renovation.

Profit per room

2013

2014

2015

2016

29.2

29.2

29.2

29.2

Rooms in excess of no
renovation

12.5

7.5

7.5

7.5

Pre-tax profit in excess of no


renovation

365

219

219

219

Capital expenditures

900

Depreciation

300

300

300

365

81

81

81

91.25

20.25

20.25

20.25

273.75

239.25

239.25

239.25

1173.75

239.25

239.25

239.25

0.909

0.826

0.751

0.683

PV

1067.05

197.73

197.73

197.73

NPV

526.16

Taxable income
Tax
After-tax income
FCF
Discount multiple

c. Explain how you would calculate the price at which the hotel is sold and how
you would use this number to augment the NPV calculation.
(7 marks)
Approaching the question
The sales price of the hotel is the present value of all future cash flows
after the sale.
To augment the NPV calculation you have to add the sales price but
subtract what the sales price would have been if the renovation was not
done. No marks for this part if they do not mention this.
There are several ways to compute the sales price. One would be to
assume a constant growth rate and discount rate and then plug the FCF
into the Gordon Growth Model: V = FCF/(r g). How to get FCF? Could
use the FCF for the last year: 239.25; however, this assumes that no
additional capital expenditures are made, and there is no need to account
for additional depreciation. This is not an unreasonable assumption since
23

FN3092 Corporate finance

it was specified that $80 is profit per room (which may include costs of
replacing depreciation); however, a better answer would specifically say
something about subtracting off additional depreciation, and replacing
depreciated capital with capital expenditures.
Question 7
You own a project which requires an initial investment of 1M. One year from
now this project will pay either 0.8M with probability 40% or 1.5M with
probability 60%. After this, there are no further cash flows. You have no money
to finance this project on your own.
Assume risk neutrality and an annual discount rate of 15%.
Reading for this question
Subject guide, Chapter 6, pp. 8999.
Approaching the question
Students should look to approach these questions by using a combination
of basic probability theory and capital structure theory outlined in the
subject guide.
a. What is the NPV of this project?

(4 marks)

Approaching the question


NPV = 1 + (0.4 * 0.8 + 0.6 * 1.5)/1.15 = 0.061M
b. You have found investors who will give you a loan for the full cost of the
project. What is the face value of the loan and the interest rate? What is the
expected present value of your payoff?
(6 marks)
Approaching the question
Loan calculation:
1 = (0.4 * 0.8 + 0.6 * F)/1.15 F = 1.383 Interest rate = 38.3 per
cent
Your NPV: [0.4 * 0 + 0.6 * (1.5 F)]/1.15 = 0.061M
c. You have found investors who will fund the full cost of the project through
equity. What is the share of equity they will ask for? What is the expected
present value of your payoff?
(6 marks)
Approaching the question
Let be the fraction of equity promised to outsiders. It must be that:
1 = * (0.4 * 0.8 + 0.6 * 1.5)/1.15 = * 1.061 = 94.26 per cent.
Your NPV: (1 ) * 1.061 = 0.061
d. You have found investors who will give you a loan for half of the cost of the
project. You will finance the rest with equity. What is the face value of the
loan and the interest rate? What is the share of equity promised to the equity
investors? What is the expected present value of your payoff?
(6 marks)
Approaching the question
Loan calculation:
0.5 = (0.4 * F + 0.6 * F)/1.15 F = 0.575 Interest rate = 15 per
cent.
Let be the fraction of equity promised to outsiders. It must be that:
0.5 = * [0.4 * (0.8 F) + 0.6 * (1.5 F)]/1.15 = * 0.561 =

24

Examiners commentaries 2013

89.13 per cent.


Your NPV: (1 ) * 0.561 = 0.061
e. In light of your numerical answers above, discuss Modigliani and Millers 1st
proposition.
(3 marks)
Approaching the question
Note that in (b),(c) and (d) the payoff was always the same and equal
to the NPV in (a). This is exactly the point of M&M; financing method
(capital structure) is irrelevant. The payoff to the firms owner will be
the same regardless of which capital structure is chosen, as long as the
conditions stipulated by M&M hold (which they do in this question).
Question 8
For this question assume that debt carries no tax advantage over equity. The
historic risk free rate is 3% and the historic stock market premium (in excess of
the risk free rate) is 7%.
Reading for this question
Subject guide, Chapter 2, pp.2540, Chapter 10 pp. 13543.
a. LexCorp is a private equity fund which owns several airlines. It has
outstanding long term debt with face value $120M and an interest rate of
5%. It has 50M shares outstanding, trading at $2/share. Its historic annual
equity return is 20%. It plans to sell one of its airlines, Inter-Continental
Airlines, as a stand alone all equity firm. Assuming its risk is similar to
LexCorp, what is the appropriate discount rate at which to value InterContinentals equity?
(6 marks)
Approaching the question
LexCorps equity market cap is 2 * 50 = 100. Its capital employed is
120 + 100 = 220. Its weight of equity is 100/220 = 0.45 and its weight of
debt is 120/220 = 0.55
LexCorps WACC is 0.55 * 4 + 0.45 * 20 = 11.81 per cent.
Inter-Continental has the same risk as LexCorp; furthermore, there are no
tax issues, therefore it has the same discount rate as LexCorps WACC.
b. Inter-Continental Airlines has annual free cash flows (FCF) of $2M. What is its
current value assuming no growth in cash flows? Suppose Inter-Continental
raises $10M in cash through a debt offering with an interest rate of 3%. What
is the new beta of Inter-Continental Airlines equity? What is the weighted
average cost of capital?
(7 marks)
Approaching the question
The current value is 2M/0.1181 = $16.93M. After the debt issuance it has
added $10M to its assets (and liabilities), raising the value to $26.93M.
The total value is not affected by choice of capital structure because debt
does not carry a tax advantage. Therefore the weights of equity and debt
are now 16.93/26.93 = 0.629 and 10/26.93 = 0.371. Note that the firm
has two assets, cash and airline. The presence of cash has not changed the
airlines risk; therefore its expected return is the same as before: 11.81
and its beta = (11.81 3)/7 = 1.26. Using the WACC approach:
WACC = 0.629 * 11.81 + 0.371 * 3 = 8.54.

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FN3092 Corporate finance

c. Inter-Continental Airlines uses the $10M in cash to purchase Southwestern


Petroleum which extracts oil. Oil extracting firms typically have betas of 2.1.
What is the new beta of Inter-Continental Airlines equity?
(7 marks)
Approaching the question
First consider the asset side of the balance sheet. Inter-Continental has two
projects: airline with a beta of 1.26 (from (b)), and oil extraction, with
a beta of 2.1. The weights are 0.629 and 0.371 just as in (b); therefore
WACC = 0.629 * 1.26 + 0.371 * 2.1 = 1.57.
Now using WACC on debt and equity (liabilities side of balance sheet):
There is still outstanding debt with market value 10 and a promised return
of 3 per cent, implying beta(Debt) = (3 3)/7 = 0. Its weight is 10/26.93
= 0.371, as in (b). Applying the WACC once more: 1.57 = 0.371 * 9 +
0.629 * Beta(equity) Beta(equity) = 2.50.
d. What must Southwestern Petroleums annual free cash flows (FCF) be to
justify the sales price? Assume no cash flow growth.
(5 marks)
Approaching the question
Its beta is 2.1, implying an expected return of 2.1 * 7 = 14.7.
FCF/0.147 = 10 FCF = $1.47M.
Black-Scholes Option Pricing Formula
C = S[N(d1)] X[N(d2)]e-rt
d1 =

ln ( S / X )

1
+ t
2

and
d 2 = d1 t

Capital Assets Pricing Model (CAPM)


E(Ri) = Rf + i E (Rm) Rf
Modigliani and Miller
Proposition I (no tax): VL = VU
Proposition II (no tax): Re = Ra + (Ra Rd) D
E
Proposition I (with corporate tax): VL = VU + Tc D
Proposition II (with corporate tax): Re = Ra + (Ra Rd) (1 Tc) D
E
Miller (1977)
(1 Tc )(1 Te )
VL = VU + 1
D
1 Td

26