This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON 279 0092 ZA

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diploma in Economics and Access Route for Students in the
External Programme

Corporate Finance

Thursday, 22nd May 2008 : 2.30pm to 5.30pm

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 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.

© University of London 2008

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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)

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)

(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)

(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)

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)

(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)

(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 marks)

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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)

(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)

(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)

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)

(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)

(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)

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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)

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)
(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)
(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)

6. (a) Outline Ross’ (1977) signalling argument for debt. There is no need to reproduce
algebra – an intuitive exposition suffices. (8 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)
(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)

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)
(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)

(question continues on next page)

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 (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)

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)

(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)

(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)

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