BMAN30111

THREE Hours

Formula Sheet attached

Normal Distribution Tables attached

THE UNIVERSITY OF MANCHESTER

ADVANCED CORPORATE FINANCE

20 January 2020

14:00 – 17:00

Answer ANY TWO questions.

All questions carry equal marks

THIS QUESTION PAPER MUST NOT BE REMOVED FROM THE EXAMINATION

ROOM

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Electronic calculators may be used in line with University regulations

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© The University of Manchester, 2020

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Answer ANY TWO questions

QUESTION 1

(a) You are the financial manager of a very profitable firm, which is currently evaluating
a new, large investment project at the start of 2020. The project involves the acquisition
of a plant, which requires an initial outlay of £300 million. The project’s investment
horizon is six years. Over this period, the initial capital investment in the plant should
be fully depreciated. Despite this, it is expected that at the end of the project (after six
years) the taxable salvage value of the plant will amount to £50 million. The project
requires an initial (at the start of 2020) working capital investment of £30 million, which
should be recovered in full at the end of 2025. Your accountants have put together the
following projections on expected sales and cash flows, and information on the cost of
capital of the company:

Table 1. Sales and cash flow projections

2020 2021 2022 2023 2024 2025

Sales 120 135 140 125 120 110
EBITD 60 75 80 65 60 50
Depreciation (50) (50) (50) (50) (50) (50)
EBIT 10 25 30 15 10 0
Tax (2) (5) (6) (3) (2) 0
expense
EBIAT 8 20 24 12 8 0

Table 2. Cost of capital

Risk-free Rate (Rf) 1%

Project Cost of Debt (Rd) 4%
Market Risk Premium 6%
Marginal Corporate Tax Rate (Tc) 20%
Asset Beta of comparable companies 0.8

Required:

Carry out the following calculations, always assuming that cash flows occur at the end
of their respective years:

(i) Estimate the NPV of the investment project at the start of 2020 if it is 100%
financed with equity. Comment on your findings. (20 marks)

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Question 1 continued

(ii) Use the WACC method to estimate the NPV of the investment at the start of
2020 assuming that it is financed 40% with equity and 60% with debt and that the
financing structure of the project does not change over the life of the project.
Comment on your findings. (20 marks)

(iii) Show how you could alternatively compute the NPV of part (ii) above by using
the APV method rather than the WACC method. (10 marks)

(iv) Calculate the NPV of the investment at the start of 2020 assuming that your
firm initially borrows £120 million and then pays down the debt at a rate of £20
million per year. Assume that interest payments can always be used to offset the
company’s taxable profits over the life of the project. Comment on your findings.
(10 marks)

(b) Contrast and compare the WACC and the APV methods and critically evaluate
strengths and weaknesses of the two methods. What are the underlying assumptions
of the two methods? Refer to the existing literature when discussing and evaluating
these assumptions. (30 marks)

(c) Practitioners sometimes consider the financial distress costs in their APV
applications. What are these costs? Why are they relevant? Briefly describe the
empirical evidence on distress costs, including studies on their magnitude relative to
firm value. (10 marks)

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QUESTION 2

A publicly listed firm possesses some assets in place and a positive NPV project at
time t=-1. At this time, both the firm’s managers and the outside investors do not know
the precise values of the assets in place and of the NPV of the project. At a subsequent
time t=0, the firm has to decide whether to issue equity to new shareholders to invest
in the project, given that the firm does not have enough internal resources to go ahead
with the project. All the assumptions of Myers and Majluf’s (1984) pecking order model
hold. At time t=0, the managers of the firm receive private information about the values
of the assets in place and of the NPV of the investment project. When deciding whether
to issue equity and go ahead with the new project, the management act in the best
interest of the passive, existing shareholders. The key financial information about the
firm and its investment opportunity can be found in the table below.

Firm type High quality Low quality

Probability of firm type 0.45 0.55

Financial slack (in £ million) 5 5

Assets in place (in £ million) 600 200

Initial outlay of new project (in £ million) 100 100

NPV of new project (in £ million) 30 15

Required:

(a) Derive a rational expectations equilibrium (REE) in which investors’ rational beliefs
at time t=0 are consistent with the management’s actions at time t=0. Show your
calculations in detail and comment on your results. (30 marks)

(b) Compute the value of the firm at time t=-1. Compare this to the value of the firm at
time t=-1 with symmetric information, i.e. assuming that the managers and the outside
investors simultaneously observe firm type at time t=0. Explain the difference (if any).
(10 marks)

(c) What would the equilibrium outcome of the model be if the firm’s financial slack
increased to 80 (S=80)? Show the steps in detail and discuss the potential value of
financial slack in mitigating the underinvestment problem. (20 marks)

Question 2 continued overleaf

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Question 2 continued

(d) Outline the predictions of the pecking order theory and evaluate them using both
survey and regression evidence. Briefly compare and contrast the predictions of the
pecking order theory with those of the trade-off theory. (30 marks)

(e) Briefly describe empirical evidence that is consistent with the pecking order theory
and at odds with the trade-off theory. Similarly, describe any empirical findings that
support the trade-off theory but are not in line with the pecking order theory.
(10 marks)

QUESTION 3

SansaStark PLC is a listed company with limited liability. It currently has assets valued
at £350 million (in terms of the sum of the market values of its debt and equity). It has
a large amount of (non-convertible) debt with a redemption value of £200 million, with
a zero coupon and a remaining term to maturity of five years. The value of the firm’s
assets is quite volatile with an asset return having an estimated standard deviation of
40%. The annual risk–free interest rate is expected to remain constant over the next
five years at 4%. It is reasonable to assume that over the foreseeable future the
company will continue to pay no dividends.
Required:
(a) Using the Black–Scholes option-pricing model, calculate:
(i) the value of the equity and debt of the company and the value of the risk-
free debt with the same redemption value and maturity as the company’s
debt; (10 marks)
(ii) the value of limited liability for SansaStark PLC and clearly explain the
benefits of the limited liability for shareholders and, more generally, for the
economy. (15 marks)

(b) Now suppose that SansaStark PLC undertakes the actions outlined below in
points (i) and (ii). In each case, recalculate the value of limited liability and
explain why the new values are different (or not) compared to the value of limited
liability in the baseline scenario outlined in (a). Also explain why shareholders
and debtholders are better off (or not) in each case.

(i) The company pays special dividends financed by liquidating assets for a total
value of £50 million. (10 marks)

(ii) The company pays dividends financed by issuing new debt worthy £50
million. (10 marks)
Question 3 continued overleaf

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Question 3 continued

(c)
(i) Describe the main characteristics of the Principal-Agent model and give details of
the two main types of agency relationships that might occur when we apply the
Principal-Agent model within a limited liability company. (10 marks)

(ii) Describe the problems that characterize those two types of agency relationships.
(20 marks)
(d)
(i) Now use the OPT (Option Pricing Theory) framework to explain the pay-off
structures of both shareholders and debtholders of a limited liability company.
(15 marks)

(ii) Outline the mechanisms that may be used to reduce agency conflicts between
shareholders and debtholders. Critically discuss their advantages and
disadvantages. (10 marks)

QUESTION 4

The listed company JohnSnow Plc operating in the construction industry has a current
market value (net of coupon payments on its debt in the current period) of £560 million.
Due to its recent risky projects, the firm’s market value is very volatile and has been
projected to either increase by 100% or decrease by 50% in any one year.
The company is financed through equity and callable convertible debt consisting of
2,600,000 debentures. Each debenture has a face value of £100, a coupon of 4%, and
a remaining term to maturity of two years. Each debenture may be converted into 5
shares at any time up to and including maturity. The company has the right to call the
debt at any time. If the debt is called, debtholders must choose to either convert their
debt immediately or accept the call amount consisting of the face value of the callable
convertible debt and any interest payment due up to the maturity.
In addition to the callable convertible debt, the company is equity financed with a total
of 38 million outstanding shares. So far, the company has never paid dividends, and it
is not expected to do so within the next two years.
The annual risk-free rate of interest is predicted to remain constant at 4% per annum
over the next two years.

Question 4 continued overleaf

Question 4 continued

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Required:
a)
(i) Define the terms “conversion price” and “conversion premium”. (5 marks)
(ii) Define the terms ‘bond value’ and ‘conversion value’. (5 marks)

(b) Using the binomial option-pricing model:

(i) calculate the current value at time t = 0 of JohnSnow Plc’s straight debt;
(10 marks)
(ii) calculate the convertible and callable convertible debt values. For your
calculations assume that debtholders act as one (i.e. in unison). Explain each
step you have taken to obtain your answers, and explain the actions of
debtholders at each stage. (20 marks)

(c) Suppose now the firm had decided to give 10 shares for each debenture if
debtholders decide to convert debt into equity at any point in time up to the
maturity.
(i) If everything else remains as in part (b), how would this affect your results in
part (b)? (15 marks)

(ii) Explain in detail your results. (15 marks)

(d)
(i) Explain how agency costs of debt might justify the issue of convertible debt
and discuss the empirical evidence related to that. (10 marks)

(ii) Outline and critically discuss other alternative theoretical explanations of

companies’ motives for issuing convertible debt, by presenting also the
empirical evidence (20 marks)

END OF EXAMINATION PAPER

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