Corporate Finance Past Papers

Examiners’ commentaries 2012

FN3092 Corporate finance
Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 2011–12. 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

Unless otherwise stated, all cross-references will be to the latest version
of the subject guide (2011).
General remarks
Learning outcomes
At the end of this course, and having completed the Essential reading and
activities, you should be able to:
• discuss and evaluate key theories relating to the role of banks as
financial intermediaries
• discuss and evaluate the risks which banks face and explain how these
risks are managed, with particular focus on techniques of asset and
liability management, and credit risk measurement and management
• discuss the importance of capital in bank management and the role of
securitisation, and explain the importance of capital adequacy within
banking regulation
• describe and analyse the various means of analysing bank performance
• explain the principles and techniques involved in the use of derivative
instruments for hedging credit, interest rate and exchange rate risk.
Format of the examination

The examination is three hours long. You must answer four questions from
a choice of eight.
Questions on this paper will often contain multiple elements. In such
cases, the primary element often requires an explanation or description
of theoretical concept(s), with the secondary element requiring the
application of such information to a specific issue of theoretical
importance or practical relevance. Complete answers to this style of
question should seek to ensure that the answers to the two elements are
well integrated.
Planning your time in the examination

It is essential that you prepare thoroughly enough to allow you to
make a serious attempt at four questions on the paper. Try to allow an
approximately equal amount of time to answer each question and make
sure that you attempt all parts or aspects of a question. It is a common
failing for candidates to be unable to provide four adequate answers in the
1
time permitted, due either to inappropriate study and revision strategies

or to ineffective time management during the examination itself. If you
gain only a low mark for the fourth answer, this has a severe effect on
your overall mark.
Select your material carefully

When reading an examination question, it is important that you first
identify key words. To begin, identify the words in the question that
indicate the depth required in each part of the answer; for example,
‘analyse’, ‘assess’ and ‘explain’ will require greater depth than ‘define’,
‘describe’ or ‘outline’. Then identify the scope of the question (i.e. what
content must be included in the answer). It is equally important to
identify what should be excluded from the answer (i.e. marks will not be
gained for information that is irrelevant to the question posed).
You should be prepared to demonstrate an understanding of theory and be
able to cite appropriate models, arguments and examples. Some questions
allow an element of independent thought and reasoning. However, where
personal opinions or experiences are offered, their relevance should be
fully explained and justified and they should not comprise the major part
of the answer provided.
Some of the examination questions will require breadth of knowledge
across the syllabus. It will be common for questions to require a synthesis
of topics from different chapters of the subject guide. Therefore, it is
important to appreciate that different topics within the subject guide
are not self-contained – you must be guided in this respect by the
cross-referencing between different chapters of the subject guide. For
examination purposes, you need to have an understanding of the subject
as a whole – and remember that the examination seeks to cover the entire
breadth of the syllabus.
Read widely
The best examination answers are those that reflect knowledge and
understanding obtained from following the suggested readings in the
subject guide. When working through the suggested readings, you need
to keep in mind the question: ‘How can I reflect the insights from this
reading in an examination answer?’. Take notes on your reading and link
these notes to the material in the subject guide. Alternatively, treat the
subject guide material as a starting point, and seek to supplement this
with relevant extracts or examples obtained from the suggested readings.
The structure of each chapter in the subject guide can guide you in
such activity. Wider reading gives you a stronger appreciation of theory
and empirical evidence, and will enable you to take a more critical and
analytical approach to examination questions. This is the very best thing
you can do when preparing for the examination.
This course covers some dynamic subject material. If you keep abreast of
current issues in financial markets (e.g. by reading from quality sources
such as the Bank of England Quarterly Bulletin, the Financial Times and
The Economist), you will be able to include topical perspectives in your
answers. The Examiners will reward answers that blend awareness of
current events (e.g. the European sovereign debt crisis, the Credit Crunch
or sub-prime mortgage crisis, or the downgrading of the USA’s sovereign
credit rating) with the theory and empirical evidence from the subject
guide and suggested readings.
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Structure your argument

Your answers should be constructed in a logical and coherent manner, and
must always address the question as it is posed. Conceptual terms and
definitions should always be clearly explained. The Examiners expect to
read a clear introduction to each answer, which sets out the objective of
the answer and the key points under analysis, and a concluding paragraph
which acts as a summary of the main points of the argument. The main
body of the answer should develop and substantiate the issues under
analysis. Make sure that you write clearly and legibly. You should also
clearly label diagrams and tables, and cite relevant sources if quoting
empirical data or evidence.
Key steps to improvement

The most important issue is to read widely beyond the subject guide,
as this additional material will allow you to provide a more thoughtful
and comprehensive answer in line with the Examiners’ expectations. The
examination is not a test of how well you have read the subject guide.
Achieving good marks requires explicit arguments in the context of the
question, and the quality of each answer depends on a critical, analytical
approach to theories and empirical evidence.
Updating of Essential reading

There is a new edition of the recommended textbook by Joel Bessis. The
full details are:
Bessis, J. Risk Management in Banking. (Chichester: Wiley, 2010) third edition
[ISBN 9780470019139].
This new edition contains additional chapters and very substantial
revisions to the material that appears in the second edition. It is very
important that you use the revised citations to this textbook, available in
the VLE.
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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.
4

FN3092 Corporate finance – Zone A
Important note

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.
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. The Modigliani and Miller proposition states that in the absence of taxes and
other frictions capital structure is irrelevant. Explain. (9 marks)
Reading for this question
Subject guide, Chapter 6, pp.91–93.
Approaching the question
When there are no taxes and frictions the firm should maximise the value
of its assets, which are on the left-hand side of the balance sheet. Capital
structure just splits up those assets into payments to different investors.
How those assets are split is irrelevant because the total value of the assets
is unchanged.
b. Consider a tax code where corporate profits are taxed but interest is tax
deductable. Explain how this changes the Modigliani and Miller proposition.
How would you expect firms to react if the tax code suddenly changed from
not allowing interest to be deductable to allowing it. (9 marks)
If corporate profits are taxed but interest is tax deductable, the way in
which we split up the cash flows does matter for the total firm values. The
more of the cash flows that are going towards creditors (as an interest
payment), the less tax the firm pays, therefore the firm becomes more
valuable. In particular VL = VU + T * B, so the value of a levered firm
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is higher than the value of an unlevered firm by the present value of

the firm’s tax shields. If the tax code suddenly allowed interest to be tax
deductible we would expect firms to increase the amount of debt in the
capital structure (increase leverage).
c. In the presence of personal taxes that differentiate different types of payout
the conclusion you reached in (b) may look different. Explain. (7 marks)
Subject guide, Chapter 6, p.97.
What really matters to investors is the final payment they receive after
all taxes (personal and corporate) have been paid. Thus if corporate
taxes favour debt, and personal taxes favour equity, then more debt in
the capital structure will only be optimal if the effect of corporate taxes
is stronger than personal taxes. In the real world most tax regimes tax
capital gains at a lower rate than interest payments, thus equity is indeed
favoured at the personal level. The net tax advantage of debt is given by:
Tg=[1–Td–(1–Tc)*(1–Te)]/(1–Td) where Td is the personal tax on debt,
Te is the personal tax on equity, and Tc is the corporate tax. For different
tax rates this Tg may be positive or negative. For example, for an average
American, Tg<0, implying she prefers debt. However, for a high-earning
American Tg>0, implying she prefers equity.
Question 2
a. Explain the different forms of market efficiency and how they relate to one
another. (9 marks)
A market is efficient if one cannot make economic profits in that market.
A market can only be judged efficient or inefficient with respect to certain
information set. A market is weak form efficient if prices fully reflect
all historical market information like past prices, past data on financial
characteristics, etc. A market is semi-strong efficient if prices reflect all
public information. A market is strong form efficient if prices reflect all
information, both public and private.
b. Suppose you find that stock returns for all firms whose name starts with A
are positively correlated at a five minute frequency. Explain what forms of
efficiency this violates. (7 marks)
Positively correlated at five-minute frequency means that if the return over
the last five minutes was positive, the return for the next five minutes is
likely to be positive too. This suggests a profitable trading strategy, which
is a violation of weak form efficiency because past prices and firm names
are all publicly available.
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c. Suppose you observe that today’s price-to-dividend ratio forecasts

future stock returns, is this necessarily a violation of the Efficient Market
Hypothesis? Explain. Briefly review evidence on the forecastability of stock
returns. (9 marks)
Certain variables (such as P/D) forecasting returns is not necessarily
a violation of the efficient market hypothesis (EMH). The EMH states
that returns should not be predictable once we have accounted for risk.
However, if certain assets are more risky, they should have higher returns.
Thus if the P/D ratio is also forecasting risk, then it should forecast
future returns. Empirical evidence suggests that stock returns are weakly
forecastable at longer horizons. Some of the variables that can forecast
stock returns are the price-to-dividend ratio, the default spread, the
wealth to consumption ratio, past volatility and the corporate spread.
Question 3
a. Explain free-rider problem in the context of takeovers as in Grossman and
Hart (1980). What are the implications for returns to (i) the bidder (ii) the
acquired firm? (9 marks)
The free-rider problem is that when a raider who can raise firm value
makes a bid on a firm, the current shareholders know that if they don’t
sell and the bid is successful they will benefit from the value added. Thus
many refuse to sell their shares unless the price is very high. However, if
the price is very high then the raider does not benefit so no raid occurs.
Thus efficient, net present value (NPV) rising raids may not occur. The
free-rider problem suggests that after a takeover announcement the
bidder’s returns are negative and the acquired firm positive. This is
consistent with the data.
b. Grossman and Hart (1980) suggested a dilution mechanism to get around the
free-rider problem. Explain how a dilution mechanism may work. (8 marks)
A dilution mechanism is any mechanism that would allow the raider to
take value away from any shareholders who held out and did not sell their
shares, if the raider was successful in acquiring enough shares to buy a
controlling stake in the firm. For example, allowing the raider, once he’s
in control, to force any holdouts to sell shares to him at a low price is a
dilution mechanism. The reason this works is that old shareholders know
that if they hold out and do not sell their shares during the raid, they may
suffer after the raid. Thus they choose to sell their shares and the efficient
raid occurs.
c. Suppose some number of shares can be accumulated in secret. Explain why
this may partially resolve the free-rider problem. (8 marks)
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This is another potential solution to the free-rider problem. It works
because prior to the raid becoming public information, the firm price is
low as it is an inefficient firm. If the raider can secretly acquire a lot of
shares at this time, he does not need to pay a high price for most shares.
After the raid becomes public, the free-rider problem will still occur and
he will have to pay a premium for the remaining shares. However, he does
not need to buy very many more shares to get to a majority, therefore the
raid may still be worth it.
Question 4
a. Suppose you selected 10 firms who received a very negative earnings shock
and another 10 who received a small negative earnings shock. Based on
Linter (1958) what do you think will happen to these firms’ dividend policy?
(8 marks)
Linter (1958) finds that firms like to keep dividends steady even if
earnings are moving around. Thus if firms receive small negative earnings
shocks we would expect that most of them would not cut dividends – a
few might cut dividends but not by much. On the other hand, if a group of
firms all had large drops in earnings we would expect many of them to cut
dividends, although a few might not. However, the dividend cut would be
likely to be smaller than the earnings downgrade.
b. Explain the tax clientele theory for the existence of dividends. (8 marks)
The tax clientele theory says that there are many different types of
investors. Some of these investors are in low tax brackets and therefore do
not pay much (if any) tax on dividend income. For these investors there is
no advantage from capital gains because even though they are taxed at a
lower rate than dividends, it makes no difference to these investors since
their tax rate is already low. On the other hand, issuing dividends carries
lower transaction costs than buying back shares. Thus to attract this class
of investor, some firms will issue dividends. Low tax investors are not just
poor people, they include tax exempt entities such as universities and
certain pension funds. On the other hand, for most investors dividends
are much more costly than capital gains in terms of taxes. These investors
prefer to be paid through repurchases and other firms will issue fewer
dividends and do more repurchases to attract this class of investor.
c. Explain how and why debt may be used as a signal to investors as in Ross
(1977). (9 marks)
Generally, a signal needs to be less costly for the good type than the bad
type in order to discourage the bad type from imitating the signal. In
Ross’s model, having a lot of debt is costly because it increases a firm’s
probability of paying bankruptcy costs or a manager’s probability of being
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fired. However, good firms can stand this increased probability because
being good, their probability of bankruptcy is still quite low. Good firms
take on a lot of debt to signal that they are good. Bad firms do not imitate
this because, for them, the probability of being in trouble, conditional on
having lots of debt, is much higher.
Section B
with at least one from Section A.)
Question 5
A share of IBM is trading at $200. In six months it will either go up by $50 or
down by $50. In the following six months it will again either go up by $50
or down by $50. During this period IBM will pay no dividends. The six month
interest rate on Treasuries is 1% and will stay that way for the full year.
a. Value a European put option on IBM with a strike price of $225. (9 marks)
The solution strategy is to work backwards. The payoffs of the stock and
put option are:
300 0
250 P+
200 200 P 25
150 P
100 125
Solve for P+ Solve for P

300H+1.01B=0 200H+1.01B=25
200H+1.01B= 25 100H+1.01B=125
100H = 25 100H = 100
H=.25, B=74.26 H= 1, B=222.77
P+=H*250+B=11.757 P=H*150+B=72.772
Solve for P
250H+1.01B= 11.757
150H+1.01B= 72.772
100H = 61.015
H=.610, B= 162.63
P=H*200+B= 40.63
@ Can use implied probabilities of 0.525 at the top node, and
0.515 at the bottom node.
b. Value an American put option on IBM with a strike price of $225. Comment
on the additional option value an American option provides. Do all American
options provide additional value? (9 marks)
The calculations for P+ and P– are identical to (a). However, now we are
able to exercise early if we want. If we were to exercise early instead of
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receiving P+ we would get 0 whereas P+=11.757 so we do not exercise

early. If we were to exercise early instead of receiving P we would get 22
150=75 which is more than the value of holding onto the option. Thus,
in this case P+=75>72.772.
Solve for P
250H+1.01B= 11.757
150H+1.01B= 75
100H = 63.243
H= .632, B= 168.12
P=H*200+B= 41.72>40.63
Not all options benefit from the addition of an American (early exercise)
option. In particular, it is never optimal to exercise a call on a non-
dividend paying stock, so an American call is not more valuable than a
European call. (Except in this case?..)
c. Briefly discuss how and why a call option value changes with volatility and
time to expiration. (7 marks)
Option values are higher as volatility increases. This is closely related to
the option’s non-linear payoff. The worst-case scenario is always zero and
the best-case scenario is very high. As volatility increases, the probability
of reaching either the worst- or best-case scenario increases. But since
the worst-case scenario cannot get any worse than zero, the expected
option payoff is higher. Time to expiration works in a very similar way
to volatility: as more time is left, there are more opportunities for the
underlying to reach very high or low states.
Question 6
The risk free rate is 2%, the expected stock market return is 9%, and the
standard deviation of the stock market is 15%. All firms considered in this
question are 100% equity owned.
Subject guide, Chapter 2, p.34 and Chapter 7, pp.102–08.
a. Firm ScottyDog has a market capitalisation of $100 million and an expected
stock return of 15%. Calculate its beta if the CAPM holds for this firm.
(6 marks)
=(Ra Rf)/(Rm Rf)=(15 2)/(9 2)=1.86
b. Firm Highlander has a market capitalisation of $50 million. Using historical
data over the past 10 years, you find that its covariance with the market
was 0.01125 and its average historical return was 5%. Has Highlander
outperformed the CAPM over this period? What is its alpha? (6 marks)
=Cov(Ra,Rm)/Var(Rm)=.01125/(.15^2)=0.5
Expected CAPM return: Rf + (RmRf)=2+.5*(92)=5.5%
Actual return: 5% so Highlander has underperformed.
= 5 5.5= 0.5%
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c. Firm Helix operates in the same industry as firm ScottyDog and its productive
assets have similar risk to firm ScottyDog. However, in addition to these
assets, Helix holds $50 million in risk free US treasuries (essentially cash).
Helix’s market cap is $300 million. What is Helix’s beta? (7 marks)
The productive assets are worth 30050=$250m and make up 5/6
of the firm, they have a beta of 1.86 (same as ScottyDog). The cash
makes up 1/6 of the firm and has a beta of 0. The firm’s beta is
(5/6)*1.86+(1/6)*0=1.55
d. Helix uses its cash to purchase Highlander. Assume Highlander is bought for
its market price and Helix does not pay a takeover premium. What is the beta
of the conglomerate Helix Highlander? What is the value of the conglomerate
Helix Highlander? Compare the risk of Helix and Helix Highlander and explain
any differences. (6 marks)
Helix Highlander has a value of $300m since $50m in cash was replaced
by another $50m asset. The beta is (5/6)*1.86+(1/6)*.5=1.63. Helix
Highlander is riskier than Helix because safe assets were replaced by
equally sized risky ones.
Question 7
Depending on the outcome of the US nuclear dispute with Iran, world oil prices
will be either high or low in each of the years 2013–2016. If they are high, they
will be $150/barrel in 2013 and grow at 5% each year. If they are low, they will
be $50/barrel in 2013 and grow at 5% each year. The probability of oil prices
being high is 30%.
Today (2012) you are considering purchasing a license from the US government
to extract oil from reserves in the Gulf of Mexico. These reserves can yield 6
million barrels per year for at least 10 years, however the license will expire
after 2016. The variable costs (extraction and transportation) are $30/barrel.
In addition to the variable costs, you need to purchase 10 oil rigs at a cost of $100
million per oil rig. These must be purchased in 2012 in order to install them in time
to extract in 2013. At the end of 2016 you estimate that you will be able to sell
the used oil rigs for $60 million per oil rig. The US government allows you to use
straight line depreciation on this equipment. The corporate tax rate is 35% and
your average cost of capital is 10%.
a. What is the maximum you are willing to pay for this license? (10 marks)
The expected revenue per barrel is .3*150+.7*50=80 in the first year
and grows at 5%. The expected cost per barrel is 30. The expected pre-
tax profit is 6*(Rev-Cost). In total, depreciation is the 2012 cost minus
the 2016 cost, or 400. Spread over four years, this is 100 per year. The
taxable income is pre-tax profit minus depreciation; the tax is taxable
income multiplied by the tax rate. After-tax income is pre-tax profit minus
the tax bill. The free cash flow (FCF) is after-tax income minus any capital
expenditures (minus 1,000 in 2012 and plus 600 in 2016). The table
below was created using the info above:
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2012 2013 2014 2015 2016

Expected revenue per barrel 80 84 88.2 92.61
Cost per barrel 30 30 30 30
Expected pre-tax profit 300 324 349.2 375.66
Capital expenditures –1000 +600
Depreciation –100 –100 –100 –100
Taxable income 200 224 249.2 275.66
Tax 70 78.4 87.22 96.481
After-tax income 230 245.6 261.98 279.179
FCF –1000 230 245.6 261.98 879.179
Discount multiple 1 0.909091 0.826446 0.751315 0.683013
PV –1000 209.0909 202.9752 196.8295 600.4911
NPV 209.3867
b. Suppose you were able to bribe a US senator and the license only cost you $1
million. What is this project’s IRR? (7 marks)
If the cost of the licence is only 1 million, then the outflow in 2012
is 1001, followed by cash flows of 230, 245.6, 261.98, 879.18 in the
following years. An IRR of 17.3% sets their present value to zero.
c. Suppose you could wait for a year to see how the US versus Iran conflict gets
resolved. You would still need to buy the license today, but you could choose
to buy or not buy the oil rigs next year (2013). If you choose to buy them
next year, you would only start extracting oil the following year (2014). The
purchase and resale prices of the oil rigs remain as before. How would your
answer to (a) change? (8 marks)
This problem is nearly identical to (a). However: 1) expected revenue
per barrel is 150 in 2013 and grows at 5% because we only invest in the
good state; 2) the capital expenditure occurs in 2013 which increases the
depreciation; 3) the first profits are in 2014 instead of 2013. Also note
that the good state occurs only 30% of the time so the NPV of cash flows
must be multiplied by 0.3. In the bad state the NPV is 0.
2012 2013 2014 2015 2016
Expected revenue per barrel 150 157.5 165.375 173.6438
Cost per barrel 30 30 30 30
Expected pre-tax profit 0 765 812.25 861.8625
Capital expenditures 1000 -600
Depreciation 133.3333 133.3333 133.3333
Taxable income 0 631.6667 678.9167 728.5292
Tax 0 221.0833 237.6208 254.9852
After-tax income 0 543.9167 574.6292 606.8773
FCF 0 –1000 543.9167 574.6292 1206.877
PV 0 –909.091 449.5179 431.7274 824.3134
NPV 238.9403
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Question 8
Charger LLC is considering one of two potential projects. Each project requires
an initial investment I=£50. Each project’s cash flows are realised in one year
and there are no subsequent cash flows. Project Thunderbolt will pay 100 in the
good state (probability 0.5) and 40 in the bad state (probability 0.5). Project
Lightning will pay 150 in the good state (probability 0.4) and 0 in the bad state
(probability 0.6).
The initial investment must be made today and all payoffs occur one year from
today. The discount rate is 5% and all investors are risk neutral. The firm will
finance the initial investment with a one-year loan.
a. Calculate the NPV of each project. Which project is better? (5 marks)
Thunderbolt: 50+(.5*100+.5*40)/1.05=16.67
Lightning: 50+(.4*150+.6*0)/1.05=7.14
b. Suppose that investors believe that project Thunderbolt will be taken.
Calculate the face value of the loan. (7 marks)
If investors believe that Thunderbolt will be taken, they believe that 50%
of the time they will receive the face value of the debt, and the rest of
the time they will recover 40%. In expectation their payoff is .5*F+.5*40
which must be discounted by 1.05. This must be equal to the amount of
money they lend to the firm: 50. (.5*F+.5*40)/1.05=50  F=65
c. Calculate the payoff to the firm’s owners under the loan contract in (b) if
they choose project Thunderbolt? Do the same for Lightning? Which project
will they choose? Will the investor belief be as in (b)? (8 marks)
Thunderbolt: .5*(100F)/1.05=16.7
Lightning: .4*(150F)/1.05=32.4
Lightning will be chosen: the investor beliefs in (b) are not rational and
they will believe that Lightning will be taken.
d. Discuss the risk-shifting (asset substitution) problem in the context of the
above calculation. What are potential solutions to this problem? (5 marks)
Risk shifting occurs when a firm has a significant amount of debt relative
to its total value. The firm is controlled by equity holders. In a levered
firm, equity looks like a call option with the face value of debt being the
strike. Call options are more valuable when there is more volatility so
equity will choose to take more volatile projects, sometimes even if they
are low or negative NPV. The intuition is that if equity chooses a more
volatile project, the worst-case scenario for them is zero (due to limited
liability), which is no worse than bankruptcy with a less volatile project.
On the other hand, the best-case scenario is much more profitable.
Potential solutions include financing the firm with equity only so that
there is no incentive to risk shift. Another solution is convertible debt
so that if equity holders do risk shift and end up in the good state of
the world, creditors can convert their debt to equity and dilute equity’s
incentives to risk shift.
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Black-Scholes’ option pricing formula

C = S[N(d1)]  X[N(d2)]e-rt
l n (S / X ) 1
d1 = + σ t
σ t 2
and
d2 = d1 − σ t
Capital Assets Pricing Model (CAPM)

E Ri   R f   i E Rm  R f 
Modigliani and Miller
Proposition I (no tax): V L  VU
Proposition II (no tax): Re  Ra  Ra  Rd 

D
E
Proposition I (with corporate tax): V L  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 − ⎥
⎣ 1 − Td ⎦
14

FN3092 Corporate finance – Zone B
Important note


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.
Section A
with at least one from Section B.)
Question 1
a. Explain free-rider problem in the context of takeovers as in Grossman and
Hart (1980). What are the implications for returns to (i) the bidder, (ii) the
acquired firm? (9 marks)
The free-rider problem is that when a raider who can raise firm value
makes a bid on a firm, the current shareholders know that if they don’t
sell and the bid is successful they will benefit from the value added. Thus
many refuse to sell their shares unless the price is very high. However, if
the price is very high then the raider does not benefit, so no raid occurs.
Thus efficient, net present value (NPV) rising raids may not occur. The
free-rider problem suggests that after a takeover announcement the
bidder’s returns are negative and the acquired firm positive. This is
consistent with the data.
b. Suppose some number of shares can be accumulated in secret. Explain why
this may partially resolve the free-rider problem. (8 marks)
This is another potential solution to the free-rider problem. It works
because prior to the raid becoming public information, the firm price is
15
low as it is an inefficient firm. If the raider can secretely acquire a lot of

shares at this time, he does not need to pay a high price for most shares.
After the raid becomes public, the free-rider problem will still occur and
he will have to pay a premium for the remaining shares. However, he does
not need to buy very many more shares to get to a majority, therefore the
c. Grossman and Hart (1980) suggested a dilution mechanism to get around the
free-rider problem. Explain how a dilution mechanism may work. (8 marks)
A dilution mechanism is any mechanism that would allow the raider to
take value away from any shareholders who held out and did not sell
their shares if the raider was successful in acquiring enough shares to buy
a controlling stake in the firm. For example, allowing the raider to force
any holdouts to sell shares to him at a low price once he’s in control is a
dilution mechanism. The reason this works is that old shareholders know
that if they hold out and do not sell their shares during the raid, they may
suffer after the raid. Thus they choose to sell their shares and the efficient
raid occurs.
Question 2
other frictions payout policy is irrelevant. Explain. (9 marks)
When there are no taxes and frictions, the firm should maximise the value
of its assets, which are on the left-hand side of the balance sheet. Payout
policy just splits up those assets into payments to different investors. How
those assets are split is irrelevant because the total value of the assets is
unchanged.
b. Consider a tax code where capital gains are taxed at a different rate than
dividends and interest. Explain how this changes the Modigliani and Miller
proposition. How would you expect firms to react if the capital gains tax was
suddenly reduced. What is the relationship between capital gains, interest,
and dividend taxes in typical tax codes around the world (for example US).
(9 marks)
If certain payouts are taxed at a lower rate than others, then firms
will prefer to use the cheapest type of payout, thus the Modigliani and
Miller irrelevance result will no longer hold. If the capital gains tax
were reduced, one would expect two things. First, firms would decrease
leverage and issue less debt in favour of equity. Second, equity payouts
would shift away from dividends towards share repurchases. In the USA
(as in most tax codes) interest payments are not taxed at the corporate
level, but other cash flows are taxed. At the personal level, both dividends
and interest are taxed at the personal tax rate (same as regular income).
On the other hand, capital gains are typically taxed at a lower rate.
16
c. Suppose corporate profits are taxed but interest is tax deductable. Discuss
the implications for optimal capital structure. (7 marks)
If corporate profits are taxed but interest is tax deductible (as is the case
in most tax regimes), then firms would want to issue as much debt as
possible in order to shield as much of their earnings as possible from
taxes. A firm’s payout is: (EBIT-Int)*(1-Tc)+Int where the first component
is going to equity and the second to creditors. This can be rewritten as
EBIT*(1-Tc)+Int*Tc so it is clear that the more interest payments a firm
has, the more total cash flows it has to distribute. Maximising leverage
would no longer be optimal if we also considered bankruptcy costs, but
this question asks for optimal capital structure in the presence of interest
tax deductions only.
Question 3
a. According to Linter’s (1958)’s characterisation of firm dividend behaviour,
if a firm’s earnings increase by £0.1/share, the firm’s dividends are likely to
increase by less than £0.1, £0.1, or more than £0.1? Explain your answer.
(9 marks)
Linter (1958) finds that firms like to keep dividends steady even if
earnings are moving around. Thus if a firm’s earnings increase by £0.1/
share, the firm is unlikely to increase dividends by £0.1/share. Most likely
dividends will stay constant or increase by some amount less than £0.1/
share.
b. Explain why some firms may choose to issue dividends as a signal to
investors. (8 marks)
Good firms want the markets to know that they are good so that they can
have cheaper access to financing. Generally, a signal needs to be less costly
for the good type than the bad type in order to discourage the bad type
from imitating the signal. Dividends are one such potential signal. Note
that dividends are an expensive way to pay investors. Dividends are taxed
at the corporate rate inside the firm, then the personal rate outside the
firm. Capital gains are also taxed at the corporate rate inside the firm but
at the capital gains rate (lower than personal) outside the firm. Interest
is not taxed inside the firm and is taxed at the personal rate outside the
firm. Thus the good firm, which benefits from investors knowing that it is
good because it can raise capital for positive NPV projects, does not mind
paying investors in a more expensive way because the benefit outweighs
the cost. The bad firm has fewer good projects and is less interested in
cheap financing – it would rather just pay its investors as cheaply as
possible.
17
c. Explain the tax clientele theory for the existence of dividends. (8 marks)
The tax clientele theory says that there are many different types of
investors. Some of these investors are in low tax brackets and therefore do
not pay much (if any) tax on dividend income. For these investors there is
no advantage from capital gains because even though they are taxed at a
lower rate than dividends it makes no difference to these investors since
their tax rate is already low. On the other hand, issuing dividends carries
lower transaction costs than buying back shares. Thus to attract this class
of investor, some firms will issue dividends. Low tax investors are not just
poor people, they also include tax exempt entities such as universities and
certain pension funds. On the other hand, for most investors, dividends
are much more costly than capital gains in terms of taxes. These investors
prefer to be paid through repurchases and other firms will issue less in the
way of dividends and carry out more repurchases to attract this class of
investor.
Question 4
a. What does it mean for markets to be efficient? Discuss the differences
between types of market efficiency. (9 marks)
A market is efficient if one cannot make economic profits in that market.
A market can only be judged efficient or inefficient with respect to certain
information set. A market is weak form efficient if prices fully reflect
all historical market information like past prices, past data on financial
characteristics, etc. A market is semi-strong efficient if prices reflect all
public information. A market is strong form efficient if prices reflect all
information, both public and private.
b. Suppose you find that the stock price of company X falls following those
days in which your neighbour has a loud argument with his wife. Explain
what forms of efficiency this violates. (7 marks)
This suggests a trading strategy: short company X on any day in which
you overhear your neighbours arguing. However, your neighbours arguing
is not public information: only you and a few other nearby neighbours are
likely to be aware of this event. Therefore this company’s stock is semi-
strong form efficient, but it is not strong form efficient as there is private
information that can lead to profits.
c. Suppose you observe that an estimate of volatility whose value is known
today (for example the VIX index) forecasts future stock returns, is this
necessarily a violation of the Efficient Market Hypothesis? Explain. Briefly
review evidence on the forecastability of stock returns. (9 marks)
18

Certain variables (such as estimates of volatility) forecasting returns are
not necessarily a violation of the Efficient Market Hypothesis (EMH).
The EMH states that returns should not be predictable once we have
accounted for risk. However, if certain assets are more risky, they should
have higher returns. Thus if the VIX index is also forecasting risk, then
it should forecast future returns. Empirical evidence suggests that stock
returns are weakly forecastable at longer horizons. Some of the variables
that can forecast stock returns are the price to dividend ratio, the default
spread, the wealth to consumption ratio, and the corporate spread.
Section B
with at least one from Section A.)
Question 5
The risk free rate is 3%, the expected stock market return is 8%, and the
standard deviation of the stock market is 16%. All firms considered in this
question are 100% equity owned.
a. Firm Jelly PLC has a market capitalisation of £120 million and an expected
stock return of 14%. Calculate its beta if the CAPM holds for this firm.
(6 marks)
=(Ra–Rf)/(Rm-Rf)=(14–3)/(8–3)=2.2
b. Firm Peanut PLC has a market capitalization of £40 million. Using historical
data over the past 15 years, you find that its covariance with the market was
0.01792 and its average historical return was 7%. Has Peanut outperformed
the CAPM over this period? What is its alpha? (6 marks)
=Cov(Ra,Rm)/Var(Rm)=.01792/(.16^2)=0.7
Expected CAPM return: Rf+(Rm-Rf)=3+.7*(8-3)=6.5%
Actual Return: 7% so Peanut has outperformed the CAPM.
=5.5-5=0.5%
c. Firm Butter PLC operates in the same industry as firm Jelly and its productive
assets have similar risk to firm Jelly. However, in addition to these assets,
Butter holds £40 million in risk free US treasuries (essentially cash). Butter’s
market cap is £120 million. What is Butter’s beta? (7 marks)
The productive assets are worth 12040=$80m and make up two-
thirds of the firm. They have a beta of 2.2 (same as Jelly). The cash
makes up one-third of the firm and has a beta of 0. The firm’s beta is
(2/3)*2.2+(1/6)*0=1.47.
19
d. Butter uses its cash to purchase Peanut. Assume Peanut is bought for its
market price and Butter does not pay a takeover premium. What is the beta
of the conglomerate PeanutButter? What is the value of the conglomerate
PeanutButter? Compare the risk of Butter and PeanutButter and explain any
differences. (6 marks)
PeanutButter has a value of $120m since $40m in cash was replaced by
another $40m asset. The beta is (2/3)*2.2+(1/3)*.7=1.7. Option values
are higher as volatility increases. PeanutButter is riskier than Butter
because safe assets have been replaced by equally sized risky assets.
Question 6
Padre LLC is considering one of two potential projects. Each project requires an
initial investment I=£50. Each project’s cash flows are realised in one year and
there are no subsequent cash flows. Project Bunt will pay 80 in the good state
(probability 0.3) and 50 in the bad state (probability 0.7). Project Homerun will
pay 320 in the good state (probability 0.1) and 0 in the bad state (probability 0.9).
The initial investment must be made today and all payoffs occur one year from
today. The discount rate is 6% and all investors are risk neutral. The firm will
finance the initial investment with a one year loan.
a. Calculate the NPV of each project. Which project is better? (5 marks)
Bunt: -50+(.3*80+.7*50)/1.06=5.66
Homerun: -50+(.1*320+.9*0)/1.06=-19.8
b. Suppose that investors believe that project Bunt will be taken. Calculate the
face value of the loan. (7 marks)
If investors believe that Bunt will be taken, they believe that 30% of the
time they will receive the face value of the debt, and the rest of the time
they will recover 50. In expectation their payoff is .3*F+.7*50 which must
be discounted by 1.06. This must be equal to the amount of money they
lend to the firm: 50. (.3*F+.7*50)/1.06=50  F=60.
c. Calculate the payoff to the firm’s owners under the loan contract in (b) if
they choose project Bunt? Do the same for Homerun? Which project will they
choose? Will the investor belief be as in (b)? (8 marks)
Bunt: .3*(80F)/1.06=5.66
Homerun: .1*(320F)/1.06=24.5
Homerun will be chosen, the investor beliefs in (b) are not rational, they
will believe that Homerun will be taken.
d. Discuss the risk-shifting (asset substitution) problem in the context of the
above calculation. What are potential solutions to this problem? (5 marks)
Risk-shifting occurs when a firm has a significant amount of debt relative
to total value. The firm is controlled by equity holders. In a levered firm,
equity looks like a call option with the face value of debt being the strike.
Call options are more valuable when there is more volatility so equity
will choose to take more volatile projects, sometimes even if they are low
20
or negative NPV. The intuition is that if equity chooses a more volatile

project, the worst-case scenario for them is zero (due to limited liability),
which is no worse than bankruptcy with a less volatile project. On the
other hand, the best-case scenario is much more profitable. Potential
solutions include financing the firm with equity only so that there is no
incentive to risk shift. Another solution is convertible debt so that if equity
holders do risk shift and end up in the good state of the world, creditors
can convert their debt to equity and dilute equity’s incentives to risk shift.
Question 7
A share of MSFT is trading at $30. In six months it will either go up by $10
or down by $8. In the following six months it will again either go up by $10
or down by $8. During this period MSFT will pay no dividends. The six-month
interest rate on Treasuries is 1.5% and will stay that way for the full year.
a. Value a European put option on MSFT with a strike price of $35. (9 marks)
The solution strategy is to work backwards. The payoffs of the stock and
put option are:
50 0
40 P+
30 32 P 3
22 P
14 21
Solve for P+ Solve for P

50H+1.015B=0 32H+1.015B=3
32H+1.015B=3 14H+1.015B=21
18H =3 18H = 18
H=.167, B=8.21 H=1, B=34.48
P+=H*40+B=1.54 PH*22+B=12.48
Solve for P
40H+1.015B=1.54
22H+1.015B=12.48
18H = 10.94
H=.61, B=25.47
P=H*30+B=7.23
b. Value an American put option on IBM with a strike price of $35. Comment
on the additional option value an American option provides. Do all American
options provide additional value? (9 marks)
The calculations for P+ and P– are identical to (a). However, now we
are able to exercise early if we want. If we were to exercise early instead
of receiving P+ we would get 0 whereas we get P+=1.54 so we do not
exercise early. If we were to exercise early instead of receiving P– we
would get 35–22=13, which is more than the value of holding onto the
option. Thus in this case P+=13>12.48.
21
Solve for P
40H+1.015B=1.54
22H+1.015B=13
18H = 11.46
P=H*30+B=7.5>7.23
Not all options benefit from the addition of a US (early exercise) option.
In particular, it is never optimal to exercise a call on a non-dividend
paying stock, so a US call is not more valuable than a European call.
c. Briefly discuss how and why a call option value changes with volatility and
time to expiration. (7 marks)
Option values are higher as volatility increases. This is closely related to
the option’s non-linear payoff. The worst-case scenario is always zero and
the best-case scenario is very high. As volatility increases, the probability
of reaching either the worst- or best-case scenario increases. But since
the worst-case scenario cannot get any worse than zero, the expected
option payoff is higher. Time to expiration works in a very similar way
to volatility, as more time is left, so there are more opportunities for the
underlying to reach very high or low states.
Question 8
Depending on the adaptation of shale gas extraction technology in Poland and
Ukraine, world natural gas prices will be either high or low in each of the years
2013–2016. If they are high, they will be $0.2 per cubic meter in 2013 and grow
at 5% each year. If they are low, they will be $0.1 per cubic meter in 2013 and
grow at 5% each year. The probability of prices being high is 40%.
Today (2012) you are considering purchasing a license from the Russian
government to extract natural gas from reserves in Siberia. These reserves can
yield 10 billion cubic meters per year for at least 10 years, however the license
will expire after 2016. The variable costs (extraction) are $0.08 per cubic meter.
In addition to the variable costs, you need to install a pipeline to transport
natural gas from your place of extraction to the buyers. This pipeline will cost
$3 billion and the installation must begin today (2012) in order to finish it in
time to extract gas in 2013. At the end of 2016 you estimate that you will be
able to sell this pipeline to the Russian government for $2 billion. The Russian
government allows you to use straight line depreciation on this pipeline. The
corporate tax rate is 30% and your average cost of capital is 11%.
a. What is the maximum you are willing to pay for this license? (10 marks)
The expected revenue per cubic meter .4*.2+.6*.1=.14 in the first year
and grows at 5%. The expected cost per cubic meter is 0.08. The expected
pre-tax profit is 10*(Rev-Cost). In total, depreciation is the 2012 cost
minus the 2016 cost, or 1. Spread over four years this is 0.25 per year.
The taxable income is pre-tax profit minus depreciation; the tax is taxable
income multiplied by the tax rate. After-tax income is pre-tax profit minus
the tax bill. The free cash flow (FCF) is after-tax income minus any capital
expenditures (–3 in 2012 and +2 in 2016). The table below was created
using the info above (in billions).
22
2012 2013 2014 2015 2016

Expected revenue per barrel 0.14 0.147 0.15435 0.162068
Cost per barrel 0.08 0.08 0.08 0.08
Expected pre-tax profit 0.6 0.67 0.7435 0.820675
Capital expenditures 3 –2
Depreciation 0.25 0.25 0.25 0.25
Taxable income 0.35 0.42 0.4935 0.570675
Tax 0.105 0.126 0.14805 0.171203
After-tax income 0.495 0.544 0.59545 0.649473
FCF –3 0.495 0.544 0.59545 2.649473
PV –3 0.445946 0.441523 0.435388 1.74529
NPV 0.068146
b. Suppose you were able to bribe a Russian Minister and the license only cost
you $1 million. What is this project’s IRR? (7 marks)
If the cost of the licence is only 1 million, then the outflow in 2012 is
3.001b, followed by cash flows of .495, .544, .5955, 2.649 in the following
years. An IRR of 11.79% sets their present value to zero.
c. Suppose you could wait for a year to see whether Poland and Ukraine are
successful in adopting shale gas extraction technology. You would still need
to buy the license today, but you could choose to build or not build the gas
pipeline next year (2013). If you choose to build it next year, you would only
start extracting gas the following year (2014). The cost and resale price of
the pipeline remains as before. How would your answer to (a) change?
(8 marks)
This problem is nearly identical to (a). However: 1) expected revenue per
cubic meter is 0.2 in 2013 and grows at 5% because we only invest in the
good state, 2) the capital expenditure occurs in 2013 which increases the
depreciation, and 3) the first profits are in 2014 instead of 2013. Also note
that the good state occurs only 40% of the time so the NPV of cashflows
must be multiplied by 0.4; in the bad state the NPV is 0.
2012 2013 2014 2015 2016
Expected revenue per barrel 0.2 0.21 0.2205 0.231525
Cost per barrel 0.08 0.08 0.08 0.08
Expected pre-tax profit 0 1.3 1.405 1.51525
Capital expenditures 3 –2
Depreciation 0.333333 0.333333 0.333333
Taxable income 0 0.966667 1.071667 1.181917
Tax 0 0.29 0.3215 0.354575
After-tax income 0 1.01 1.0835 1.160675
FCF 0 –3 1.01 1.0835 3.160675
PV 0 –2.7027 0.819739 0.792246 2.082035
NPV 0.99
23
Black-Scholes’ option pricing formula

C = S[N(d1)]  X[N(d2)]e-rt
l n (S / X ) 1
d1 = + σ t
σ t 2
and
d2 = d1 − σ t

E Ri   R f   i E Rm  R f 
Proposition I (no tax): V L  VU

D
E
Proposition I (with corporate tax): V L  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 − ⎥
⎣ 1 − Td ⎦
24
~~FN3092 ZA d0
This paper is not to be removed from the Examination Halls
UNIVERSITY OF LONDON FN3092 ZA
BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route
Corporate Finance
Tuesday, 14 May 2013 : 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 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.
PLEASE TURN OVER
© University of London 2013

UL13/0057 Page 1 of 6 D1
SECTION A
Answer one question and no more than two further questions from this section.
1. (a) Briefly explain the concept of risk shifting and what implications it has for optimal capital
structure. (9 marks)
(b) Personal taxes result in the Modigliani and Miller 1st proposition being violated. Briefly explain
why. (8 marks)
(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)
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)
(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 NORNE’s 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)
(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)
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)
(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)
(c) Describe the stylized facts about dividend payments which were listed in Linter (1958).
(8 marks)
4. (a) How does the empirical security market line compare to the one predicted by the CAPM?
(7 marks)
(b) Discuss possible explanations for the differences between the empirical line and the one
predicted by theory. (10 marks)
(c) Suppose the CAPM does not hold, is this evidence of the violation of market efficiency?
(8 marks)

UL13/0057 Page 2 of 6 D1
SECTION B
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.
(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 Cyberdyne's beta. (5 marks)
(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 UAC's weighted average cost of capital. (6 marks)
(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)
(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 UAC's expected cost of equity? Briefly explain why the return on
equity is different from before. (7 marks)

UL13/0057 Page 3 of 6 D1
6. There are two types of firms. Each firm has a project whose quality is known by the firm’s 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.
(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 firm’s market value?
(3 marks)
(b) Suppose the outside market knows each firm’s type. What is the payoff to each firm’s original
owners if they do not invest in this project? What is the payoff to each firm’s 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)
(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)
(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)
(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)

UL13/0057 Page 4 of 6 D1
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 hotel’s expenses, such as paying staff, are
unchanged due to long term contracts).
Hotel California’s 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.
(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)
(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)
(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)
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.
(a) What is the NPV of this project? (4 marks)
(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)
(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)
(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 project’s 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)
(e) In light of your numerical answers above, discuss Modigliani and Miller’s 1st proposition.
(3 marks)

UL13/0057 Page 5 of 6 D1
Black-Scholes’ Option Pricing Formula
C = S[N(d1)] - X[N(d2)]e-rt
ln  S / X   1
d1  t
 t 2
and
d 2  d1   t

E Ri   R f   i E Rm   R f 
Proposition I (no tax): VL  VU

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 
END OF PAPER

UL13/0057 Page 6 of 6 D1
~~FN3092 ZA d0
UNIVERSITY OF LONDON FN3092 ZB
BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route
Corporate Finance
Tuesday, 14 May 2013 : 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.
PLEASE TURN OVER

UL13/0058 Page 1 of 6 D1
SECTION A
1. (a) Discuss evidence on “anomalies” such as size, book-to-market, and return predictability.
(9 marks)
(b) Are these anomalies consistent with the CAPM? How does Roll's critique relate to this?
(8 marks)
(c) Are these anomalies consistent with market efficiency? (8 marks)
2. (a) Corporate taxes result in the Modigliani and Miller 1st proposition being violated. Briefly explain
why. (8 marks)
(b) Asymmetric information result in the Modigliani and Miller 1st proposition being violated.
Briefly explain why. (9 marks)
(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)
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)
(b) How does clientele theory explain the existence of dividends? (9 marks)
(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)
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)
(b) Describe the NPV and IRR approaches to project evaluation. When do they agree? Give an
example of when they disagree. (8 marks)
(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)

UL13/0058 Page 2 of 6 D1
SECTION B
5. There are two types of firms. Each firm has a project whose quality is known by the firm’s 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.
(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 firm’s market value?
(3 marks)
(b) Suppose the outside market knows each firm’s type. What is the payoff to each firm’s original
owners if they do not invest in this project? What is the payoff to each firm’s 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)
(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)
(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)
(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)

UL13/0058 Page 3 of 6 D1
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 hotel’s expenses, such as paying staff, are
unchanged due to long term contracts).
Hotel California’s 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.
(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)
(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)
(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)
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%.
(a) What is the NPV of this project? (4 marks)
(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)
(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)
(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)
(e) In light of your numerical answers above, discuss Modigliani and Miller’s 1st proposition.
(3 marks)

UL13/0058 Page 4 of 6 D1
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%.
(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 Inter-Continental’s equity? (6 marks)
(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)
(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)
(d) What must Southwestern Petroleum’s annual free cash flows (FCF) be to justify the sales price?
Assume no cash flow growth. (5 marks)

UL13/0058 Page 5 of 6 D1
C = S[N(d1)] - X[N(d2)]e-rt
ln  S / X   1
d1  t
 t 2
and
d 2  d1   t

E Ri   R f   i E Rm   R f 

D
E

D
E
Miller (1977)
 1  Tc 1  Te 
VL  VU  1  D
 1  Td 
END OF PAPER

UL13/0058 Page 6 of 6 D1

Important note
Information about the subject guide and the Essential reading

references
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
• 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 Black–Scholes 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.
1
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.
2
Question spotting
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.
the same depth, but you need to be aware that Examiners are free to
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
examination paper. We strongly advise you not to adopt
this strategy.
3

Important note

references

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.
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)
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
4
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 CEO’s 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)
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)
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).
5
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)
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 don’t 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 NORNE’s 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)
Note that a CEO’s 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 CEO’s 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)
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:
6
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)
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)
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.
7
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)
• 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.
• Lintern’s 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)
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)
This pattern may be due to mismeasurement of beta. Mismeasurement can
be due to Roll’s 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.
8
c. Suppose the CAPM does not hold, is this evidence of the violation of market
efficiency? (8 marks)
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
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.
Subject guide, Chapter 2, pp.25–40, Chapter 10, pp.135–43.
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
Cyberdyne’s beta. (5 marks)
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 UAC’s
weighted average cost of capital. (6 marks)
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)
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
9
Since UAC’s 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 UAC’s expected
cost of equity? Briefly explain why the return on equity is different from
before. (7 marks)
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 firm’s 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.
Students should look to approach these questions by using a combination
of basic probability theory and signalling theory outlined in the subject
guide.
10
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 firm’s market value? (3 marks)
–20 +.75 * 24 + .25 * 18 = 2.5
Avg firm: 0.4 * 30 + 0.6 * 18 = 22.8
b. Suppose the outside market knows each firm’s type. What is the payoff
to each firm’s original owners if they do not invest in this project? What
is the payoff to each firm’s 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)
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
firm’s 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.
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
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
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)
11
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 firm’s 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 hotel’s expenses, such as paying staff, are unchanged due to long term
contracts).
Hotel California’s 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.
Subject guide, Chapter 1, pp. 10–23.
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)
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)
Note that in the table below, everything is done in excess of what would
happen if the hotel did not undergo renovation.
2013 2014 2015 2016
Profit per room 32.85 32.85 32.85 32.85
Rooms in excess of no
renovation –16 14 14 14
Pre-tax profit in excess of
no renovation –525.6 459.9 459.9 459.9
Capital expenditures 1000
Depreciation 333.3 333.3 333.3
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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
FCF –1420.5 434.6 434.6 434.6
Discount multiple 0.917 0.842 0.772 0.708
PV –1303.2 365.8 335.6 307.9
NPV –294.0
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)
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.
of basic probability theory and capital structure theory outlined in the
subject guide.
a. What is the NPV of this project? (4 marks)
NPV = –50 + (0.5 * 40 + 0.5 * 100)/1.1 = $13,636
Note that the cash you have is irrelevant for this calculation.
13
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)
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)
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.
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 project’s 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)
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.
e. In light of your numerical answers above, discuss Modigliani and Miller’s 1st
proposition. (3 marks)
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 firm’s 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

C = S[N(d1)] – X[N(d2)]e-rt
ln ( S / X ) 1
d1 = + σ t
σ t 2
and
d 2 = d1 − σ t

E(Ri) = Rf + i E (Rm) – Rf 
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

Important note

references

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.
Section A
attempted with at least one from Section B.)
Subject guide, Chapter 5, pp.73–89/Chapter 2, pp.25–40.
Question 1
a. Discuss evidence on ‘anomalies’ such as size, book-to-market, and return
predictability. (9 marks)
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
b. Are these anomalies consistent with the CAPM? How does Roll’s critique
relate to this? (8 marks)
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 market’s return. In
practice, a beta is typically computed relative to some equity index. Roll’s
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)
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)
Subject guide, Chapter 6, pp. 89–99 and Chapter 9, pp.127–33.
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)
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
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)
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)
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
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)
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)
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)
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
b. Describe the NPV and IRR approaches to project evaluation. When do they
agree? Give an example of when they disagree. (8 marks)
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)
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
acquirer’s 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
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
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 firm’s 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.
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 firm’s market value? (3 marks)
–17 + .5 * 21 + .5 * 15 = 1
Avg firm: 0.3 * 40 + 0.7 * 25 = 29.5
b. Suppose the outside market knows each firm’s type. What is the payoff
to each firm’s original owners if they do not invest in this project? What
is the payoff to each firm’s 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)
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
firm’s 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
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)
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)
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)
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 hotel’s expenses, such as paying staff, are unchanged due to long term
contracts).
Hotel California’s 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.
22
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)
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)
Note that in the table below, everything is done in excess of what would
happen if the hotel did not undergo renovation.
2013 2014 2015 2016
Profit per room 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
Taxable income –365 –81 –81 –81
Tax –91.25 –20.25 –20.25 –20.25
After-tax income –273.75 239.25 239.25 239.25
FCF –1173.75 239.25 239.25 239.25
Discount multiple 0.909 0.826 0.751 0.683
PV –1067.05 197.73 197.73 197.73
NPV –526.16
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)
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
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%.
of basic probability theory and capital structure theory outlined in the
subject guide.
a. What is the NPV of this project? (4 marks)
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)
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)
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)
Loan calculation:
0.5 = (0.4 * F + 0.6 * F)/1.15  F = 0.575  Interest rate = 15 per
cent.
0.5 = * [0.4 * (0.8 – F) + 0.6 * (1.5 – F)]/1.15 = * 0.561   =
24
89.13 per cent.

Your NPV: (1– ) * 0.561 = £0.061
e. In light of your numerical answers above, discuss Modigliani and Miller’s 1st
proposition. (3 marks)
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 firm’s 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%.
Subject guide, Chapter 2, pp.25–40, Chapter 10 pp. 135–43.
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 Inter-
Continental’s equity? (6 marks)
LexCorp’s 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
LexCorp’s 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 LexCorp’s 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)
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
airline’s 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.
25
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)
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 Petroleum’s annual free cash flows (FCF) be to
justify the sales price? Assume no cash flow growth. (5 marks)
Its beta is 2.1, implying an expected return of 2.1 * 7 = 14.7.
FCF/0.147 = 10  FCF = $1.47M.

C = S[N(d1)] – X[N(d2)]e-rt
ln ( S / X ) 1
d1 = + σ t
σ t 2
and
d 2 = d1 − σ t

E(Ri) = Rf + i E (Rm) – Rf 
Proposition II (no tax): Re = Ra + (Ra – Rd) D
E
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
~~FN3092 ZB d0
BSc degrees and Diplomas for Graduates in Economics, Management, Finance

and the Social Sciences, the Diplomas in Economics and Social Sciences and
Access Route
Corporate Finance
Friday, 16 May 2014 : 14:30 to 17:30
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.
PLEASE TURN OVER

UL14/0235 Page 1 of 1 D1
SECTION A
1. (a) According to Modigliani and Miller, capital structure policy and payout policy are
irrelevant. Explain. (9 marks)
(b) One reason capital structure policy may be relevant is due to taxes. Discuss another
alternative reason. (8 marks)
(c) One reason payout policy may be relevant is due to taxes. Discuss another alternative
reason. (8 marks)
2. (a) Many valuable takeovers may not occur due to the free-rider problem. Explain.
(10 marks)
(b) What are the empirical facts regarding the stock returns of the participants in a takeover
(bidder and target)? Is this consistent with the free-rider problem? (6 marks)
(c) Describe one possible solution to the free-rider problem. (9 marks)
3. (a) Briefly explain the intuition behind the CAPM. According to the CAPM, which
characteristic explains whether an asset should have a high or a low return?
(9 marks)
(b) Discuss empirical evidence regarding the CAPM. Are there certain assets for which the
CAPM appears wrong? (8 marks)
(c) One possible explanation for (b) is Roll’s critique. Explain. (8 marks)
4. (a) Which forms of efficiency are satisfied and/or violated in the following hypothetical
situations:
i. Jill Crener, the host of TV show Crazy Cash, gives stock recommendations every
day and insists following these recommendations will beat the market.
ii. Inintech announces that it has discovered a cure for colon cancer. It share price
rises by 45%.
iii. If a firm’s stock price falls by more than 2% on any given day, the return is typically
positive the following day.
iv. The difference between the best performing and worst performing London hedge
funds was 86% in 2013. (12 marks)
(b) Describe the Net Present Value and the Internal Rate of Return decision rules.
Compare the two, does one have advantages over another? (13 marks)

UL14/0235 Page 2 of 2 D1
SECTION B
5. As the procurement manager for a factory producing Slap Wrap bracelets, you are charged
with finding a machine to expand capacity. You have found a machine available to be leased.
The lease would start one year from now and would last four years at a cost of $200,000 per
year. At the end of the four year lease you must compensate the machine’s owner for any
aging damage to the machine, which you estimate to be $225,000 due to natural wear and
tear.
You project that you will incur additional labour expenses of $100,000 per year to operate
this machine; there are no other significant expenses to be considered. The bracelets
produced by the machine will result in revenues of $350,000 per year.
The tax law is such the entity in a procession of a machine (ie the lessee as opposed to the
owner) can claim depreciation, which can be evenly distributed over the length of the lease.
Your tax rate is 25% and the discount rate is 10% per year.
(a) Would you take on the lease described above? Explain and show your calculations.
(20 marks)
(b) Suppose the lease additionally contained an option for you to keep the machine
indefinitely by paying an additional $300,000. Explain how you would incorporate this
into your calculation (there is no need for explicit calculations). (5 marks)
6. Cyberdyne systems creates robotic stuffed toys, remote controlled cars, and toy guns, which
make up 60%, 25%, and 15% of its market value. You are interested in estimating the
required rate of return to discount Cyberdyne’s cash flows.
You found a stand-alone stuffed toy maker whose historic return volatility is 30% and whose
historic correlation with the market is 0.6.
You have found a stand-alone remote controlled car maker whose historic return volatility is
35% and whose historic correlation with the market of 0.7.
There are no stand-alone toy gun makers, however a firm which derives half of its value from
producing toy guns, and half from remote controlled cars, has a historic return volatility of
50% and a historic correlation with the market of 0.85.
The historic stock market expected return and volatility are 10% and 20% while the average
risk free rate was 4%.
(a) Estimate Cyberdyne’s beta. (12 marks)
(b) Compute Cyberdyne’s discount rate? (5 marks)
(c) Cyberdyne plans to raise debt in amount equal to half of Cyberdyne’s market value.
What is Cyberdyne’s equity beta if the yield on the debt is 5%? (8 marks)

UL14/0235 Page 3 of 3 D1
7. Crudgington Brewery is considering adding a new ale to its product list. Adding the ale would
require an investment of £0.5 million today, and would result in a cash flow of £0.6 million in
one year.
Crudgington’s assets consist of £0.5 million in cash, as well as facilities to produce ales and
ciders. Next year these facilities will produce cash flows of £5 million if UK demand is high,
but only £2 million if it is low. The probability of high demand is 70%.
Crudgington’s only liability is debt with face value £2.5 million due in one year. The
appropriate discount rate is 0% and you can ignore all cash flows more than one year in the
future.
(a) Just for parts (a) and (b) suppose that Crudgington has no debt outstanding. What is
the expected net worth of Crudgington’s owners if they do not add the new ale but
rather pay the cash to themselves as a dividend? (3 marks)
(b) Just for parts (a) and (b) suppose that Crudgington has no debt outstanding. What is
the expected net worth of Crudgington’s owners if they choose to add the new ale?
(3 marks)
(c) Now redo with debt. What is the expected net worth of Crudgington’s owners if they do
not add the new ale but rather pay the cash to themselves as a dividend? (6 marks)
(d) Now redo with debt. What is the expected net worth of Crudgington’s owners if they
choose to add the new ale? (6 marks)
(e) Parts (a) – (d) illustrate the debt overhang problem. Explain it. (7 marks)
8. Beverage maker Black & Tan is currently worth €70 per share with one million shares
outstanding. Depending on demand, one year from now it will be worth either €105 or €40
per share. The risk free rate is 1%.
(a) What is the price of a European call option on Black & Tan with a strike price of €60 that
expires in one year? (5 marks)
(b) How does volatility affects call option prices? Explain. (6 marks)
(c) Suppose Black & Tan has outstanding debt with face value €50 million due in one year.
What is the value of the equity of Black & Tan? (7 marks)
(d) Explain how volatility affects equity prices when equity is close to default? Does this
have any implications for optimal capital structure? (7 marks)

UL14/0235 Page 4 of 4 D1
C = S[N(d1)] - X[N(d2)]e-rt
d1 =
ln (S / X )+ 1
σ t
σ t 2
and
d 2 = d1 − σ t
[
E (Ri ) = R f + β i E ( R m ) − R f ]
Proposition II (no tax): Re = Ra + (Ra − Rd )

D
E
Proposition I (with corporate tax): V L = 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 − 
 1 − Td D
END OF PAPER

UL14/0235 Page 5 of 5 D1
~~FN3092 ZB d0

Access Route
Corporate Finance
Friday, 16 May 2014 : 14:30 to 17:30
carry equal marks.
PLEASE TURN OVER

UL14/0236 Page 1 of 5 D1
SECTION A
1. (a) What are some examples of financial signals discussed in the course?
What is necessary for a signal to be effective? (9 marks)
(b) What did Modigliani and Miller mean when they said financial policy is irrelevant?
Explain. (8 marks)
(c) Is NPV a better appraisal technique than the Internal Rate of Return? Explain.
(8 marks)
2. (a) Discuss three motives for corporate takeovers. (9 marks)
(b) What empirical evidence do we have in regard to value creation following a takeover for
i. the bidder firm’s shareholders and,

ii. the acquired firm’s shareholders. (7 marks)
(c) Can the free rider problem explain the pattern in (b)? Explain. (9 marks)
3. (a) Lintner (1958) characterized dividend behaviour. Based on his observations, if a firm's
earnings increase by $0.05/share, the firm's dividends are likely to increase by less than
$0.05, $0.05, or more than $0.05? Explain your answer. (9 marks)
(b) Explain the tax clientele theory for the existence of dividends. (8 marks)
(c) Explain the signalling theory of dividends. (8 marks)
4. (a) Discuss the risk shifting (asset substitution) problem. What kind of capital structure does
it favour? (9 marks)
(b) Discuss the debt overhang problem. What kind of capital structure does it favour?
(8 marks)
(c) Discuss the agency problem of managers not putting in enough effort or using up firm
resources for personal gain. What kind of capital structure does it favour?
(8 marks)

UL14/0236 Page 2 of 5 D1
SECTION B
5. This historic risk free rate is 3%, the historic market return is 8%, and the historic market
volatility is 18%.
Atlantic Southern Railroad is an all equity firm valued at $500 million. Its historic volatility is
15% and its correlation with the market is 0.5.
(a) What is the expected return and the beta of Atlantic Southern Railroad? (5 marks)
(b) Atlantic Southern just raised $300 million of debt with a yield of 4%. It plans to keep
the $300 million as cash to allow it to make acquisitions in the future. What is Atlantic
Southern’s new equity beta? (10 marks)
(c) Atlantic plans to some of that cash to buy the troubled Dannager Coal Company and
to pay off its debt. Dannager’s debt has a market value of $150 million and a yield of
6%. Dannager’s equity is worth $50 million and has an expected return of 13%. What
will be Atlantic Southern’s equity beta after this transaction? (10 marks)
6. American automaker TMCO is an all equity firm with current share price $10 per share and
one billion shares outstanding. It is introducing a new fleet of efficient electric cars. Some
analysts project the share prices falling to $8 per share due to low oil prices and lack of
demand for electric cars, while others project it rising to $12.5 per share because of the high
quality of TMCO’s engineering. The risk free rate is 4%.
(a) What is the price of a European call option on TMCO with a strike price of $10 that
expires in one year? (5 marks)
(b) How does volatility affects call option prices? Explain. (6 marks)
(c) Suppose TMCO has outstanding debt with face value $9 billion due in one year. What
is the value of the equity of TMCO? (7 marks)
(d) Explain how volatility affects equity prices when equity is close to default? Does this
have any implications for optimal capital structure? (7 marks)

UL14/0236 Page 3 of 5 D1
7. Your factory owns an old machine which has four more years of life remaining. Its current
book value is £14 million and straight line depreciation can be used to compute any tax
breaks. The tax rate is 20% and the discount rate is 11% per year.
You receive revenues of £11 million per year from this machine’s production, and it costs
you £3 million per year to employ this machine’s operators. Assume that all cash flows are
end of year, so that you must discount the first cash flow.
Another factory has offered to buy this machine from you for £23 million, would you agree?
Show your work. (25 marks)
8. The RAMJAC corporation has productive assets in place which will be worth $5 million or
$10 million next year with equal probability. It also has cash in amount $2 million.
Additionally, it is considering an investment project which requires an investment of $2
million and will payout $3.1 million with certainty next year. Assume that the appropriate
discount rate is 5%.
(a) Compute the payout to RAMJAC’s shareholders if the CEO does not take on the
investment project but rather pays the cash out as a one-time dividend. (3 marks)
(b) Compute the payout to RAMJAC’s shareholders if the CEO uses the cash to invest in
the project. (3 marks)
(c) Now suppose that RAMJAC also has outstanding debt with face value $8 million due
next year. Compute the payout to RAMJAC’s shareholders if the CEO does not take
on the investment project but rather pays the cash out as a one-time dividend.
(6 marks)
(d) Continue the assumption about debt as in (c). Compute the payout to RAMJAC’s
shareholders if the CEO uses the cash to invest in the project. (6 marks)
(e) Parts (a) – (d) illustrate the debt overhang problem. Explain it. (7 marks)

UL14/0236 Page 4 of 5 D1
C = S[N(d1)] - X[N(d2)]e-rt
ln ( S / X ) + 1σ
d1 = t
σ t 2
and
d 2 = d1 − σ t
[
E (Ri ) = R f + β i E (Rm ) − R f ]
D
Proposition II (no tax): Re = Ra + (Ra − Rd )
E
D
Proposition II (with corporate tax): Re = Ra + (Ra − Rd )(1 − Tc )
E
Miller (1977)
⎡ (1 − Tc )(1 − Te )⎤
VL = VU + ⎢1 − ⎥
⎣ 1 − Td ⎦ D
END OF PAPER

UL14/0236 Page 5 of 5 D1

Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2013–14. 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).
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
Black–Scholes 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
• discuss why merger and acquisition activities exist, and calculate the related gains and
losses.
1
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:
• Candidates’ answers are often too general or narrow. When you are asked to critically assess
a theory or concept, you should 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
• You should not regurgitate materials from the subject guide. Consequently, you may be
giving either descriptive or irrelevant material in your answer. Rather, you should carefully
consider what the examination question is in fact asking and respond accordingly.
• 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.
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
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.
2

Important note
section.
Comments on specific questions – Zone A
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.
Section A
Question 1
(a) According to Modigliani and Miller, capital structure policy and payout policy
are irrelevant. Explain.
(9 marks)
(b) One reason capital structure policy may be relevant is due to taxes. Discuss
another alternative reason.
(8 marks)
(c) One reason payout policy may be relevant is due to taxes. Discuss an
alternative reason.
(8 marks)
The subject guide, Chapter 6, pp. 91–99.
3
(a) Both payout and capital structure policy are irrelevant because they are purely financial
transactions, they neither create nor destroy value. As long as the firm invests in all positive
NPV projects, the firm will maximise value and payouts. Capital structure just determines
how the total investment necessary is split among different investors, while payout
determines how the total payout is split among different investors.
(b) There are multiple reasons why M&M fails in the real world. Among them are risk shifting,
debt overhang, insufficient effort, perks and diversion of cashflows, and asymmetries of
information. Candidates should explain whichever reason they give and not just give its
name.
(c) Dividends may be used as a costly signal to inform the market of the firms quality. Only
good firms can afford to pay high dividends due to either bankruptcy costs or high taxes.
Bad firms would not imitate.
Question 2
(a) Many valuable takeovers may not occur due to the free-rider problem. Explain.
(10 marks)
(b) What are the empirical facts regarding the stock returns of the participants in
the takeover (bidder and target). Is this consistent with the free-rider problem?
(6 marks)
(c) Describe one possible solution to the free-rider problem.
(9 marks)
(a) The free-rider problem is that when a raider who can raise firm value makes a bid on a firm,
the current shareholders know that if they do not sell and the bid is successful they will
benefit from the value added. Thus many refuse to sell their shares unless the price is very
high. However, if the price is very high than the raider does not benefit so no raid occurs.
Thus efficient, NPV rising raids may not occur.
(b) The free rider problem suggests that after a takeover announcement the bidder’s returns are
negative and the acquired firm positive; this is consistent with the data. In the data
shareholders of target firms gain from takeovers as they receive a high premium on the
shares when they are sold/taken over. For bidding firms – results are mixed. Cash offer
appears to have no significant impact on the bidder’s return. Share exchange on the other
hand seems to suggest a decline in the bidder’s share price and return.
(c) Grossman and Hart (1980) suggested a dilution mechanism: any mechanism that would
allow the raider to take value away from any shareholders who held out and did not sell
their shares if the raider was successful in acquiring enough shares to buy a controlling stake
in the firm. For example, allowing the raider to force any holdouts to sell shares to him at a
low price once he is in control is a dilution mechanism. The reason this works is that old
shareholders know that if they hold out and do not sell their shares during the raid, they
may suffer after the raid. Thus they choose to sell their shares and the efficient raid occurs.
Another potential solution to the free-rider problem is to accumulate shares in secret. It
works because prior to the raid becoming public information, the firm price is low as it is an
inefficient firm. If the raider can acquire a lot of shares at this time, secretly, he does not
need to pay a high price for most shares. After the raid becomes public, the free-rider
4
problem will still occur and he will have to pay a premium for the remaining shares.
However, he does not need to buy very many more shares to get to a majority, therefore the
Question 3
(a) Briefly explain the intuition behind the CAPM. According to the CAPM, which
characteristic explains whether an asset should have a high or a low return?
(9 marks)
(b) Discuss empirical evidence regarding the CAPM. Are there certain assets for
which the CAPM appears wrong?
(8 marks)
(c) One possible explanation for (b) is Roll’s critique. Explain.
(8 marks)
(a) The CAPM is an equilibrium model based on certain assumptions about preferences about
risk. The intuition is that the average agent holds the market portfolio, therefore any asset
with a positive covariance with the market portfolio does poorly when the agent does poorly
and is therefore bad insurance. Such assets should have low prices and high returns. Thus,
according to the CAPM, the only characteristic that matters for asset pricing is an asset’s
covariance with the market, or equivalently its beta. Assets with high beta should have high
expected returns.
(b) There are multiple anomalies discussed in the subject guide for which the CAPM does not
seem to work. Among these are the small stock premium, the value premium, and
momentum. Candidates should give some details about them, rather than simply listing
their names.
(c) The CAPM says that the only thing that matters is covariance with the market portfolio.
However, according to Rolls critique, we do not actually observe the true market portfolio.
We observe the return on a public equity market such as the S&P500, whereas the true
market portfolio may contain private equity, corporate debt, real estate, and labour income.
Thus, we cannot really determine that the anomalies discussed in (b) disprove the CAPM.
Question 4
(a) Which forms of efficiency are satisfied and/or violated in the following
hypothetical situations:
i. Jill Crener, the host of TV show Crazy Cash, gives stock recommendations
every day and insists following these recommendations will beat the market.
ii. Inintech announces that it has discovered a cure for colon cancer. Its share
price rises by 45%.
iii. If a firm’s stock price falls by more than 2% on any given day, the return is
typically positive the following day.
iv. The difference between the best performing and worst performing London
hedge funds was 86% in 2013.
(12 marks)
5
(b) Describe the Net Present Value and the Internal Rate of Return decision rules.
Compare the two, does one have advantages over another?
(13 marks)
(a) i. If Jill’s strategies are indeed profitable than the market is not efficient since everyone has
access to them. However, more likely she is just crazy and the recommendations are not
profitable.
ii. It appears that the market responds swiftly to an announcement, suggesting that it is
consistent with the semi-strong form efficiency. The market is unlikely to be strong form
efficient as the privately held information is not already in the price.
iii. This is negative autocorrelation which implies that past returns are not fully
incorporated in the stock price. This is a violation of weak form efficiency.
iv. If managers have superior or private information then this may be a violation of strong
form efficiency. However, this may simply be due to luck.
(b) The NPV rule is the right rule for discounting cash flows. It takes every possible cash inflow
and outflow at future dates and values them as of today by discounting. If the net is
positive, the project should be taken.
The IRR computes the discount rate which would make the NPV equal to zero. If the IRR
is above the true discount rate, the project should be taken.
For standard projects the two give identical answers. However, for non-standard projects,
where there are choices of size or magnitude, or only one project may be taken, the IRR
may give misleading answers.
Section B
Examiner’s note: this is largely a numeric section, and so requires candidates to write equations and
to solve them. Examiners allocate partial marks for carried mistakes.
Question 5
As the procurement manager for a factory producing Slap Wrap bracelets, you are
charged with finding a machine to expand capacity. You have found a machine
available to be leased. The lease would start one year from now and would last four
years at a cost of $200,000 per year. At the end of the four year lease you must
compensate the machine’s owner for any aging damage to the machine, which you
estimate to be $225,000 due to natural wear and tear.
You project that you will incur additional labour expenses of $100,000 per year to
operate this machine; there are no other significant expenses to be considered. The
bracelets produced by the machine will result in revenues of $350,000 per year.
The tax law is such the entity in a procession of a machine (ie the lessee as opposed
to the owner) can claim depreciation, which can be evenly distributed over the
length of the lease. Your tax rate is 25% and the discount rate is 10% per year.
(a) Would you take on the lease described above? Explain and show your
calculations.
(20 marks)
6
(b) Suppose the lease additionally contained an option for you to keep the machine
indefinitely by paying an additional $300,000. Explain how you would
incorporate this into your calculation (there is no need for explicit calculations).
(5 marks)
(a) There are two solutions that were acceptable, depending on the treatment of tax credits. In
the first solution below, we do not assume that there are further operations that tax credits
are valued. As such, the deprecation offset shields the entire income from tax, so there is no
tax payable.
Year 0 1 2 3 4
Rent −200 −200 −200 −200
Expenses −100 −100 −100 −100
Revenue 350 350 350 350
Wear/Tear −225
Pre-Tax CF 50 50 50 −175
Depreciation Shield 56.25 56.25 56.25 56.25
Tax 0 0 0 0
Post-Tax CF 50 50 50 −175
PV 45.5 41.3 37.6 −119.5
NPV 4.8
In the second version below, we have assumed that tax credits are valuable to this firm,
therefore they are part of the calculation. It is easy to see therefore that the NPV of the
project increases, especially when you receive a lot more tax credits in time 4.
Year 0 1 2 3 4
Rent −200 −200 −200 −200
Expenses −100 −100 −100 −100
Revenue 350 350 350 350
Wear/Tear −225
Pre-Tax CF 50 50 50 −175
Tax Credit 1.25 1.25 1.25 46.25
Post-Tax CF 51.25 51.25 51.25 −128.75
PV 46.6 42.4 38.5 −87.9
NPV 40
In both cases, the NPV is positive therefore you would take the project.
(b) You should discuss computing the present value of the additional cash flows with something
like the Gordon Growth model and comparing the total cost to the total revenue. Even
better (though unnecessary for full marks) if you discuss the additional value of the option
to decide whether to keep the machine or not by knowing the demand four years from now.
Question 6
Cyberdyne systems creates robotic stuffed toys, remote controlled cars, and toy
guns, which make up 60%, 25%, and 15% of its market value. You are interested in
estimating the required rate of return to discount Cyberdyne’s cash flows.
You found a stand-alone stuffed toy maker whose historic return volatility is 30%
and whose historic correlation with the market is 0.6.
7
You have found a stand alone remote controlled car maker whose historic return
volatility is 35% and whose historic correlation with the market of 0.7.
There are no stand-alone toy gun makers, however a firm which derives half of its
value from producing toy guns, and half from remote controlled cars, has a historic
return volatility of 50% and a historic correlation with the market of 0.85.
The historic stock market expected return and volatility are 10% and 20% while the
average risk free rate was 4%.
(a) Estimate Cyberdyne’s beta.

(12 marks)
(b) Compute Cyberdyne’s discount rate?
(5 marks)
(c) Cyberdyne plans to raise debt in amount equal to half of Cyberdyne’s market
value. What is Cyberdyne’s equity beta if the yield on the debt is 5%?
(8 marks)
The subject guide, Chapter 2, pp. 28–30 and Chapter 3, pp. 44–52.
(a) The beta for stuffed toys is:
Cov[R, Rm ] Corr[R, Rm ] × StD[R] 0.6 × 0.3

= = = 0.9.
Var[Rm ] StD[Rm ] 0.2
The beta for remote controlled cars is:

= = = 1.225.
V ar[Rm ] StD[Rm ] 0.2
The beta for the car/gun firm is:
0.85 × 0.50
= 2.125.
0.2
The estimated beta for guns alone is:
2.125 = 0.5βg + 0.5βt = 0.5βg + 0.5 × 1.225 ⇒ βg = 3.025.
Cyberdyne’s beta is:
0.6 × 0.9 + 0.25 × 1.225 + 0.15 × 3.025 = 1.3.
(b) We have:
R = 4 + 1.3 × (10 − 4) = 11.8%.
(c) The beta of debt is:

5−4
= 0.167.
10 − 4
The beta for equity satisfies:
1.3 − 0.5 × .167
βall = 0.5βd + 0.5βe ⇒ βe = = 2.433.
0.5
8
Question 7
Crudgington Brewery is considering adding a new ale to its product list. Adding the
ale would require an investment of £0.5 million today, and would result in a cash
flow of £0.6 million in one year.
Crudgington’s assets consist of £0.5 million in cash, as well as facilities to produce

ales and ciders. Next year these facilities will produce cash flows of £5 million if UK
demand is high, but only £2 million if it is low. The probability of high demand is
70%.
Crudgington’s only liability is debt with face value £2.5 million due in one year.
The appropriate discount rate is 0% and you can ignore all cash flows more than one
year in the future.
(a) Just for parts (a) and (b) suppose that Crudgington has no debt outstanding.
What is the expected net worth of Crudgington’s owners if they do not add the
new ale but rather pay the cash to themselves as a dividend?
(3 marks)
(b) Just for parts (a) and (b) suppose that Crudgington has no debt outstanding.
What is the expected net worth of Crudgington’s owners if they choose to add
the new ale?
(3 marks)
(c) Now redo (a) with debt. What is the expected net worth of Crudgington’s
owners if they do not add the new ale but rather pay the cash to themselves as
a dividend?
(6 marks)
(d) Now redo with debt. What is the expected net worth of Crudgington’s owners
if they choose to add the new ale?
(6 marks)
(e) (a) – (d) illustrate the debt overhang problem. Explain it.
(7 marks)
The subject guide, Chapters 2, 3 and 7, and pp. 128–133 for dividends.
(a) We have:
0.5 + 0.3 × 2 + 0.7 × 5 = 4.6.
(b) We have:
0 + 0.3 × 2 + 0.7 × 5 + 0.6 = 4.7.
(c) We have:
0.5 + 0.3 × 0 + 0.7 × (5 − 2.5) = 2.25.
(d) We have:
0 + 0.3 × 0.1 + 0.7 × (5.6 − 2.5) = 2.2.
Note that in the bad state of the world, there is still a small positive payoff for equity; that
is, the firm does not default.
9
(e) This is an example of debt overhang. Note that the firm has a positive NPV project
available to it and positive NPV projects should always be taken to maximise value. Indeed
in (a) and (b), when there is no debt, the firm prefers to take the positive NPV project as
we would expect.
On the other hand, in (c) and (d) the firm has a high amount of debt outstanding. In other
words, the firm is distressed and likely to default next year. If equity holders choose to take
the project instead of paying themselves a dividend, they will be incurring the full cost of
the project but receiving only part of the benefit. Note that in the bad state of the world,
they receive 0 if there is no project, and only 0.1 if there is a project; the creditors receive
an additional 0.5 from the project. Thus equity holders choose to not take a positive NPV
project.
Question 8
Beverage maker Black & Tan is currently worth A C70 per share with one million
shares outstanding. Depending on demand, one year from now it will be worth
either A
C105 or A
C40 per share. The risk free rate is 1%.
(a) What is the price of a European call option on Black & Tan with a strike price
of A
C60 that expires in one year?
(5 marks)
(b) How does volatility affects call option prices? Explain.
(6 marks)
(c) Suppose Black & Tan has outstanding debt with face value AC50 million due in
one year. What is the value of the equity of Black & Tan?
(7 marks)
(d) Explain how volatility affects equity prices when equity is close to default? Does
this have any implications for optimal capital structure?
(7 marks)
(a) Setting up a replication portfolio:

105X + 1.01B = 105 − 60
40X + 1.01B = 0
65X = 45
Therefore X = 0.6923, B = −27.4178 and C = 70X + B = 21.043.
You can also calculate the risk-neutral probabilities.
(b) Volatility increases the value of call options. This is because call option payoffs are convex
in the underlying. As the underlying is worth more, the payoff is higher; however, if the
underlying is worth less (below the strike) the payoff is still the same – zero. Thus
increasing volatility increases the probability of very low and very high payoffs of the
underlying. Low and very low payoffs are equally painful as they result in zero; however,
high payoffs are not as good as very high payoffs.
(c) The key in this problem was to note that equity is just a call option on the firm with the
face value of debt being the strike price. In this case, the solution follows the same strategy
as in (a).
10
105X + 1.01B = 105 − 50

40X + 1.01B = 0
65X = 55
(d) Just as with call options, volatility increases the value of equity when equity is close to
default. The intuition is the same as in (b); taking on more risk has little cost on the
downside and large benefits on the upside. This is referred to as risk shifting or asset
substitution, which is one of several potential distress costs. Firms susceptible to risk
shifting are better off using equity rather than debt financing.
Black–Scholes’ Option Pricing Formula
C = S[N (d1 )] − X[N (d2 )]e−rt
ln(S/X) 1 √
d1 = √ + σ t
σ t 2
√
and d2 = d1 − σ t
E(Ri ) = Rf + βi [E(Rm ) − Rf ]
Proposition II (no tax): Re = Ra + (Ra − Rd ) D

E
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
11

Important note
section.
Comments on specific questions – Zone B
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.
Section A
Question 1
(a) What are some examples of financial signals discussed in the course? What is
necessary for a signal to be effective?
(9 marks)
(b) What did Modigliani and Miller mean when they said financial policy is
irrelevant? Explain.
(8 marks)
(c) Is NPV a better appraisal technique than the Internal Rate of Return? Explain.
(8 marks)
The subject guide, Chapter 8, pp. 112–123. Also, Chapter 1.
(a) We have discussed signalling with dividends and signalling with debt. For a signal to be
effective ‘bad’ firms must find it more costly to use the signal than ‘good’ firms. If this is the
12
case, good firms can use the signal and bad firms would not imitate. At the same time, the
signal should not be too costly for good firms, otherwise they would rather do nothing and
be grouped with bad firms.
(b) Both payout and capital structure policy are irrelevant because they are purely financial
transactions, they neither create nor destroy value. As long as the firm invests in all positive
NPV projects, the firm will maximise value and payouts. Capital structure just determines
how the total investment necessary is split among different investors, while payout
determines how the total payout is split among different investors.
(c) For standard projects the two give identical answers. However, for non-standard projects,
where there are choices of size or magnitude, or only one project may be taken, the IRR
may give misleading answers whereas the NPV is correct.
Question 2
(a) Discuss three motives for corporate takeovers.

(9 marks)
(b) What empirical evidence do we have in regard to value creation following a
takeover for:
i. the bidder firm’s shareholders, and
ii. the acquired firms shareholders.
(7 marks)
(c) Can the free rider problem explain the pattern in (b)? Explain.
(9 marks)
(a) In this question, students should explain the three motives for takeover: Financial, Strategic
and Conglomerate. In each case, talk about the inefficiency that was exploited and how the
improvement would benefit the shareholders of the acquiring firm. In this case, you are
expected to describe the inefficiencies of management, economies of scale and economies of
scope as reasons for the acquisition.
(b) In the data shareholders of target firms gain from takeovers as they receive a high premium
on the shares when they are sold/taken over. For bidding firms – results are mixed. Cash
offer appears to have no significant impact on the bidder’s return. Share exchange on the
other hand seems to suggest a decline in the bidder’s share price and return.
(c) The free rider problem suggests that after a takeover announcement the bidder’s returns are
negative and the acquired firm positive; this is consistent with the data. The free-rider
problem is that when a raider who can raise firm value makes a bid on a firm, the current
shareholders know that if they dont sell and the bid is successful they will benefit from the
value added. Thus many refuse to sell their shares unless the price is very high.
Question 3
(a) Linter (1958) characterized dividend behaviour. Based on his observations, if a

firm’s earnings increase by $0.05/share, the firm’s dividends are likely to
increase by less than $0.05, $0.05, or more than $0.05? Explain your answer.
(9 marks)
13
(b) Explain the tax clientele theory for the existence of dividends.
(8 marks)
(c) Explain the signalling theory of dividends.
(8 marks)
(a) Linter (1958) finds that firms like to keep dividends steady even if earnings are moving
around. Thus if a firm’s earnings increase by $0.05/share, the firm is unlikely to increase
dividends by $0.05/share. Most likely dividends will stay constant or increase by some
amount less than $0.05/share. Here you should highlight the model, explain the equation
and talk a little about the motives, like dividend smoothing.
(b) The tax clientele theory says that there are many different types of investors. Some of these
investors are in low tax brackets and therefore do not pay much (if any) taxes on dividend
income. For these investors there is no advantage from capital gains because even though
they are taxed at a lower rate than dividends it makes no difference to these investors since
their tax rate is already low. On the other hand, issuing dividends carries lower transaction
costs than buying back shares. Thus to attract this class of investors some firms will issue
dividends. Low tax investors are not just poor people, they include tax exempt entities such
as universities and certain pension funds. On the other hand, for most investors dividends
are much more costly than capial gains in terms of taxes. These investors prefer to be paid
through repurchases and other firms will issue less dividends and do more repurchases to
attract this class of investor.
(c) Good firms want the markets to know that they are good so that they can have cheaper
access to financing. Generally, a signal needs to be less costly for the good type than the
bad type in order to discourage the bad type from imitating the signal. Dividends are one
such potential signal. Note that dividends are an expensive way to pay investors. Dividends
are taxed at the corporate rate inside the firm, rather than at the personal rate outside the
firm. Capital gains are also taxed at the corporate rate inside the firm but at the capital
gains rate (lower than personal) outside the firm. Interest is not taxed inside the firm and is
taxed at the personal rate outside the firm. Thus the good firm, which benefits from
investors knowing that it is good because it can raise capital for positive NPV projects, does
not mind paying investors in a more expensive way because the benefit outweighs the cost.
The bad firm has fewer good projects and is less interested in cheap financing; it would
rather just pay its investors as cheaply as possible.
Question 4
(a) Discuss the risk shifting (asset substitution) problem. What kind of capital
structure does it favour?
(9 marks)
(b) Discuss the debt overhang problem. What kind of capital structure does it
favour?
(8 marks)
(c) Discuss the agency problem of managers not putting in enough effort or using
up firm resources for personal gain. What kind of capital structure does it
favour?
(8 marks)
14
(a) When a firm is close to default, equity holders want to take on more risk than optimal. This
is because they are ‘gambling for resurrection’ → the downside is not going to get any worse
due to limited liability. On the upside, the bigger the gamble, the bigger the potential
payoff. This may only happen if the firm has taken on too much debt; thus this problem
favours equity in the capital structure.
(b) With debt overhang the firm chooses not to invest in positive NPV projects. This occurs
when a firm is distressed and likely to default soon. If equity holders choose to take the
project instead of paying themselves a dividend, they will be incurring the full cost of the
project but receiving only part of the benefit since most of the benefit goes to creditors
(equity holders are unlikely to receive anything). Thus equity holders choose to not take a
positive NPV project.
(c) When managers are not properly incentivised, they may not work very hard, or may waste
the firm’s resources. To prevent them from doing this we can set proper incentives by giving
managers compensation which is highly dependent on how well the firm does – in this case
the manager wants to work hard and would not want to waste firm resources. Equity is one
form of such compensation. Thus we want the equity of the firm to be highly concentrated
in the hands of the manager. But to do that, most of the firm’s financing needs must be met
by debt (if they are met by outside equity, then the manager cannot hold a large fraction of
the equity). Thus this friction favours lots of debt in the capital structure and a small
amount of equity that is held by the insiders.
Section B
Examiner’s note: this is largely a numeric section, and so requires candidates to write equations and
to solve them. Examiners allocate partial marks for carried mistakes.
Question 5
This historic risk free rate is 3%, the historic market return is 8%, and the historic
market volatility is 18%.
Atlantic Southern Railroad is an all equity firm valued at $500 million. Its historic
volatility is 15% and its correlation with the market is 0.5.
(a) What is the expected return and the beta of Atlantic Southern Railroad?
(5 marks)
(b) Atlantic Southern just raised $300 million of debt with a yield of 4%. It plans to
keep the $300 million as cash to allow it to make acquisitions in the future.
What is Atlantic Southern’s new equity beta?
(10 marks)
(c) Atlantic plans to some of that cash to buy the troubled Dannager Coal
Company and to pay off its debt. Dannager’s debt has a market value of $150
million and a yield of 6%. Dannager’s equity is worth $50 million and has an
expected return of 13%. What will be Atlantic Southern’s equity beta after this
transaction?
(10 marks)
15
The subject guide, Chapters 7 and 3, pp. 101–108 and 43–52, respectively.
(a) We have:

Beta = = = = 0.42.
Var[Rm ] StD[Rm ] 0.18
The expected return is 3 + 0.42 × (8 − 3) = 5.08%.

(b) In this question and the following, you must: (i) first calculate the beta of the assets; and
(ii) secondly calculate the beta of the equity (namely, one part of the liability side). We
assume that cash has a beta of 0, thus the left hand side of the balance sheet has a beta of
(5/8)βa + (3/8) × 0 where βa = 0.42 is the beta of the original assets we found in (a).
On the right hand side of the balance sheet we have (5/8)βe + (3/8)βd . We can find βd using
the yield:
4−3
βd = = 0.2.
8−3
The left- and right-hand sides must be equal:
(5/8)βe + (3/8) × 0.2 = (5/8) × 0.42 ⇒ βe = 0.3.
(c) Dannager’s beta is:

(150/200)βd + (50/200)βe
where βd = (6 − 3)/(8 − 3) = 0.6 and βe = (13 − 3)/(8 − 3) = 2. Thus Dannager’s beta is
0.95.
Atlantic’s assets will now be: (a) Railroad worth 500 with a beta of 0.42; (b) Dannager
worth 200 with a beta of 0.95; (c) cash of 100 with a beta of 0. Therefore:
β = (500/800) × 0.42 + (200/800) × 0.95 + (100/800) × 0 = 0.5.
On the liability side it still has 300 of debt with a beta of 0.2.
(5/8)βe + (3/8) × 0.2 = 0.5 ⇒ βe = 0.68.
Question 6
American automaker TMCO is an all equity firm with current share price $10 per
share and one billion shares outstanding. It is introducing a new fleet of efficient
electric cars. Some analysts project the share prices falling to $8 per share due to
low oil prices and lack of demand for electric cars, while others project it rising to
$12.5 per share because of the high quality of TMCOs engineering. The risk free
rate is 4%.
(a) What is the price of a European call option on TMCO with a strike price of $10
that expires in one year?
(5 marks)
(b) How does volatility affects call option prices? Explain.
(6 marks)
(c) Suppose TMCO has outstanding debt with face value $9 billion due in one year.
What is the value of the equity of TMCO?
(7 marks)
16
(d) Explain how volatility affects equity prices when equity is close to default? Does
this have any implications for optimal capital structure?
(7 marks)
(a) Setting up a replication portfolio:

12.5X + 1.04B = 12.5 − 10
8X + 1.04B = 0
4.5X = 2.5
Candidates can also attempt this question by calculating the risk neutral probabilities.
(b) Volatility increases the value of call options. This is because call option payoffs are convex
in the underlying. As the underlying is worth more, the payoff is higher; however, if the
underlying is worth less (below the strike) the payoff is still the same – zero. Thus
increasing volatility increases the probability of very low and very high payoffs of the
underlying. Low and very low payoffs are equally painful as they result in zero; however,
high payoffs are not as good as very high payoffs.
(c) The key in this problem was to note that equity is just a call option on the firm with the
face value of debt being the strike price. In this case, the solution follows the same strategy
as in (a) above.
12.5X + 1.04B = 12.5 − 9
8X + 1.04B = 0
4.5X = 3.5
(d) Candidates must realise and comment on the similarities between an equity with a fixed
income component and a call option with a strike price. Just as with call options, volatility
increases the value of equity when equity is close to default. The intuition is the same as in
(b); taking on more risk has little cost on the downside and large benefits on the upside.
This is referred to as risk shifting or asset substitution, which is one of several potential
distress costs. Firms susceptible to risk shifting are better off using equity rather than debt
financing.
Question 7
Your factory owns an old machine which has four more years of life remaining. Its
current book value is £14 million and straight line depreciation can be used to
compute any tax breaks. The tax rate is 20% and the discount rate is 11% per year.
You receive revenues of £11 million per year from this machine’s production, and it
costs you £3 million per year to employ this machine’s operators. Assume that all
cash flows are end of year, so that you must discount the first cash flow.
Another factory has offered to buy this machine from you for £23 million, would
you agree? Show your work.
17
The NPV calculation is as follows:
Year 0 1 2 3 4
Rent 0 0 0 0
Expenses 3 3 3 3
Revenue 11 11 11 11
Wear/Tear 0
Pre-Tax CF 8 8 8 8
Tax 0.9 0.9 0.9 0.9
Post-Tax CF 7.1 7.1 7.1 7.1
PV 6.396396 5.762519 5.191459 4.67699
NPV 22.02736
Given the NPV, candidates must calculate the taxes they will need to pay. Given the book value
of 14, this is 1.8M in taxes. The net gain due to the sale is therefore 23 − 1.8 = 21.2 < 22.03.
Thus you are better off keeping the machine.
Question 8
The RAMJAC corporation has productive assets in place which will be worth $5
million or $10 million next year with equal probability. It also has cash in amount
$2 million. Additionally, it is considering an investment project which requires an
investment of $2 million and will payout $3.1 million with certainty next year.
Assume that the appropriate discount rate is 5%.
(a) Compute the payout to RAMJAC’s shareholders if the CEO does not take on
the investment project but rather pays the cash out as a one-time dividend.
(3 marks)
(b) Compute the payout to RAMJAC’s shareholders if the CEO uses the cash to
invest in the project.
(3 marks)
(c) Now suppose that RAMJAC also has outstanding debt with face value $8
million due next year. Compute the payout to RAMJAC’s shareholders if the
CEO does not take on the investment project but rather pays the cash out as a
one time dividend.
(6 marks)
(d) Continue the assumption about debt as in (c). Compute the payout to
RAMJAC’s shareholders if the CEO uses the cash to invest in the project.
(6 marks)
(e) Parts (a) – (d) illustrate the debt overhang problem. Explain it.
(7 marks)
The subject guide, Chapters 2, 8 (for the empirical part) and 9 (for the final component of debt
overhang).
(a) We have:
2 + (0.5 × 5 + 0.5 × 10)/1.05 = 9.143.
18
(b) We have:
0 + (0.5 × 5 + 0.5 × 10 + 3.1)/1.05 = 10.095.
(c) We have:
2 + (0.5 × 0 + 0.5 × (10 − 8))/1.05 = 2.952.
(d) We have:
0 + (0.5 × 0.1 + 0.5 × (13.1 − 8))/1.05 = 2.476.
Note that in the bad state of the world, there is still a small positive payoff for equity; that
is, the firm does not default.
(e) This is an example of debt overhang. Note that the firm has a positive NPV project
available to it and positive NPV projects should always be taken to maximise value. Indeed
in (a) and (b), when there is no debt, the firm prefers to take the positive NPV project as
we would expect.
On the other hand, in (c) and (d) the firm has a high amount of debt outstanding. In other
words, the firm is distressed and likely to default next year. If equity holders choose to take
the project instead of paying themselves a dividend, they will be incurring the full cost of
the project but receiving only part of the benefit. Note that in the bad state of the world,
they receive 0 if there is no project, and only 0.1 if there is a project; the creditors receive
an additional 3.4 from the project. Thus equity holders choose to not take a positive NPV
project.
Black–Scholes’ Option Pricing Formula
C = S[N (d1 )] − X[N (d2 )]e−rt
ln(S/X) 1 √
d1 = √ + σ t
σ t 2
√
and d2 = d1 − σ t
E(Ri ) = Rf + βi [E(Rm ) − Rf ]
Proposition II (no tax): Re = Ra + (Ra − Rd ) D

E
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
19
~~FN3092 ZA d0

Access Route
Corporate Finance
Tuesday, 12 May 2015 : 10:00 to 13:00
carry equal marks.
PLEASE TURN OVER

UL15/0225 Page 1 of 9 D1
SECTION A
1. (a) A firm with a total asset beta of 0.3 has a third of its assets as excess cash, which is not
used in the operations of the firm and is invested in risk-free T-bills. Suppose it pays
half of its cash to shareholders and invests the other half in the market. What is the
firm’s asset beta now? Why does it change? Discuss. (10 marks)
(b) Explain how and why dividend policy can be used as a signal to investors. (8 marks)
(c) Explain the tax clientele theory for the existence of dividends. (7 marks)
2. (a) Plot the following risky portfolios on a graph. (2 marks)
A B C D E F G
Expected return (%) 10 11 12.5 15 16 18 21
Standard deviation (%) 23 24 21 26 28 32 32
(b) Which of these portfolios are not efficient? (5 marks)
(c) Suppose you are prepared to tolerate a standard deviation of 26 percent. What is the
maximum expected return that you can achieve if you cannot borrow or lend (so you
have to stick to one of the existing portfolios)? (5 marks)
(d) What is your optimal strategy if you can borrow or lend at 12% and are prepared to
tolerate a standard deviation of 26%? What is the maximum expected return that you
can achieve with this strategy? (6 marks)
(e) Draw the efficient frontier and locate the market portfolio assuming you can lend and
borrow at 12% (7 marks)

UL15/0225 Page 2 of 9 D1
3. (a) What are event studies and what are they used for? What type of information efficiency
can they test? Explain in detail the hypothesis used in event studies and how you would
design an even time study (hint: consider an event time study around earnings
announcements). (7 marks)
(b) What is undiversifiable risk? Give an example. (2 marks)
(c) How does CAPM price diversifiable risk? (6 marks)
(d) Describe a result in the empirical literature that argues against the CAPM. What does
the result imply with respect to CAPM and market efficiency more generally?
(10 marks)
4. (a) The Modigliani and Miller proposition states that in the absence of taxes and other
frictions capital structure is irrelevant. Explain. (5 marks)
(b) One potential violation of the Modigliani and Miller assumptions is the existence of
agency conflicts. What are they and why do they arise? (5 marks)
(c) What is empire building? Give an example on how financial policy can mitigate empire
building. (5 marks)
(d) What is risk shifting? Give an example on how financial policy can mitigate risk shifting.
(5 marks)
(e) What is debt overhang? Explain the role of debt restructuring in mitigating this issue.
(5 marks)

UL15/0225 Page 3 of 9 D1
SECTION B
5. Acquirer Co (AC) has earnings per share of $3. It has 1 million shares outstanding, each of
which has a price of $30 per share. AC is thinking of buying Target Limited (TL), which has
earnings per share of $2, 1 million shares outstanding, and a price per share of $25. AC will
pay for TL by issuing new shares. There are no expected synergies from the transaction.
(a) Assume first that AC pays no premium to buy TL. What are the earnings per share of
the merged firm after the transaction? (5 marks)
(b) Explain the economic rationale behind the change in the earnings per share (EPS) of
TL before and after the merger in point (a). Are the shareholders of AC any better or
worse off after the merger? Carefully discuss your arguments. (5 marks)
(c) What will the price-earnings ratio (PE) be after the merger when AC pays no premium?
How does this compare to the PE ratio of AC before the merger? Are the shareholders
of AC any better or worse off after the merger? Carefully discuss your results.
(5 marks)
(d) Your DCF calculations indicate that TL should be trading at 28 per share, what would
be an appropriate premium that AC should pay for TL? Carefully discuss your results.
(5 marks)
(e) Explain the free rider problem in the context of takeovers as in Grossman and Hart
(1980). (5 marks)

UL15/0225 Page 4 of 9 D1
6. Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success
of this product, MI will have a value of either $100 million, $150 million, or $191 million, with
each outcome being equally likely. The cash flows are unrelated to the state of the economy
(i.e. risk from the project is diversifiable). The risk-free rate is currently 5%. MI has 5.6 million
shares of stock outstanding and no debt. Assume that the Modigliani-Miller assumptions
hold.
(a) What is MI’s share price? (5 marks)
Suppose now that one of the assumptions of Modigliani and Miller does not hold: in the event
of default, 20% of the value of MI's assets will be lost in bankruptcy costs. Assume also that
MI issues debt of $125 million due next year and uses the proceeds to repurchase shares.
(b) What is the cost of debt? Why? (4 marks)
(c) What is the yield to maturity? Is it the same as the cost of debt? Why? (5 marks)
(d) What is the new price per share? Why? What is the new number of shares?
(6 marks)
Suppose now that another of the assumptions of Modigliani and Miller does not hold: there is
a corporate tax rate of 35%.
(e) Without doing any calculation, how will the existence of taxes affect the calculation of
the new price per share? Will it be higher, lower, the same as your answer in (d)?
Discuss. (5 marks)

UL15/0225 Page 5 of 9 D1
7. Pepso is a well-established company that sells apple juice, the value of the assets in place is
100 and it has no leverage. The CEO of Pepso is considering entering into the pear juice
business. The net cost to the firm of entering this business is 20 (i.e., the costs exceed the
benefits by 20), and the private benefits to the CEO of this business equal 1.5. The CEO
owns 5% of the company and the discount rate is 0.
(a) Find the NPV of investing in the pear juice business for the firm and the CEO. Would
the CEO invest in the pear juice business if Pepso had enough internal resources?
(5 marks)
The board of Pepso meets to discuss how to use financial policy to align management
interests. They ask you to provide an alternative capital structure that can discipline the
manager.
(b) What is the minimum level of debt that aligns CEO preferences to those of the board?
Assume that in the recapitalization the CEO shares are not tendered, and that outside
investors are naïve such that they do not infer any potential agency conflicts from the
financial policy of the firm. (6 marks)
Assume that Pepso’s board decides to follow your advice and recapitalizes the company.
The board decides to issue debt with face value of 80, and use the proceeds to buy back
shares.
(c) What is the new equity stake of the CEO in the firm? (3 marks)
After the share repurchase, Pepso’s main competitor, Appleok, decides to launch an
aggressive competitive attack. The Head of research and development at Pepso comes up
with a counterattack move that involves investing in a new and risky technology of apple juice
production, which in case of success can stop the attack, and increase the value of the
assets in place to 150. In case of failure the value of the assets in place decreases to 80. The
probability that the technology is successful is 0.5. Investing in the technology has a cost of
20. Pepso must raise external equity finance to invest in the technology. You are hired by
Pepso’s board to structure the deal.
(d) What is the equity stake that an outside investor will require in exchange of the
investment cost of 20? (6 marks)
(e) Briefly explain the concepts of debt overhang and risk shifting. (5 marks)

UL15/0225 Page 6 of 9 D1
8. Carrie International (CI) is considering entering the shoe business in the US. The manager
of CI believes that there exists a very narrow window for entering this market. Because of
the Christmas demand, the time is right to invest is either today or exactly a year from now.
Other than these two opportunities, there is no alternative opportunity to break into this
market.
It will cost CI £35 million to enter the shoe market. Because other shoe manufactures exist
and they are public companies, the manager of CI reckons that the current value of a
comparable shoe company is £36 million. The manager of CI also reckons that 15% percent
of the value of the firm is attributable to the value of the expected free cash flows in the first
year of operation.
The flow of customers is uncertain, and so is the value of the shoe company. The volatility of
the expected firm value is 25% per year. The risk free rate is 4%.
(a) What is the expected value for CI of entering the shoe business this year? (4 marks)
(b) What is the value of the option to wait to enter the shoe market next year? When should
CI enter the shoe business? (8 marks)
(c) How should the decision of CI change if the expected value of the shoe company is £40
million instead of £36 million? (8 marks)
(d) Without doing any calculation, explain how would your decision change
i. if the volatility of the expected firm value is 50%?

ii. if the window for entering is not 1 year but 2 years?
Explain your answer in the context of call option pricing. (5 marks)
END OF PAPER

UL15/0225 Page 7 of 9 D1
C = S[N(d1)] - X[N(d2)]e-rt
ln  S / X   1
d1  t
 t 2
and
d 2  d1   t


E Ri   R f   i E Rm   R f


D
E

D
E
Miller (1977)
 1  Tc 1  Te 
VL  VU  1  D
 1  Td 
Values of natural logarithms you may find useful
x 36/35 40/35 30.6/35 30.6/36 40/36

Ln(x) 0.028171 0.133531 -0.13435 -0.16252 0.10536
x 35/36 34/35 34/36 40/30.6 36/30.6

Ln(x) -0.02817 -0.02899 -0.05716 0.267879 0.16252

UL15/0225 Page 8 of 9 D1
UL15/0225 Page 8 of 9 D1
~~FN3092 ZB d0

Access Route
Corporate Finance
Tuesday, 12 May 2015 : 10:00 to 13:00
carry equal marks.
PLEASE TURN OVER

UL15/0226 Page 1 of 9 D1
SECTION A
1. (a) Plot the following risky portfolios on a graph. (2 marks)
A B C D E F G
Expected return (%) 10 12.5 15 16 16 18 20
(b) Which of these portfolios are not efficient? (5 marks)
(c) Suppose you are prepared to tolerate a standard deviation of 25 percent. What is the
maximum expected return that you can achieve if you cannot borrow or lend (so you
have to stick to one of the existing portfolios)? (5 marks)
(d) What is your optimal strategy if you can borrow or lend at 12% and are prepared to
tolerate a standard deviation of 25%? What is the maximum expected return that you
can achieve with this strategy? (6 marks)
(e) Draw the efficient frontier and locate the market portfolio assuming you can lend and
borrow at 12%. (7 marks)
2. (a) The Modigliani and Miller proposition states that in the absence of taxes and other
frictions capital structure is irrelevant. Explain. (5 marks)
(b) One potential violation of the Modigliani and Miller assumptions is the existence of
agency conflicts. What are they and why do they arise? (5 marks)
(c) What is empire building? Give an example on how financial policy can mitigate empire
building. (5 marks)
(d) What is risk shifting? Give an example on how financial policy can mitigate risk shifting.
(5 marks)
(e) What is debt overhang? Explain the role of debt restructuring in mitigating this issue.
(5 marks)

UL15/0226 Page 2 of 9 D1
3. (a) What are event studies and what are they used for? What type of information efficiency
can they test? Explain in detail the hypothesis used in event studies and how you would
design an even time study (hint: consider an event time study around earnings
announcements). (7 marks)
(b) What is undiversifiable risk? Give an example. (2 marks)
(c) How does CAPM price diversifiable risk? (6 marks)
(d) Describe a result in the empirical literature that argues against the CAPM. What does
the result imply with respect to CAPM and market efficiency more generally?
(10 marks)
4. (a) A firm with a total asset beta of 0.25 has a fifth of its assets as excess cash, which is
not used in the operations of the firm and is invested in risk-free T-bills. Suppose it pays
half of its cash to shareholders and invests the other half in the market. What is the
firm’s asset beta now? Why does it change? Discuss. (10 marks)
(b) Explain how and why dividend policy can be used as a signal to investors. (8 marks)
(c) Explain the tax clientele theory for the existence of dividends. (7 marks)

UL15/0226 Page 3 of 9 D1
SECTION B
5. Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success
of this product, MI will have a value of either $100 million, $150 million, or $191 million, with
each outcome being equally likely. The cash flows are unrelated to the state of the economy
(i.e. risk from the project is diversifiable). The risk-free rate is currently 5%. MI has 10 million
shares of stock outstanding and no debt. Assume that the Modigliani-Miller assumptions
hold.
(a) What is MI’s share price? (5 marks)
Suppose now that one of the assumptions of Modigliani and Miller does not hold: in the event
of default, 20% of the value of MI's assets will be lost in bankruptcy costs. Assume also that
MI issues debt of $130 million due next year and uses the proceeds to repurchase shares.
(b) What is the cost of debt? Why? (4 marks)
(c) What is the yield to maturity? Is it the same as the cost of debt? Why? (5 marks)
(d) What is the new price per share? Why? What is the new number of shares?
(6 marks)
Suppose now that another of the assumptions of Modigliani and Miller does not hold: there is
a corporate tax rate of 35%.
(e) Without doing any calculation, how will the existence of taxes affect the calculation of
the new price per share? Will it be higher, lower, the same as your answer in (d)?
Discuss. (5 marks)

UL15/0226 Page 4 of 9 D1
6. Acquirer Co (AC) has earnings per share of $4. It has 1 million shares outstanding, each of
which has a price of $40 per share. AC is thinking of buying Target Limited (TL), which has
earnings per share of $2, 1 million shares outstanding, and a price per share of $25. AC will
pay for TL by issuing new shares. There are no expected synergies from the transaction.
(a) Assume first that AC pays no premium to buy TL. What are the earnings per share of
the merged firm after the transaction? (5 marks)
(b) Explain the economic rationale behind the change in the earnings per share (EPS) of
TL before and after the merger in point (a). Are the shareholders of AC any better or
worse off after the merger? Carefully discuss your arguments. (5 marks)
(c) What will the price-earnings ratio (PE) be after the merger when AC pays no premium?
How does this compare to the PE ratio of AC before the merger? Are the shareholders
of AC any better or worse off after the merger? Carefully discuss your results.
(5 marks)
(d) Your DCF calculations indicate that TL should be trading at 28 per share, what would
be an appropriate premium that AC should pay for TL? Carefully discuss your results.
(5 marks)
(e) Explain the free rider problem in the context of takeovers as in Grossman and Hart
(1980). (5 marks)

UL15/0226 Page 5 of 9 D1
7. Carrie International (CI) is considering entering the shoe business in the US. The manager
of CI believes that there exists a very narrow window for entering this market. Because of
the Christmas demand, the time is right to invest is either today or exactly a year from now.
Other than these two opportunities, there is no alternative opportunity to break into this
market.
It will cost CI £35 million to enter the shoe market. Because other shoe manufactures exist
and they are public companies, the manager of CI reckons that the current value of a
comparable shoe company is £40 million. The manager of CI also reckons that 15% percent
of the value of the firm is attributable to the value of the expected free cash flows in the first
year of operation.
The flow of customers is uncertain, and so is the value of the shoe company. The volatility of
the expected firm value is 25% per year. The risk free rate is 4%.
(a) What is the expected value for CI of entering the shoe business this year? (4 marks)
(b) What is the value of the option to wait to enter the shoe market next year? When should
CI enter the shoe business? (8 marks)
(c) How should the decision of CI change if the expected value of the shoe company is £36
million instead of £40 million? (8 marks)
(d) Without doing any calculation, explain how would your decision change if the volatility of
the expected firm value is 50%? If the window for entering is not 1 year but 2 years?
Explain your answer in the context of call option pricing. (5 marks)

UL15/0226 Page 6 of 9 D1
8. Pepso is a well-established company that sells apple juice, the value of the assets in place is
100 and it has no leverage. The CEO of Pepso is considering entering into the pear juice
business. The net cost to the firm of entering this business is 10 (i.e., the costs exceed the
benefits by 10), and the private benefits to the CEO of this business equal 1.5. The CEO
owns 5% of the company and the discount rate is 0.
(a) Find the NPV of investing in the pear juice business for the firm and the CEO. Would
the CEO invest in the pear juice business if Pepso had enough internal resources?
(5 marks)
The board of Pepso meets to discuss how to use financial policy to align management
interests. They ask you to provide an alternative capital structure that can discipline the
manager.
(b) What is the minimum level of debt that aligns CEO preferences to those of the board?
Assume that in the recapitalization the CEO shares are not tendered, and that outside
investors are naïve such that they do not infer any potential agency conflicts from the
financial policy of the firm. (6 marks)
Assume that Pepso’s board decides to follow your advice and recapitalizes the company.
The board decides to issue debt with face value of 80, and use the proceeds to buy back
shares.
(c) What is the new equity stake of the CEO in the firm? (3 marks)
After the share repurchase, Pepso’s main competitor, Appleok, decides to launch an
aggressive competitive attack. The Head of research and development at Pepso comes up
with a counterattack move that involves investing in a new and risky technology of apple juice
production, which in case of success can stop the attack, and increase the value of the
assets in place to 150. In case of failure the value of the assets in place decreases to 80. The
probability that the technology is successful is 0.5. Investing in the technology has a cost of
20. Pepso must raise external equity finance to invest in the technology. You are hired by
Pepso’s board to structure the deal.
(d) What is the equity stake that an outside investor will require in exchange of the
investment cost of 20? (6 marks)
(e) Explain the concepts of debt overhang and risk shifting. (5 marks)
END OF PAPER

UL15/0226 Page 7 of 9 D1
C = S[N(d1)] - X[N(d2)]e-rt
ln  S / X   1
d1  t
 t 2
and
d 2  d1   t


E Ri   R f   i E Rm   R f


D
E

D
E
Miller (1977)
 1  Tc 1  Te 
VL  VU  1  D
 1  Td 
Values of natural logarithms you may find useful
x 36/35 40/35 30.6/35 30.6/36 40/36

Ln(x) 0.028171 0.133531 -0.13435 -0.16252 0.10536
x 35/36 34/35 34/36 40/30.6 36/30.6

Ln(x) -0.02817 -0.02899 -0.05716 0.267879 0.16252

UL15/0226 Page 8 of 9 D1
UL15/0226 Page 9 of 9 D1

Important note

references
General remarks
Learning outcomes
• 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 Black–Scholes 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
• discuss why merger and acquisition activities exist, and calculate the
related gains and losses.
1
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:
• Candidates’ answers are often too general or narrow. When you are
asked to critically assess a theory or concept, you should 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
• You should not regurgitate materials from the subject guide.
Consequently, you may be giving either descriptive or irrelevant
material in your answer. Rather, you should carefully consider what the
examination question is in fact asking and respond accordingly.
• 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.
2
Examination revision strategy

performance is poorer than they expected. This may be due to a
number of reasons. The Examiners’ commentaries suggest ways of
addressing common problems and improving your performance. One
particular failing is ‘question spotting’, that is, confining your
examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious
consequences.
the same depth, but you need to be aware that examiners are free to
section of the VLE dedicated to each course. You should read the
syllabus 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. Examination papers may legitimately include
questions on any topic in the syllabus. So, although past papers can be
helpful during your 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
examination. We strongly advise you not to adopt this
strategy.
3

Important note

references

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 and useufl logarithm and normal distribution tables is
given at the end of the paper.
Section A
Question 1
a. A firm with a total asset beta of 0.3 has a third of its assets as excess cash,
which is not used in the operations of the firm and is invested in risk-free
T-bills. Suppose it pays half of its cash to shareholders and invests the other
half in the market. What is the firm’s asset beta now? Why does it change?
Discuss. (10 marks)
b. Explain how and why dividend policy can be used as a signal to investors
(7.5 marks)
c. Explain the tax clientele theory for the existence of dividends (7.5 marks)
Subject guide, Chapters 7, 8 and 9 (respectively).
4

a. Yes, it changes. It is higher because the company exchanged a risk-free
asset, the cash, for a risky security, the market. The best way to see this
is by calculating the new exposure of the company to market risk using
the information provided to first back-out the exposure of the non-cash
assets to market risk, and then use the new asset structure of the firm
to recalculate the exposure to the market. In detail:
1 2
∗ 0 + ∗ βNon cash = 0.3
3 3
3
βNon cash = 0.3 = 0.45
2
Now, 5/6 of the firm is invested in the asset and 1/6 in the market. So
the new asset beta is:
5 1
βasset = 0.45 + 1 = 0.54
6 6
b. The simplest way to understand why dividend policy can be used as a

signal to investors is by reversing the argument of debt as signalling in
the Myers and Majluf model of information asymmetries. Just as debt
sends a signal to the market that the company is of good quality, so
does paying out a dividend to investors. Best answers may include an
example and also mention share repurchases.
c. An example can be best used to explain this theory. Consider a
company that currently pays a high dividend and has attracted a
clientele whose investment goal is to obtain stock with a high dividend
payout. If the company decides to decrease its dividend, these investors
will sell their stock, and the company’s share price will decline. The
company is then somewhat forced to keep paying dividends.
Question 2
a. Plot the following risky portfolios on a graph (2 marks)
A B C D E F G
Expected return (%) 10 11 12.5 15.5 16 18 21
b. Which of these portfolios are not efficient? (5 marks)

c. Suppose you are prepared to tolerate a standard deviation of 26 percent.
What is the maximum expected return that you can achieve if you cannot
borrow or lend? (5 marks)
d. What is your optimal strategy if you can borrow or lend at 12% and are
prepared to tolerate a standard deviation of 26%? What is the maximum
expected return that you can achieve with this strategy? (6 marks)
e. Draw the efficient frontier and locate the market portfolio assuming you can
lend and borrow at 12% (7 marks)
Subject guide, Chapter 2.
a. The plot should mimic the standard mean-variance frontier. The best
way to approach this question is to plot in a two-dimension plot the
5
points provided with the standard deviation in the x-axis and returns in
the y-axis.
b. Portfolio F is not efficient because the investor can obtain a higher
return investing in portfolio G and obtain same standard deviation
(same risk) as portfolio F.
c. The maximum expected returns that can be achieved if investor cannot
borrow or lend is 15.5 by investing in portfolio D.
d. The best way to find the optimal strategy is to consider a replicating
portfolio based on any portfolio (say portfolio G) and the risk free rate
as follows:
∗ (32) + (1 − ) ∗ 0 = 26
26
=
32
26 26
32
∗ (21) + 1 − (
32 )
∗ 12 = 19.31
6 26
The strategy is thus to lend 32 of the wealth at 12% and invest of
32
the wealth in portfolio G. The maximum expected return is 19.31.
e. Include in the plot a ray extending from the Y-axis (intersection of 12%
= Risk free rate) and is tangent to the frontier of risky assets drawn in
part a. This is the CML.
Question 3
a. What are event studies and what are they used for? What type of information
efficiency can they test? Explain in detail the hypothesis used in event
studies and how you would design an even time study (hint: consider an
event time study around earnings announcements). (6.5 marks)
b. What is undiversifiable risk? Give an example. (2 marks)
c. How does CAPM price diversifiable risk? (6.5 marks)
d. Describe a result in the empirical literature that argues against the CAPM.
What does the result imply with respect to CAPM and market efficiency more
generally? (10 marks)
Subject guide, Chapters 2 and 5.
a. 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 The semi-strong form of the EMH states that all public
information is embedded in asset prices. The study should contain an
announcement (e.g. earnings announcements) then an announcement
window (including a period leading up to the announcement and a
period after the announcement), and investigate the abnormal returns
over the announcement window. The test consists of looking at the
pattern of abnormal returns. It should have a large jump around the
announcement date, and small abnormal returns in the period leading
up to the jump and small abnormal returns in the period following the
jump. The public announcement should dictate the price jump.
6
b. Undiversifiable risk, also known as systematic risk, is the volatility in

returns of assets due to changes in the market. Any change in a market
index, say S&P 500, is an undiversifiable risk.
c. Diversifiable risk is not priced. Rational investors can hedge this type
of risk. The best way to see this is by focusing on the pricing equation
of the CAPM in which the only compensation for risk demanded by
investors, above and beyond the risk-free rate, is exposure to market
risk in the form of beta.
d. Empirically, small capitalised firms seem to have a higher expected
return than what the CAPM predicts. Fama and French (1992) argue
that small size portfolios appear to outperform large size portfolios
even after controlling their respective betas. This evidence is often
regarded as an anomaly to the CAPM. However, any testing of the
CAPM depends very much on how efficient the market is and whether
we choose the correct proxies for the market in those tests.
Question 4
b. One potential violation of the Modligiani and Miller assumptions is the
existence of agency conflicts. What are they and why do they arise? (5 marks)
c. What is empire building? Give an example on how financial policy can
mitigate empire building (5 marks)
d. What is risk shifting? Give an example on how financial policy can mitigate
risk shifting. (5 marks)
e. What is debt overhang? Explain the role of debt restructuring in mitigating
this issue (5 marks)
a. The main insight from Modigliani and Miller is that under no frictions
financial policy only determines how value is distributed among
stakeholders, value is only created from assets: security issuances are
0 NPV transactions. One way to see this is to recall the proof of the
Modigliani and Miller theorem in Chapter 6 of the subject guide.
b. Agency conflicts arise when stakeholders in a firm have different
incentives (preferences). These conflicts are exacerbated by the
separation of ownership and control in modern corporations. There
are several types of agency conflicts in a firm including those between:
debtholders and shareholders, and between CEOs and shareholders.
c. Empire building refers to the desire of CEOs to invest in negative NPV
acquisitions if they derive private benefits from exerting control over
larger assets, or if their compensation is tied to asset size. Financial
policy can mitigate this agency conflict. In particular, debt can be used
to reduce available cash flow for acquisitions.
d. An equity stake in a levered firm corresponds to a call option on the
cash flow of the firm with strike equal to the face value of debt. This
implies that if given the chance, shareholders will always pick risky
over safe projects, even if detrimental for firm value, as they are not
really affected by the downside but have extraordinary potential
gains from the upside (in detriment of debtholders). This tendency
of shareholders is known as risk-shifting or asset substitution. One
7
potential solution is financial restructuring where the face value of

debt is reduced.
e. Shareholders in a firm may forgo positive NPV projects if they have
a large face value of debt because they will get to appropriate very
little from the NPV. This issue is known as debt-overhang. If debt is
restructured, such that some of the face value is forgiven, shareholders
will be allowed to appropriate more of the positive NPV project and
thus will invest. Restructuring is only feasible as long as debtholders
remain just as well off after it.
Section B
Question 5
Acquirer Co (AC) has earnings per share of $3. It has 1 million shares
outstanding, each of which has a price of $30 per share. AC is thinking of
buying Target Limited (TL), which has earnings per share of $2, 1 million shares
outstanding, and a price per share of $25. AC will pay for TL by issuing new
shares. There are no expected synergies from the transaction.
a. Assume first that AC pays no premium to buy TL. What are the earnings per
share of the merged firm after the transaction? (5 marks)
b. Explain the economic rationale behind the change in the earnings per share
(EPS) of TL before and after the merger in point (a). Are the shareholders
of AC any better or worse off after the merger? Carefully discuss your
arguments. (5 marks)
c. What will the price-earnings ratio (PE) be after the merger when AC pays no
premium? How does this compare to the PE ratio of AC before the merger?
Are the shareholders of AC any better or worse off after the merger?
Carefully discuss your results. (5 marks)
d. Your DCF calculations indicate that TL should be trading at 30 per share,
what would be an appropriate premium that AC should pay for TL? Carefully
discuss your results. (5 marks)
e. Explain the free rider problem in the context of takeovers as in Grossman and
Hart (1980). (5 marks)
a. There are no expected synergies from the transaction; hence the new
earnings of the firm are just the combined earnings of the previous
stand-alone companies. Because TL shares are worth 25 and AC shares
are worth $30, AC will have to issue 25/30 (=5/6) shares per share
of TL to be able to buy it. That means that, in the aggregate, AC will
have to issue 5/6*1 million = 833,333 new shares. After the merger,
there will be 1,833,333 shares outstanding and the total earnings
will be 5 million. Thus, the new EPS (earnings per share) will be 5
million/1.833 million = 2.72
b. The economic rationale can be best understood as follows. In point (a),
the change in EPS simply came from combining the two companies.
One is worth $3 per share and the other is worth 2 per share. However,
a reduction in the EPS of the shareholders of AC need not mean that
they did a bad transaction. Although the shareholders of AC end up
with a lower EPS under the transaction, they have paid a fair price,
exchanging their 3 per share before the transaction for either lower,
but safer EPS after the transaction, or lower EPS that are expected to
8
grow more in the future. Either way, focusing on EPS alone cannot tell
us whether the shareholders of AC are better or worse off.
c. If AC pays no premium that means, as stated in the problem that
there are no expected synergies. Hence, if we simply combine the
two companies and there are no synergies as indicated, then the total
value of the company will be 30 + 25 = 55 million. The merged firm
has earnings totalling 5 million, so that the PE ratio is 55/5 = 11. The
PE ratio of AC before the merger was 30/3 = 10 and TL’s was 25/2
= 12.5. To determine whether shareholders of AC are any better or
worse, recall, just as in Part b, that simply focusing on metrics such
as the PE ratio does not tell anything about whether shareholders
are worse or better off. The PE ratio of AC went from 10 to 11, but
shareholders are no better or worse off.
d. An appropriate premium can be calculated based on the price at which
other companies are selling. In particular, if other companies are
selling at 30 per share, then a starting point for the premium to pay
would be 30/25 = 20% premium.
e. The free-rider problem in the context of Grossman and Hart can be
best explained as follows. The efficiency gains from a valuable takeover
are a public good: all existing shareholders want the takeover to occur
as it increases value, but for the same reason none of them will want
to tender their shares because they want to appropriate the increase in
value. In other words, shareholders would like to free-ride on others to
sell the shares so they can obtain the value gains. The raider will then
have to bid for the shares the original price plus the expected increase
in value in shares making it extremely difficult for takeovers to occur in
practice unless raiders have a pre-existing toehold of shares or there is
a freeze out rule, etc.
Question 6
Monsters Incorporated (MI) is ready to launch a new product. Depending upon
the success of this product, MI will have a value of either $100 million, $150
million, or $191 million, with each outcome being equally likely. The cash
flows are unrelated to the state of the economy (i.e. risk from the project is
diversifiable). The risk-free rate is currently 5%. MI has 5.6 million shares of
stock outstanding and no debt. Assume that the Modigliani-Miller assumptions
hold.
a. What is MI’s share price? (5 marks)
Suppose now that one of the assumptions of Modigliani and Miller does not
hold: in the event of default, 20% of the value of MI’s assets will be lost in
bankruptcy costs. Assume also that MI issues debt of face value $125 million
due next year and uses the proceeds to repurchase shares.
b. What is the cost of debt? Why? (4 marks)
c. What is the yield to maturity? Is it the same as the cost of debt? Why?
(5 marks)
d. What is the new price per share? Why? What is the new number of shares?
(6 marks)
Suppose now that another of the assumptions of Modigliani and Miller does
not hold: there is a corporate tax rate of 35%.
e. Without doing any calculation, how will the existence of taxes affect the
calculation of the new price per share? Will it be higher, lower, the same as
your answer in d.? Discuss. (5 marks)
9

a. To calculate the price we first estimate expected value as follows:
1 3 (100 ) + 1 3 (150 ) + 1 3 (191) +
=VU = $140 million
1.05
Price per share = $140M / 5.6 million shares = $25.00.

b. The cost of debt is 5% because the risk of cash flows is diversifiable, so
investors demand no extra compensation for risk.
c. The yield to maturity corresponds to the interest rate that equates
expected value of debt (market value) to its face value. We first have to
calculate the expected value of debt as follows:
Value of MI’s debt:
1 3 (100 (1 − .20 ) ) + 1 3 (125 ) + 1 3 (125 ) +

Vdebt = $104.76 million
1.05
$125
YTM = - 1 = .193182 or 19.3%. No, reflects probability of
$104.76
bankruptcy and loss in value.
d. To calculate the new price per share we first recalculate the value of
equity taking into account the bankruptcy instance.
Value of MI’s equity:
1 1 1
∗ 0 + 3 ∗ 25 + 3 ∗ 66
= 3 = 28.89
1.05
Total Value = VL + Vdebt = $28.89 + $104.765 = $133.6508 million

Price per Share = $133.65M / 5.6 million shares = $23.87
Shares repurchased: 125/23.87 = 5.237. New number of shares:
5.6 – 5.237 = 0.36.
e. The price will be lower because with taxes part of the value is
appropriated by government.
Question 7
Pepso is a well-established company that sells apple juice, the value of the
assets in place is 100 and it has no leverage. The CEO of Pepso is considering
entering into the pear juice business. The net cost to the firm of entering this
business is 20 (i.e., the costs exceed the benefits by 20), and the private benefits
to the CEO of this business equal 1.5. The CEO owns 5% of the company and the
discount rate is 0.
a. Find the NPV of investing in the pear juice business for the firm and the CEO.
Would the CEO invest in the pear juice business if Pepso had enough internal
resources? (5 marks)
The board of Pepso meets to discuss how to use financial policy to align
management interests. They ask you to provide an alternative capital
structure that can discipline the manager.
b. What is the minimum level of debt that aligns CEO preferences to those
of the board? Assume that in the recapitalization the CEO shares are not
tendered, and that outside investors are naïve such that they do not infer any
potential agency conflicts from the financial policy of the firm. (6 marks)
10
c. Assume that Pepso’s board decides to follow your advice and recapitalizes
the company. The board decides to issue debt with face value of 80, and use
the proceeds to buy back shares.
d. What is the new equity stake of the CEO in the firm? (3 marks)
After the recapitalization, Pepso’s main competitor, Appleok, decides
to launch an aggressive competitive attack. The Head of Research and
Development at Pepso comes up with a counterattack move that involves
investing in a new and risky technology of apple juice production, which
in case of success can stop the attack, and increase the value of the assets
in place to 150. In case of failure the value of the assets in place decreases
to 80. The probability that the technology is successful is 0.5. Investing in
the technology has a cost of 20. Pepso must raise external equity finance to
invest in the technology. You are hired by Pepso’s board to structure the deal.
e. What is the equity stake that an outside investor will require in exchange of
the investment cost of 20? (6 marks)
f. Explain the concepts of debt overhang and risk shifting (5 marks)
a. We need to compare the NPV of the business with the outside option
of the firm which is to derive value from the assets in place. For the
CEO it is important to recall that he has private benefits from the pear
investment.
NPV(pear project) = 100 – 20 = 80 ≤ 100 = Value Assets in Place
NPV(pear project) for CEO = 5%(100 – 20) + 1.5 = 5.5 ≥ 5
= 5%(Value Assets in Place)
Given our calculations above, we conclude that: yes, the CEO will
invest because his benefit of investing is higher than the value of his
stake of the assets in place.
b. The board would like to issue debt with face value of D and use the
proceeds to buy back shares, in order to discipline the manager.
Because investors are naïve the recapitalisation does not change the
value of the assets in place, the new equity stake of the CEO, after the
recapitalisation can be calculated as:
5
5% (100) = α%(100 − D) → α% =
100 − D
The minimum value of debt for the CEO not to invest in the pear
project is defined by the following inequality, where the value to the
CEO from the project (after the recapitalisation) is forced to be lower
than the value of the assets in place ≤ 5:
5
(80 − D) + 1.5 ≤ 5
100 − D
D ≥ 33 .33
c. The equity stake of the CEO corresponds to the number of shares he

started out with divided by the new number of shares, which is smaller
because some of the shares have been repurchased as part of the
recapitalisation.
5
= = 25%
100−80
11
d. The outside investors just desire to break even, so we use the break-
even condition to price the debt:
[0.5 ∗ 0 + 0.5 ∗(100 − 80)] = 20
20
= >1
10
The equity stake is prohibitive (i.e. higher than 1), which means that
Pepso cannot invest in the technology. The problem here is one of debt
overhang.
e. The concepts of risk shifting and debt overhang are as follows: An
equity stake in a levered firm corresponds to a call option on the cash
flow of the firm with strike equal to the face value of debt. This implies
that if given the chance, shareholders will always pick risky over safe
projects, even if detrimental for firm value, as they are not really
affected by the downside but have extraordinary potential gains from
the upside (in detriment of debtholders). This tendency of shareholders
is known as risk-shifting or asset substitution. One potential solution
is financial restructuring where the face value of debt is reduced.
Shareholders in a firm may forgo positive NPV projects if they have
Question 8
Carrie International (CI) is considering entering the shoe business in the US. The
manager of CI believes that there exists a very narrow window for entering this
market. Because of the Christmas demand, the time is right to invest is either
today or exactly a year from now. Other than these two opportunities, there is
no alternative opportunity to break into this market.
It will cost CI £35 million to enter the shoe market. Because other shoe
manufactures exist and they are public companies, the manager of CI reckons
that the current value of a comparable shoe company is £36 million. The
manager of CI also reckons that 15% percent of the value of the firm is
attributable to the value of the expected free cash flows in the first year of
operation.
The flow of customers is uncertain, and so is the value of the shoe company. The
volatility of the expected firm value is 25% per year. The risk free rate is 4%.
a. What is the expected value for CI of entering the shoe business this year?
(4 marks)
b. What is the value of the option to wait to enter the shoe market next year?
When should CI enter the shoe business? (Hint: use discrete discounting)
(8 marks)
c. How should the decision of CI change if the expected value of the shoe
company is £40 million instead of £36 million? (8 marks)
d. Without doing any calculation, explain how would your decision change if
(i) the volatility of the expected firm value is 50%? (ii) if the window for
entering is not 1 year but 2 years? Explain your answer in the context of call
option pricing (5 marks)
12

a. The value of investing today corresponds to the difference between the
value of a comparable company and the costs: 36 – 35 = 1.
b. We apply the Black-Scholes formula, First, we adjust the value of the
underlying, which in this case is the cash flow, to reflect the loss of
the sales during the first year. S^{∗} = – PV(Cash)= 36 × (1 – 0.15).
Then we find the present value of the strike, which in this case is the
cost of entering the market PV(K) =((35)/(1.04)) = 33.6538. Then
using the information provided on volatility of cash flows and knowing
that the option last for a year we calculate the constants: d₁ = 0.2555,
d₂ = – 0.5055. Plugging the information in the formula we have that
the value of the call option (and the value of waiting) is C = 1.90. This
value is higher than the value of waiting of investing today (i.e. 1.90 >
1). Hence Carrie International should wait.
c. We follow the same procedure as that in point b but now the expected
cash flow is 40 as opposed to 36. First we adjust the value of the
underlying, which in this case is the cash flow, to reflect the loss of the
sales during the first year. S^{∗} = S –PV(Cash) = 40 × (1 – 0.15).
cost of entering the market PV(K) = ((35)/(1.04)) = 33.6538. Then
that the option last for a year we calculate the constants: d₁ = 0.1659,
d₂ = 0.0841. Plugging the information in the formula we have that
the value of the call option (and the value of waiting) is C = 3.54. It
is thus more valuable to enter now (5 > 3.54). There is no value in
waiting.
d. Because as seen in class and as explained in the guidebook the value
of a call option is increasing in volatility and time, the value of waiting
also increases with volatility and time.
13

Important note

references

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 and useufl logarithm and normal distribution tables is
given at the end of the paper.
Section A
Question 1
a. Plot the following risky portfolios on a graph (2 marks)
A B C D E F G
Expected return (%) 10 12.5 15 16 16 20 18
b. Which of these portfolios are not efficient? (5 marks)
c. Suppose you are prepared to tolerate a standard deviation of 25 percent.
What is the maximum expected return that you can achieve if you cannot
borrow or lend (so you have to stick to one of the existing portfolios)?
(5 marks)
d. What is your optimal strategy if you can borrow or lend at 12% and are
prepared to tolerate a standard deviation of 25%? What is the maximum
expected return that you can achieve with this strategy? (6 marks)
14
e. Draw the efficient frontier and locate the market portfolio assuming you can
lend and borrow at 12% (7 marks)
a. The plot should mimic the standard mean-variance frontier. The best
way to approach this question is to plot in a two-dimensional graph the
points provided with the standard deviation in the x-axis and returns in
the y-axis.
b. Portfolio G is not efficient because the investor can obtain a higher
return investing in portfolio F and obtain same standard deviation
(same risk) as portfolio G.
c. The maximum expected returns that can be achieved if investor cannot
borrow or lend is 15 by investing in portfolio C.
d. The best way to find the optimal strategy is to consider a replicating
portfolio based on any portfolio (say portfolio F) and the risk free rate
as follows:
∗ (32) + (1 − ) ∗ 0 = 25
25
=
32
25
32 (
∗ (20) + 1 −
25
32 ) ∗ 12 = 18.25
The strategy is thus to lend 7

of the wealth at 12% and invest 25
of
32 32
the wealth in portfolio F. The maximum expected return is 18.25.
e. Include in the plot a ray extending from the Y-axis (intersection of 12%
= Risk free rate) and is tangent to the frontier of risky assets drawn in
part a. This is the CML.
Question 2
b. One potential violation of the Modigliani and Miller assumptions is the
existence of agency conflicts. What are they and why do they arise? (5 marks)
c. What is empire building? Give an example on how financial policy can
mitigate empire building (5 marks)
d. What is risk shifting? Give an example on how financial policy can mitigate
risk shifting. (5 marks)
e. What is debt overhang? Explain the role of debt restructuring in mitigating
this issue (5 marks)
a. The main insight from Modigliani and Miller is that under no frictions
financial policy only determines how value is distributed among
stakeholders, value is only created from assets: security issuances are
15
0 NPV transactions. One way to see this is to recall the proof of the
Modigliani and Miller theorem in Chapter 6 of the subject guide.
b. Agency conflicts arise when stakeholders in a firm have different
incentives (preferences). These conflicts are exacerbated by the
separation of ownership and control in modern corporations. There
are several types of agency conflicts in a firm including those between:
debtholders and shareholders, and between CEOs and shareholders.
c. Empire building refers to the desire of CEOs to invest in negative NPV
acquisitions if they derive private benefits from exerting control over
larger assets, or if their compensation is tied to asset size. Financial
policy can mitigate this agency conflict. In particular, debt can be used
to reduce available cash flow for acquisitions.
d. An equity stake in a levered firm corresponds to a call option on the
cash flow of the firm with strike equal to the face value of debt. This
implies that if given the chance, shareholders will always pick risky
over safe projects, even if detrimental for firm value, as they are not
really affected by the downside but have extraordinary potential
gains from the upside (in detriment of debtholders). This tendency
of shareholders is known as risk-shifting or asset substitution. One
potential solution is financial restructuring where the face value of debt
is reduced.
e. Shareholders in a firm may forgo positive NPV projects if they have
Question 3
a. What are event studies and what are they used for? What type of information
efficiency can they test? Explain in detail the hypothesis used in event
studies and how you would design an even time study (hint: consider an
event time study around earnings announcements). (7 marks)
b. What is undiversifiable risk? Give an example. (2 marks)
c. How does CAPM price diversifiable risk? (6 marks)
d. Describe a result in the empirical literature that argues against the CAPM.
What does the result imply with respect to CAPM and market efficiency more
generally? (10 marks)
a. 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. The semi-strong form of the EMH states that all public
information is embedded in asset prices. The study should contain an
announcement (e.g. earnings announcements) then an announcement
window (including a period leading up to the announcement and a
period after the announcement), and investigate the abnormal returns
16
over the announcement window. The test consists of looking at the

pattern of abnormal returns. It should have a large jump around the
announcement date, and small abnormal returns in the period leading
up to the jump and small abnormal returns in the period following the
jump. The public announcement should dictate the price jump.
b. Undiversifiable risk, also known as systematic risk, is the volatility in
returns of assets due to changes in the market. Any change in a market
index, say S&P 500, is an undiversifiable risk.
c. Diversifiable risk is not priced. Rational investors can hedge this type
of risk. The best way to see this is by focusing on the pricing equation
of the CAPM in which the only compensation for risk demanded by
investors, above and beyond the risk-free rate, is exposure to market
risk in the form of beta.
d. Empirically, small capitalised firms seem to have a higher expected
return than what the CAPM predicts. Fama and French (1992) argue
that small size portfolios appear to outperform large size portfolios
even after controlling their respective betas. This evidence is often
regarded as an anomaly to the CAPM. However, any testing of the
CAPM depends very much on how efficient the market is and whether
we choose the correct proxies for the market in those tests.
Question 4
a. A firm with a total asset beta of 0.25 has a fifth of its assets as excess cash,
which is not used in the operations of the firm and is invested in risk-free
T-bills. Suppose it pays half of its cash to shareholders and invests the other
half in the market. What is the firm’s asset beta now? Why does it change?
Discuss. (10 marks)
b. Explain how and why dividend policy can be used as a signal to investors
(8 marks)
c. Explain the tax clientele theory for the existence of dividends. (7 marks)
Subject guide, Chapters 7, 8 and 9 (respectively).
a. Yes, it changes. It is higher because the company exchanged a risk-free
asset, the cash, for a risky security, the market. The best way to see this
is by calculating the new exposure of the company to market risk using
the information provided to first back-out the exposure of the non-cash
assets to market risk, and then use the new asset structure of the firm
to recalculate the exposure to the market. In detail:
1 4
∗0+ ∗β = 0 .25
5 5 Non cash
5
β = 0.25 = 0.3125
Non cash 4
Now, 9/10 of the firm is invested in the asset and 1/10 in the market.
So the new asset beta is:
9 1
β = 0.3125 + 1 = 0 .38125
asset 10 10
17
b. The simplest way to understand why dividend policy can be used as a

signal to investors is by reversing the argument of debt as signalling in
the Myers and Majluf model of information asymmetries. Just as debt
sends a signal to the market that the company is of good quality, so
does paying out a dividend to investors. Best answers may include an
example and also mention share repurchases.
c. An example can be best used to explain this theory. Consider a
company that currently pays a high dividend and has attracted clientele
whose investment goal is to obtain stock with a high dividend payout.
If the company decides to decrease its dividend, these investors will sell
their stock, and the company’s share price will decline. The company is
then somewhat forced to keep paying dividends.
Section B
Question 5
Monsters Incorporated (MI) is ready to launch a new product. Depending upon
the success of this product, MI will have a value of either $100 million, $150
million, or $191 million, with each outcome being equally likely. The cash
flows are unrelated to the state of the economy (i.e. risk from the project is
diversifiable). The risk-free rate is currently 5%. MI has 10 million shares of stock
outstanding and no debt. Assume that the Modigliani-Miller assumptions hold.
a. What is MI’s share price? (5 marks)
Suppose now that one of the assumptions of Modigliani and Miller does not
hold: in the event of default, 20% of the value of MI’s assets will be lost in
bankruptcy costs. Assume also that MI issues debt of face value $130 million
due next year and uses the proceeds to repurchase shares.
b. What is the cost of debt? Why? (4 marks)
c. What is the yield to maturity? Is it the same as the cost of debt? Why?
(5 marks)
d. What is the new price per share? Why? What is the new number of shares?
(6 marks)
Suppose now that another of the assumptions of Modigliani and Miller does
not hold: there is a corporate tax rate of 35%.
e. Without doing any calculation, how will the existence of taxes affect the
calculation of the new price per share? Will it be higher, lower, the same as
your answer in d.? Discuss. (5 marks)
a. To calculate the price we first estimate expected value as follows:
1 3 (100 ) + 1 3 (150 ) + 1 3 (191) +
=VU = $140 million
1.05
Price per Share = $140M / 10 million shares = $14.00.

b. The cost of debt is 5% because the risk of cash flows is diversifiable, so
investors demand no extra compensation for risk.
c. The yield to maturity corresponds to the interest rate that equates
expected value of debt (market value) to its face value. We first have to
calculate the expected value of debt as follows:
18
Value of MI’s debt:

1 1 1
∗ (100(1 − 0.20)) + ∗ (130) + ∗ (130)
3 3 3 = 107.9365
debt =
1.05
YTM = – 1 = .20442 or 20.44%. No, reflects probability of bankruptcy

and loss in value.
d. To calculate the new price per share we first recalculate the value of
equity taking into account the bankruptcy instance.
Value of MI’s equity:
1 1 1
∗ 0 + ∗ 20 + ∗ 61
L = 3 3 3 = 25.71429
1.05
Total Value = VL + Vdebt = $25.71429 + $107.9365 = $133.6508

million.
Price per Share = $133.65M / 10 million shares = $13.365.
Shares repurchased: 130/13.365=9.73. New number of shares:
10 – 9.73 = 0.27.
e. The price will be lower because with taxes part of the value is
appropriated by government.
Question 6
Acquirer Co (AC) has earnings per share of $4. It has 1 million shares
outstanding, each of which has a price of $40 per share. AC is thinking of
buying Target Limited (TL), which has earnings per share of $2, 1 million shares
outstanding, and a price per share of $25. AC will pay for TL by issuing new
shares. There are no expected synergies from the transaction.
a. Assume first that AC pays no premium to buy TL. What are the earnings per
share of the merged firm after the transaction? (5 marks)
b. Explain the economic rationale behind the change in the earnings per share
(EPS) of TL before and after the merger in point (a). Are the shareholders
of AC any better or worse off after the merger? Carefully discuss your
arguments. (5 marks)
c. What will the price-earnings ratio (PE) be after the merger when AC pays no
premium? How does this compare to the PE ratio of AC before the merger?
Are the shareholders of AC any better or worse off after the merger?
Carefully discuss your results. (5 marks)
d. Your DCF calculations indicate that TL should be trading at 28 per share,
what would be an appropriate premium that AC should pay for TL? Carefully
discuss your results. (5 marks)
e. Explain the free rider problem in the context of takeovers as in Grossman and
Hart (1980). (5 marks)
a. There are no expected synergies from the transaction; hence the new
earnings of the firm are just the combined earnings of the previous
stand-alone companies. Because TL shares are worth 25 and AC shares
are worth 40, AC will have to issue 25/40 (= 5/8) shares per share of
19
TL to be able to buy it. That means that, in the aggregate, AC will have
to issue 5/8*1 million = 625,000 new shares. After the merger, there
will be 1,625,000 shares outstanding and the total earnings will be
5 million. Thus, the new EPS (earnings per share) will be 6 million /
1625 million = 3.69.
b. The economic rationale can be best understood as follows. In point (a)
the change in EPS simply came from combining the two companies.
One is worth 4 per share and the other is worth 2 per share. However,
a reduction in the EPS of the shareholders of AC need not mean that
they did a bad transaction. Although the shareholders of AC end up
with a lower EPS under the transaction, they have paid a fair price,
exchanging their 4 per share before the transaction for either lower, but
safer EPS after the transaction, or lower EPS that are expected to grow
more in the future. Either way, focusing on EPS alone cannot tell us
whether the shareholders of AC are better or worse off.
c. If AC pays no premium that means, as stated in the problem that
there are no expected synergies. Hence, if we simply combine the two
companies and there are no synergies as indicated, then the total value
of the company will be 40 + 25 = 65 million. The merged firm has
earnings totalling 6 million, so that the PE ratio is 65/6 = 10.83. The
PE ratio of AC before the merger was 40/4 = 10 and TL’s was 25/2
= 12.5. To determine whether shareholders of AC are any better or
worse, recall, just as in Part b, that simply focusing on metrics such
as the PE ratio does not tell anything about whether shareholders are
worse or better off. The PE ratio of AC went from 10 to 10.83, but
shareholders are no better or worse off.
d. An appropriate premium can be calculated based on the price at which
other companies are selling. In particular, if other companies are selling
at 28 per share, then a starting point for the premium to pay would be
28/25 = 12% premium.
e. The free-rider problem in the context of Grossman and Hart can be best
explained as follows. The efficiency gains from a valuable takeover are
a public good: all existing shareholders want the takeover to occur as
it increases value, but for the same reason none of them will want to
tender their shares because they want to appropriate the increase in
value. In other words, shareholders would like to free-ride on others to
sell the shares so they can obtain the value gains. The raider will then
have to bid for the shares the original price plus the expected increase
in value in shares making it extremely difficult for takeovers to occur in
practice unless raiders have a pre-existing toehold of shares or there is
a freeze out rule etc.
Question 7
Carrie International (CI) is considering entering the shoe business in the US. The
manager of CI believes that there exists a very narrow window for entering this
market. Because of the Christmas demand, the time is right to invest is either
today or exactly a year from now. Other than these two opportunities, there is
no alternative opportunity to break into this market.
It will cost CI £35 million to enter the shoe market. Because other shoe
manufactures exist and they are public companies, the manager of CI reckons
that the current value of a comparable shoe company is £40 million. The
manager of CI also reckons that 15% percent of the value of the firm is
attributable to the value of the expected free cash flows in the first year of
operation.
20
The flow of customers is uncertain, and so is the value of the shoe company. The
volatility of the expected firm value is 25% per year. The risk free rate is 4%.
a. What is the expected value for CI of entering the shoe business this year?
(4 marks)
b. What is the value of the option to wait to enter the shoe market next year?
When should CI enter the shoe business? (8 marks)
c. How should the decision of CI change if the expected value of the shoe
company is £36 million instead of £40 million? (8 marks)
d. Without doing any calculation, explain how would your decision change if the
volatility of the expected firm value is 50%? If the window for entering is not
1 year but 2 years? Explain your answer in the context of call option pricing
(5 marks)
a. The value of investing today corresponds to the difference between the
value of a comparable company and the costs: 40 – 35 = 5.
b. We apply the Black-Scholes formula, First we adjust the value of the
sales during the first year. S^{*} = S – PV(Cash) = 40 × (1 – 0.15).
that the option last for a year we calculate the constants: d1 = 0.1659,
d2 = 0.0841. Plugging the information in the formula we have that
the value of the call option (and the value of waiting) is C = 3.54. The
value of the option is lower than that of investing today (i.e., 3.54 < 5).
Hence Carrie International should not wait.
c. We follow the same procedure as that in point b but now the expected
cash flow is 40 as opposed to 36. First we adjust the value of the
sales during the first year. S^{*} = S–PV(Cash) = 36 × (1 – 0.15).
that the option last for a year we calculate the constants: d1=0.2555,
d2= – 0.5055. Plugging the information in the formula we have that
the value of the call option (and the value of waiting) is C = 1.90. It is
thus more valuable to enter now (1.90). There is no value in waiting.
The value of investing today is now 36 – 35 = 1 which is lower than
the value of waiting. Hence they should wait.
d. Because as seen in class and as explained in the guidebook the value
of a call option is increasing in volatility and time, the value of waiting
also increases with volatility and time.
21
Question 8
Pepso is a well-established company that sells apple juice, the value of the
assets in place is 100 and it has no leverage. The CEO of Pepso is considering
entering into the pear juice business. The net cost to the firm of entering this
business is 10 (i.e., the costs exceed the benefits by 10), and the private benefits
to the CEO of this business equal 1.5. The CEO owns 5% of the company and the
discount rate is 0.
a. Find the NPV of investing in the pear juice business for the firm and the CEO.
Would the CEO invest in the pear juice business if Pepso had enough internal
resources? (5 marks)
The board of Pepso meets to discuss how to use financial policy to align
management interests. They ask you to provide an alternative capital
structure that can discipline the manager.
b. What is the minimum level of debt that aligns CEO preferences to those
of the board? Assume that in the recapitalisation the CEO shares are not
tendered, and that outside investors are naïve such that they do not infer any
potential agency conflicts from the financial policy of the firm. (6 marks)
Assume that Pepso’s board decides to follow your advice and recapitalizes
the company. The board decides to issue debt with face value of 70, and use
the proceeds to buy back shares.
c. What is the new equity stake of the CEO in the firm? (3 marks)
After the share repurchase, Pepso’s main competitor, Appleok, decides
to launch an aggressive competitive attack. The Head of research and
development at Pepso comes up with a counterattack move that involves
investing in a new and risky technology of apple juice production, which
in case of success can stop the attack, and increase the value of the assets
in place to 150. In case of failure the value of the assets in place decreases
to 80. The probability that the technology is successful is 0.5. Investing in
the technology has a cost of 20. Pepso must raise external equity finance to
invest in the technology. You are hired by Pepso’s board to structure the deal.
d. What is the equity stake that an outside investor will require in exchange of
the investment cost of 20? (6 marks)
e. Explain the concepts of debt overhang and risk shifting (5 marks)
a. We need to compare the NPV of the business with the outside option
of the firm which is to derive value from the assets in place. For the
CEO it is important to recall that he has private benefits from the pear
investment.
NPV(pear project)= 100 – 10 = 90 ≤ 100 = Value Assets in Place
NPV(pear project) for CEO = 5%(100 – 10) + 1.5 = 6 ≥ 5 = 5%
(Value Assets in Place)
Given our calculations above, we conclude that: yes, the CEO will
invest because his benefit of investing is higher than the value of his
stake of the assets in place.
b. The board would like to issue debt with face value of D and use the
proceeds to buy back shares, in order to discipline the manager.
Because investors are naïve the recapitalisation does not change the
value of the assets in place. The new equity stake of the CEO, after the
recapitalisation can be calculated as:
22
5
5%(100) = α%(100 − D) → α% =
100 − D
The minimum value of debt for the CEO not to invest in the pear
project is defined by the following inequality, where the value to the
CEO of the project (after the recapitalisation) is forced to be lower than
the value of the assets in place
NPV (pear project) for CEO with recapitalization ≤ 5

5
(90 − D) + 1.5 ≤ 5
100 − D
D ≥ 66 .67
c. The equity stake of the CEO corresponds to the number of shares he
started out with divided by the new number of shares, which is smaller
because some of the shares have been repurchased as part of the
recapitalisation.
5
= = 16.67%
100−70
d. The outside investors just desires to break even, so we use the break
even condition to price the debt:
[0.5 ∗ 0 + 0.5 ∗ (100 − 70)] = 20

20
= > 1
15
The equity stake is prohibitive (i.e. higher than 1), which means that
Pepso cannot invest in the technology. The problem here is one of debt
overhang.
e. The concepts of risk shifting and debt overhang are as follows: An
equity stake in a levered firm corresponds to a call option on the cash
flow of the firm with strike equal to the face value of debt. This implies
that if given the chance, shareholders will always pick risky over safe
projects, even if detrimental for firm value, as they are not really
affected by the downside but have extraordinary potential gains from
the upside (in detriment of debtholders). This tendency of shareholders
is known as risk-shifting or asset substitution. One potential solution
is financial restructuring where the face value of debt is reduced.
Shareholders in a firm may forgo positive NPV projects if they have
23

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Examiners’ commentaries 2012

Examiners’ commentaries 2012

Information about the subject guide

Format of the examination

Planning your time in the examination

time permitted, due either to inappropriate study and revision strategies

Select your material carefully

Structure your argument

Key steps to improvement

Updating of Essential reading

Examiners’ commentaries 2012

Information about the subject guide

Comments on specific questions

is higher than the value of an unlevered firm by the present value of

c. Suppose you observe that today’s price-to-dividend ratio forecasts

Approaching the question

Solve for P+ Solve for P

receiving P+ we would get 0 whereas P+=11.757 so we do not exercise

2012 2013 2014 2015 2016

Black-Scholes’ option pricing formula

Capital Assets Pricing Model (CAPM)

Proposition II (no tax): Re  Ra  Ra  Rd 

Proposition I (with corporate tax): V L  VU  Tc D

Proposition II (with corporate tax): Re = Ra + (Ra − Rd ) (1 − Tc)

Examiners’ commentaries 2012

Information about the subject guide

Comments on specific questions

low as it is an inefficient firm. If the raider can secretely acquire a lot of

Approaching the question

or negative NPV. The intuition is that if equity chooses a more volatile

Solve for P+ Solve for P

2012 2013 2014 2015 2016

Black-Scholes’ option pricing formula

Capital Assets Pricing Model (CAPM)

Proposition II (no tax): Re  Ra  Ra  Rd 

Proposition I (with corporate tax): V L  VU  Tc D

Proposition II (with corporate tax): Re = Ra + (Ra − Rd ) (1 − Tc)

This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON FN3092 ZA

Tuesday, 14 May 2013 : 2.30pm to 5.30pm

A list of formulas is given at the end of the paper.

PLEASE TURN OVER

© University of London 2013

© University of London 2013

© University of London 2013

© University of London 2013

(a) What is the NPV of this project? (4 marks)

© University of London 2013

Capital Assets Pricing Model (CAPM)

Proposition I (no tax): VL  VU

Proposition II (no tax): Re  Ra  Ra  Rd 

Proposition I (with corporate tax): VL  VU  Tc D

Proposition II (with corporate tax): Re  Ra  Ra  Rd 1  Tc 

© University of London 2013

This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON FN3092 ZB

Tuesday, 14 May 2013 : 2.30pm to 5.30pm

A list of formulas is given at the end of the paper.

PLEASE TURN OVER

© University of London 2013

(c) Are these anomalies consistent with market efficiency? (8 marks)

© University of London 2013

© University of London 2013

(a) What is the NPV of this project? (4 marks)