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(1) p =
1
N2
i =1
2
i
1
N2
ij
i j
92 Corporate finance
(2 ) p =
N 2 N ( N 1)
1 2
1
+
C= + 1 C
2
2
N
N
N
N
Some key points that you might want to discuss would be as follows:
i. The acquired firms value will increase if the takeover is successful. The
gain is z.
ii. The equity of the acquired firm is held by many, small
shareholders.
iii. The acquiring firm pays a premium p and incurs a cost of takeover, c.
iv. Acquiring firm will take over the acquired firm provided that z > p + c.
v. But a minority shareholder will only be willing to sell his/her shares if
p > z; if thats not the case, he/she will wait for the others to sell their
shares and enjoy the free-ride to see his/her equity rise to value at z.
vi. As long as none of the minority shareholders perceive themselves to
be pivotal, everyone will free-ride on the improvement of the value
offered by the acquiring firm.
vii. Given that, the bid will fail.
b. Outline the arguments for the agency cost on debt. Explain how the use of
convertible bonds might mitigate the agency conflict between equity-holders
and debt-holders in financially distressed firms with high debt to equity ratios.
(15 marks)
Reading for the question
Subject guide, pp.11218.
Approaching the question
Key points:
i. The agency costs on debt arise in two folds:
a. The value of debt decreases due to sub-optimal managerial decision
b. Debt-holders impose more measures on corporate governance
structure and restrictive clauses in the debt covenants to safeguard
their interests.
ii. These costs rise as more debts are issued
iii. If corporate managers are not looking after the debt-holders interests,
then there might be cases when a firm might be over-investing in risky
projects in the expense of debt-holders, under-investing when small
but safe NPV projects are passed, and swapping for more risky projects
once a loan is obtained
iv. Convertible bonds might help mitigate these problems when the debtholders perceive that their interests are not being protected and risks
are being shifted from the shareholders to them.
Question 3
a. Explain clearly the 3 main conditions for debt to work effectively as a signal
of a firms value.
(9 marks)
Reading for the question
Subject guide, pp.11920.
Approaching the question
Many candidates simply reproduced the material from the subject guide
without clearly identifying and explaining those three key conditions.
The subject guide outlines the Ross model (1977) but what you need is to
understand how those equations in the model work. In general, there are
three key conditions:
3
92 Corporate finance
i. The market is adhering to the semi-strong form efficient but not strong
form. A firms true value is therefore not observable.
ii. Good quality firms have high future cash flows and low quality firms
do not. Good firms can issue relatively high percentages of debt and
still comfortably service the high interest payments.
iii. The penalty for the managers of a low quality firm to lie about its value
by issuing temporarily high levels of debt would need to outweigh the
benefit that those managers might derive from the short-term rise in
the firms value.
b. Critically assess the empirical evidence for the semi-strong form of market
efficiency.
(10 marks)
Reading for the question
Subject guide, pp.8183.
Approaching the question
To tackle this question, you should highlight the key points relating to the
testing of semi-strong form efficient markets. Some of the key points can
be summarised as follows:
i. The test for semi-strong form efficiency is about how fast and accurate
information from an event can be incorporated into prices.
ii. Identify a sample of firms for a particular event.
iii. Measure the ex ante expected return of each firm.
iv. Construct the average abnormal return by comparing the actual
average return to the average expected return.
v. The cumulative abnormal returns before and after the event is then
examined.
To improve the quality of the answer, you should provide a discussion
on the empirical evidence. For example, Asquith and Mullins (1983)
suggested that information incorporated within 510 minutes and share
prices moved up on unexpected dividend announcements. It seems to
suggest that such a market is adhering to the semi-strong form efficiency.
However, Ball and Brown (1968) argued that unexpected earnings may
not be fully incorporated in stock prices. This seems to suggest that
empirical evidence for or against market efficiency might be period
specific and methodology dependence.
c. Explain why Net Present Value is a better investment appraisal technique
than Internal Rate of Return.
(6 marks)
Reading for the question
Subject guide, pp.1819; BMA, Chapter 5, pp.13743.
Approaching the question
This part was generally quite well answered. The key points that should
be discussed are:
i. IRR does not account for the size or magnitude of the project. It is not
a good tool to rank projects.
ii. Cost of capital may vary over time but IRR assumes that any spare cash
can be re-invested at the same rate. This might not be realistic.
iii. IRR is not additive and therefore the total IRR of all projects need
to be re-computed. NPV has an additive property and therefore the
combined effect can be determined easily.
Question 4
a. Explain, with the aid of a diagram, why a firms dividend policy is independent
from its investment policy in a perfect and complete market. You should
include a discussion of the Fishers Separation Theorem in your answer.
(10 marks)
Reading for the question
Subject guide, pp.914.
Approaching the question
In a perfect and complete capital market where there is no transaction cost
and information is widely available to everyone, it is argued that a firms
investing, financing and dividend decisions are not interlinked. This can be
illustrated in the following diagram.
W1
B
Individual 1
y1
C1*
A
C0*
y0
Individual 2
W0
C0
92 Corporate finance
b. Using the arguments for the signalling and tax clientele effects of dividends,
to what extent would you conclude that dividend policy is relevant to
corporate value?
(15 marks)
Reading for the question
Subject guide, pp.12932.
Approaching the question
This question requires candidates to carefully explain the signalling
effect and the tax effect of dividend policy. A good answer should
provide a balanced view on how a change of dividend policy might
affect a firms value based on these two theories.
Some of the key points which might be discussed are as follows:
i. Discuss the stylised facts of dividend by Lintner (1958).
a. Some kind of target payout ratio
b. No change to dividend payout unless it is sustainable
c. Short term increase in earnings does not necessarily prompt
managers to increase payout.
ii. Market is not consistent with the strong form and the quality of a firm
is not observable; and hence dividend may serve as a signal.
iii. Unexpected rise in dividend may indicate that a firm has a better
ability to generate future cash flows. Its value will rise accordingly. On
the other hand, an unexpected dividend cut may signal the financial
problem a firm is facing. Share price may fall as a result.
iv. Tax shareholders pay different marginal tax rates on dividend income
and capital gain. Therefore those who have a higher tax rate on capital
gain would prefer firms to pay a higher dividend while those who pay
a lower capital gain tax will prefer the firms to pay a lower dividend.
v. However, the tax clientele effect will disappear in equilibrium. The no
arbitrage ensures that any difference in value of firms with different
payout ratios will disappear.
Section B
Answer one question from this section and not more than a further
two questions. (You are reminded that four questions in total are to be
attempted with at least one from Section A.)
Question 5
a. Tiger plc has the following projects:
Projects
A
B
C
D
Initial Investment,
NPV (after tax),
100,000
10,000
150,000
25,000
75,000
5,000
50,000
6,000
92 Corporate finance
Initial Investment,
100,000
150,000
75,000
50,000
PI
1.10
1.17
1.07
1.12
Ranking
3
1
4
2
(100,000)
Revenue
4
20,000
300,000
300,000
300,000
300,000
(250,000)
(262,500)
(275,625)
(289,406)
50,000
37,500
24,375
30,594
(7,500)
(5,625)
(3,094)
3,478
(100,000)
42,500
31,875
21,281
34,072
DF
0.909
0.826
0.751
0.683
PV
(100,000)
38,633
26,329
15,982
23,271
50,000
37,500
24,375
30,594
(25,000)
(18,750)
(14,063)
(42,188)
25,000
18,750
10,313
(11,594)
7,500
5,625
3,094
(3,478)
Costs
NCF before tax
(100,000)
Tax
NCF after tax
NPV
NCF = Taxable profit
Capital allowances
Taxable profit after CA
Tax (@30%)
4,215
ii. Non cash items should not be included in the NPV calculations. You
should also clearly mention why those non cash items should be
excluded from the analysis.
iii. Capital allowance must be calculated in accordance with the rule given
in the question.
Year
0
Written down value
100,000
Capital allowance
75,000
56,250
42,188
25,000
18,750
14,063
42,188
Part (ii) requires candidates to re-work the NPV if the project is to defer by
one year.
Year
0
Machine
360,000
360,000
(330,750)
(347,288)
45,000
29,250
32,713
(6,000)
(3,150)
7,061
(100,000)
39,000
26,100
39,774
0.909
0.826
0.751
0.683
(90,900)
32,214
19,601
27,165
Tax
1
PV
(11,919)
20,000
360,000
(100,000)
(315,000)
costs
NPV
(100,000)
Revenue
DF
100,000
45,000
29,250
32,713
(25,000)
(18,750)
(56,250)
20,000
10,500
(23,538)
6,000
3,150
(7,061)
75,000
56,250
25,000
18,750
56,250
Assumptions:
i. We assume that the machine will be purchased in one years time if the
project is to be deferred. The resale value remains the same by the end
of year 4.
ii. The annual cost will still rise at 10% per annum.
iii. The firm will only (potentially) engage in this project if the good state
of the economy is realised.
Since there is a 50% chance that the good state of the economy will
realise, the expected NPV of deferring the project until year 2 is 5,960
(0.5 11,919). The deferment is not advantageous.
92 Corporate finance
Question 6
a. The last 5 years returns on Vjay plc and on the broad market index are as
follows:
Year
Vjay, %
Market, %
2010
2009
2008
10
2007
13
10
2006
14
15
If the risk free rate is expected to be 3% per annum in the foreseeable future,
estimate Vjays beta using the covariance method and its expected return
according to the Capital Asset Pricing Model (CAPM).
(10 marks)
Reading for the question
BMA, Chapter 7, pp.20205 (especially Table 7.7).
Approaching the question
This is a straightforward textbook type question.
I
II
III
IV
VI
VII
Vjays rtn, %
Markets rtn, %
I - mean
II - mean
III2
IV2
III x IV
2010
2009
2008
2007
2006
2
0
10
13
14
5
2
7
10
15
Sum
Mean
Variance
Covariance
Standard deviation
Beta = Cov/Var(M)
Expected return
35
7
25
5
Year
9
7
3
6
7
10
7
2
5
10
81
49
9
36
49
100
49
4
25
100
90
49
6
30
70
224
278
245
56
69.5
61.25
7.48
61.25/69.5
0.88
4.76
rx = 0.2 + 2 F1 F2 = 5%
ry = 0.16 + 4 F1 + 2 F2 = 7%
rz = 0.1 + 1F1 + F2 = 9%
i. Determine the portfolio weights you need to place on x, y and z in order
to replicate the portfolio returns on F1 and F2 respectively.
(10 marks)
Reading for the question
Subject guide, pp.4850.
Approaching the question
Let w1, w2, and w3 be the weights in x, y and z respectively.
Forming the first factor loading, we have:
1. w1 + w2 + w3 = 1
2. 2w1 + 4w2 + w3 = 1
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8.34
3. w1 + 2w2 + w3 = 0
We can either solve the three equations simultaneously using a matrix or
solve each pair of equations at a time.
(2) (3) => 3w1 + 2w2 = 1
(2) (1) => w1 + 3w2 = 1
=> w2 = 2/7
=> w1 = 11/7
=> w3 = 9/7
Forming the second factor loading, we have
1. w1 + w2 + w3 = 1
2. 2w1 + 4w2 + w3 = 0
3. w1 + 2w2 + w3 = 1
=> w2 = 1/7
=> w1 = 3/7
=> w3 = 2/7
ii. The return on Stock M is known to follow the factor model below rm = 0.5
F1 + 1.5F2. It is currently traded with a return of 10%. Explain if any arbitrage
opportunity arises in this case.
(5 marks)
F1 = 0.43r1 + 0.417r2 + 0.194r3 = 0.43 5 +0.417 7 + 0.194 9 = 2.515
F2 = 0.333r1 + 0.667r3 = 0.333 5 + 0.667 9 = 4.338
rm = 0.5 F1 +1.5F2 = 0.5 2.515 + 1.5 4.338 = 4.492
Since the return based on the factor model is well below the
observed return (10%), an arbitrage opportunity seems to exist.
However, if the factor representation is not a true model, then such
a price difference might not be reconciled.
Question 7
Blue Shark plc, a quoted company in the UK, is considering a takeover of Black
Seal Ltd. Both companies are 100% equity financed. The following information is
available for these two companies:
Blue Shark
Number of shares
Black Seal
10,000,000
1,000,000
10
Not available
0.8
Share price
Dividend per share (latest)
You discover the following additional information:
i. Black Seal Ltd. has been paying a constant dividend for the last 5 years to its
shareholders.
ii. The Directors of Black Seal have been using a discount rate of 15% to
appraise its projects.
iii. It is believed that if the takeover is successful, Black Seals dividend per
share will grow at 10% per year.
[For the full question, please refer to the Examination paper.]
Reading for the question
BMA, Chapter 31, pp.82933.
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92 Corporate finance
Acquired
Acquiring
Advantages
Disadvantages
There is a liquidity
implication. Acquiring firm
needs to raise sufficient cash
flows for the acquisition.
Advantages
Disadvantages
Share exchange
Question 8
a. Mojito plcs share price, S, can either go up to SH or down to SL in the next
period. Derive the price of a call option written on S in terms of a position in
the stock and a risk free asset.
(7 marks)
b. Mojito plcs shares are currently traded at 10 each. Its share price is
expected to go up to 13 or down to 8 in three months time. The effective
interest rate for the next three months is 2%. What is the price of a call
option on Mojitos share with an exercise price of 10?
(5 marks)
c. Explain clearly why the price of a call option does not depend on the
investors risk preference and the probabilities of the future states of the
economy. Determine the risk neutral probabilities of the two states of the
economy in (b).
(13 marks)
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