Advanced Corporate Finance Student`s

1

AdvancedCorporate Finance

Assignment1

AdvancedCorporate Finance

Question2 Capital structure

Parta). Component of the firm’s capital structure

Thecomponents of the capital structure refer to the various sources offinance used by the firm. Even though the term is used for othercapital components, the majority think of debt to equity ratiowhenever the term capital structure blows across their minds.

Thecomponent of capital structure can be broadly categorized into twothat is, borrowed capital and shareholders’ equity. Borrowedcapital are external sources of finance to the firms. These types ofcapital are associated with fixed rate of interest though their costsare lower as compared to any other source of capital. The lenders ofthis capital bear a lower risk and therefore, the demand for lowreturns. Borrowed capital include debentures, long-term debt andalso public deposits.

Onthe other hand, Shareholders’ capital constitute the financescontributed by internal business owners who are commonly known as theshareholders. These type of capital include common capital,preference capital and the retained earnings. The providers of thiscapital require higher returns to compensate for the risk andtherefore, making it a bit expensive than borrowed capital.

Organizationof the components of the capital structure in the balance sheet

Theyare organized as shown in the balance sheet extract shown below

Balancesheet extract

Finance by

Shareholders’ capital

Common capital

xx

Preferred capital

xx

Retained earnings

xx

Total shareholders’ capital

xxx

Liabilities

Debentures

xx

Long-term debt

xx

Total borrowed capital

xx

Total capital

xxxx

Thecriteria used in organizing these components in the balance sheet isas provided in the Generally Accepted Accounting Principles (GAAP).The organizing principles requires that the firm should start bylisting that capital it owns internally. That is shareholders’equity should come first.

Partb). The relationship between the proforma balance sheet and proformaincome statement

Proforma balance sheet and pro forma income statement are importanttools that helps the managers in evaluating the general performanceof the firm. They are therefore, important when it comes to decisionmaking within the internal management of the firm. The maindifference between the two financial statements is that, the proforma balance sheet shows the financial position of the firm. It alsoreveals the net worth of the firm and the possibilities of solvency.On the other hand, proforma income statement shows the profitabilityof the firm. Therefore, the major criteria used in deciding whichelement will go to which statement is the purpose that it serves.That is, the element that are associated with profit generation(revenue and expenditures) will go to the income statement whilethose associated with capital structure and capital investment goesto the balance sheet.

Partc). Howthe various indenture provisions in a corporate debt contract mayinteract

Indentureprovisions refer to the agreement statement that are associated withdebt contract. The agreement helps to specify the terms andconditions of the debt and therefore, minimizing the chances ofconflict among the parties involved. The provisions in the indenturecontain rights and obligations of each party in the debt contract. Inthe case of bonds, it give provision over the convertible,collateral, call or put options among others. The overall provisionof indenture provision is therefore, to promote harmony among theparties involved in eliminating uncertainties.

Assignment2

AdvancedCorporate Finance

  1. What is the market value of debt for firms A and B?

  1. Required rate of return:

Marketvalue of debt = rf+ (rm+ rf

Whererfisthe risk free rate, rmis the risk of the market and ß is the market beta.

Requiredrate = 0.03 + (0.14 – 0.03)*1 = 0.14 (continuously compounded).

Therefore,market value of debt

Marketvalue = = = 394.22

Marketvalue of debt for firm A = market value of debt for firm B = 394.22

Marketequity = Value of the firm – Market value of debt

=1,000 – 394.22 = 605.78

  1. Instantaneous betas

Question2

Myers&amp Majluf (1984)

  1. Value

State 1

State 2

Assets-in-place

a = 200

a = 50

(Project NPV)

b = 25

b = 10

Wheres = 0, E = I = 25

VI= 0.5(200 + 25) + 0.5(50 + 10) = 142.5

Therefore,the old shareholders share of profit after issue = = = 0.825

Issue and invest

E = 25

Do nothing

E = 0

V state 1

0.824(200 + 25 + 25) = 206

200 = (a)

V state 2

0.824(50 + 10 + 25) = 70.04

50 = (a)

Thefirm should issue stock under state 2 to undertake the project.Issuing stock and investing under state 2 will help in achievinghigher value of the firm. And the fraction of the equity ismaintained at = 41.67%

  1. At 150

Wheres = 0, E = I = 150

Issue and invest

E = 150

Do nothing

E = 0

V state 1

0.824(200 + 25 + 150) = 309

200 = (a)

V state 2

0.824(50 + 10 + 150) = 173

50 = (a)

Thefirm should still issue stock under state 2 to undertake the project.Investing under state 2 will obtain the optimal value of the firm.And the stock price should be set at 0.75 × 150 = 112.5

Thefraction of the equity is = 40%

  1. Why and how the decision of the firm to invest will not only depend on the NPV but also on the investment amount

Mostfirms use NPV to measure the profitability and viability of thepotential projects. A project with higher positive NPV is preferable.However, it is not in all cases where profitable projects with highpositive NPV are given priority. There are other factors thatfinancial analysts in a firm needs to consider when assessing theprojects apart from the NPV. Such factors include the investmentamount. Firms should not accept projects that require hung investmentamount even if they have got a high NPV. This is because firms willonly be willing to invest in projects based on their financialconstraint. The new project should not have an impact on the capitalstructure of the firm. That is, the firm does not have to increaseits leverage ratio so as to finance a new project by borrowingfundsThe main insights of Myers and Majluf (1984)

Thekey insights of Myers and Majluf (1984) include the following

  • The undervalued stock may sell at a cost which exceeds b. If this is the case, then the firm should not undertake the project rather than issuing and investing in such projects.

  • Myers and Majluf (1984) also provides an insight on how firms should use alternative floatation techniques so as to minimize the information asymmetry.

  • The objective of the firm is to maximize the value of the shareholders’ claim in the long-run.

  • The values of a and b are known or can be estimated with certain

  • The firm will need to issue equity to raise finances of I dollars to support execution of the new projects.

Assignment3

ECO422 Advanced Corporate Finance

  1. ks = ρ + (1 – tc) (ρ + rf)

Whereksis the cost of equity

ρis the cost of unlevered equity

tcisthe corporate tax rate

rfis the riskless rate/risk free rate

Bis the value of equity in the firm and

Sis the value of debt in the firm

Thiscan also be expressed in terms of the cost of capital

ρ= rf+ (rm+ rfu

Whereis ßuthe beta of the firm which is also equal to the beta of the unleveredequity = beta of the assets.

  1. And the cost of levered capital Ks is given as

ks= rf+ (rm+ rfL

ßLis the beta of levered equity

  1. If the debt is riskless the condition here is that the cost of debt is the same as risk free rate. That is, kb = rf

Thisimplies that the new expression for the betas will be as follows

ßL= [1 + (1 – tc) ]ßu

  1. New balance sheet extracts

Scenario1

Balance Sheet

Assets

Liabilities

Debt

Equity

Scenario2

Balance Sheet

Assets

Liabilities

Debt

Tax

Equity

Theexpression for betas will be as follows

ks= rf+ (rm+ rfL

  1. If the debts were riskless,

ßL= ßUL[1 + (1 – tc)]

Question2

  1. Repeated

  2. Main insights of Jensen &amp Meckling (1976)

MichaelC. Jensen and William H. Meckling tried to integrate the key elementsin the theory of agency. In their model, they developed a ownershipstructure of the firm and the excess free cash flow problem. The keyinsight of Jensen and Meckling was to explain the principal – agentrelationship between the shareholders and the managers. Theshareholders contract the managers to undertake the role of operatingthe task of the firm on behalf of the principals. The managers as theagent are required to serve the best interest of the shareholders andmaximize the utility of the shareholders. However in some cases, themanagers may make decisions for the firm based on their personalinterest. This eventually results to agency problem that Jensen andMeckling (1976) referred to as the conflict of interest. They alsoexplained that the cost associated with the divergence of theinterest of the principals as the agency cost. The agent (manager)are required to bear full responsibility for this agency cost.

Apartfrom the monitoring and controlling cost incurred, these is alsoadditional expenditures incurred when deviations have been noticed bythe management. Jensen and Meckling also suggested that there is aneed for incentives for the managers to motivate them acting towardsaccomplishment of the organizational goals and objectives rather thanserving for their personal objectives. The theory of agency isconcerned with ownership structure and the conflicting interests ofthe managers and the shareholders or the debt holders. The conflictis much likely to occur for the firms that are highly levered thanthe ones with low leverage ratio. This is because the lenders mayacquire the holding of the firm and therefore, influencing the waythe company is managed.

Inthe case of excess free cash flow problem, Jensen argued that, firmsspend the excess money in a way that is not meant for valuemaximization of the firm and hence leading to agency problem. Theproblem also arise when the firm prefer using debt instead of equityto finance most of its activities.

Question3

Capitalstructure

Advantagesand disadvantages of debt financing

Debtis a fixed return source of capital and the interest rate is based onthe face value of the debt. It is raised from external sources andthe lenders are referred to as the debt holders. Debt as a sources ofcapital has got the following benefits attached to it

  • It involves lesser floatation cost than the equity finance

  • The interest expense attracted by debt is tax allowable and therefore it provides an interest tax shield that effectively makes the source of capital less costly.

  • Since the return are fixed, the lenders perceive low risk and therefore, they will demand lower compensation that results to lower costs.

However,the major disadvantage attached to this source of finance is theimpact on the capital structure. Debt will increase the insolvency ofthe firm since it is a liability. Also, the debt holders may obtainindirect control over the firm and therefore neglecting the votingright of the shareholders. This will eventually result into an agencyproblem as it was explained by Jensenand Meckling (1976).

Advantagesand disadvantages ofequity finance

Equityfinancing refers to the internal sources of capital. It is thecontribution from the owners of the company. Equity finance is themost common source of capital for majority of the firms. It is themost preferred source of capital since it increases the value of thefirm. Even if equity finance is more expensive source of finance ascompared to debt, it still has a benefit in that, the shareholdersstill remain with the controlling power and therefore there are nochances of agency problem or conflicting of powers between themanagers and the shareholders. With the equity finance being themajority, there would be no external party that would influence thedecision – making process within the firm. However one of the majordisadvantage of this source of capital is that equity finance isassociated with high cost due to high risk that is taken by theshareholders.

Question4

Assetsubstitution

CalamityCo.

Initialcost = 100

State

Placido

Jane

UU

200

0

UD

100

0

DD

200

500

  1. NPV Placido: {0.5[(0.5 * 200) + (0.4 * 100)] +0.4[(0.5 * 100) + (0.4 * 200)}

=122 – 100 = 22

NPVJane: 0.4(0.4 * 500) – 100 = -20

Therefore,Placido project will help to maximize the value of the firm.

  1. Yes Placido project can be financed with risk free, zero-coupon debt.

  2. If Placido project will be financed with a zero coupon debt then the value of debt should be 100 + 200 = 300

  3. If Calamity Co. obtains sufficient debt financing to fund Placido Jane’s project could be the best as it maximizes the value of Calamity due to less uncertainties associated with it.

  4. If Jane project was discovered by the public before Calamity obtains the debt to finance the project, then it means that the firm will not be in a position to raise sufficient capital to finance the project and therefore, it could become impossible to undertake this project.

Assignment4

Question1 (Mergers and acquisition)

Downprice, = 0.4 up price 0.5

State

Firm A

Firm B

Firm A&ampB

UU

200

100

400

UD

100

200

250

DD

0

100

150

debt

100

50

150

  1. Value of the firm

VoA=0.5[(0.5 × 200) + (0.4 × 100)] + 0.4[(0.5 × 100) + (0.4 × 0)] =90

VoB=0.5[(0.5 × 100) + (0.4 × 200)] + 0.4[(0.5 × 200) + (0.4 × 100)] =121

VoAB=0.5[(0.5 × 400) + (0.4 × 250)] + 0.4[(0.5 × 250) + (0.4 × 150)] =224

VoAB– VoA– VoB=224 – 90 – 121 = 13

Themargining decision of the above firms results to an increase in thevalue of the firm. That is, VoAB&gt VoA+VoB.However there is no synergy derived from combining the two firms andtherefore, the manager’s claim is not correct. The total synergy =-3 as shown below.

  1. Face value of debt in A 100 (million), face value of debt in B- 50 (million)

BoA=0.5[(0.5 × 100) + (0.4 × 100)] + 0.4[(0.5 × 100) + (0.4 × 0)] =65

BoB=0.5[(0.5 × 50) + (0.4 × 50)] + 0.4[(0.5 × 50) + (0.4 × 50)] =40.5

BoAB=0.5[(0.5 × 150) + (0.4 × 150)] + 0.4[(0.5 × 150) + (0.4 × 150)] =121.5

BoAB– BoA– BoB=121.5 – 65 – 40.5 = 16

Synergy

SoA=VoA-BoA=90 – 65 = 25

SoB=VoB-BoB=121 – 40.2 = 80.5

SoAB=VoAB-BoAB=224 – 121.5 = 102.5

SoAB-SoA-SoB=102.5 – 25 – 80.5 = -3

  1. Face value of the debt in firm A&ampB 150million. The face value of debt increases by 16 million dollars.

  2. No, the merger will not increase the total value of equity in the firm. This is because the increase in the total debt is higher than the increase in the value of the firms. That is debt value increases by 16 while the value of the firm increases by 13 and this means that the total equity will reduce by 3million dollars.

  3. A conflict of interest may arise between the shareholder, debt holders/bond holders and the society. This conflict will depend the on the benefits created by the merger decision and to whom the benefit is shared with. For instance, in the above case, we have seen that the surplus created is only adding more value to the total debt in the firm but there is no gain on the equity value. The primary objective of every investor is to maximize returns. However, in this case, the shareholders have been denied the benefit gained and therefore they might be against the merging decision of the firm. This conflict can be solved or mitigated by involving both the debt holders and the shareholders in the merging process and also negotiating for their value gain from the merger.

Question2

Grossmanand Hart (1980)

Themajor focus of the Grossman and Hart (1980) is on how the problem offree-rider excludes the external raider from acquiring or capturingthe surplus gained by the firm and the agency problem. Takeover bidsact as a disciplinary tool in the market place. Grossman and Hart(1980) are trying to find ways of mitigating the problem of takeover. The external raiders may take the opportunity of acquiring or takingover a firm when its value is lower than its potential value andimproves its stock valuation by changing the operations. However, thebig problem comes in deciding on who should receive the surplus. Theinsight of Grossman and Hart (1980) provides that the problem of thefree rider is to eliminate the external riders benefiting from theincreased value.

Intheir argument on the theory of corporation, Grossman and Hartsuggested that incumbent situation of management is insufficient.Corporate raider can raid a firm on extra cost and fire off theunproductive management after the take-over. The shareholders alsomay free-ride on the corporate rider and share the surplus made bythe raid shareholders. They can achieve this by retaining theirsecurities in the firm instead of selling them to the raider. Byretaining their shares, they will prevent the raider form capturingthe entire surplus generated from the raid.

Anotherinsight that Grossman and Hart (1980) are trying to put across isfact that the raider forced to bear the total cost of the raid butthe hold out problem does not allow them to capture the entirebenefit generated and therefore, they have to share the benefit. Freeriding may also be said that it is due to indivisibility problem. Forexample, a repetitive split of stock may cause an increase in thenumber of shares held by the shareholders but the total value of thefirm remains constants.

Question3 (Jensen (1986)

  1. Main insights of Jensen

Thekey insight of Jensen (1986) was to explain the principal – agentrelationship between the shareholders and the managers as a result offree cash flow problem problem. Managers spend excess money invarious ways that are not meant for adding value to the firm. Theshareholders delegate mangers the role of undertaking and operatingthe task of the firm on behalf of the principals. The managers as theagent are required to serve the best interest of the shareholders andmaximize the utility of the shareholders. However in some cases, themanagers may make decisions for the firm based on their personalinterest. This eventually results to agency problem that Jensen(1986) referred to as the conflict of interest. He also explainedthat the cost associated with the divergence of the interest of theprincipals as the agency cost. The agent (manager) are required tobear full responsibility for this agency cost.

Jensenemphasised on the impact of capital structure to the agency problem.The managers also increases the risk to the shareholders by usingdebt capital instead of equity. According to Jensen, debt restrictsmanager’s promise and hence, increasing the firm’s bankruptcyrisk.

  1. Comparing the main insights of Jensen (1986) with those of Myers &amp Majluf (1984)

Thebasic reasoning of Myers and Majluf, (1984) was on the pecking ordertheory. The theory is a combination of the terms in the informationasymmetry which was developed by Myers and Majluf, (1984) and theagency cost that was developed by Jensen (1986). Peking order theoryis essential to the firms especially when evaluating their financeprojects. When considering external sources of finance, firms willprefer debt rather than equity.

Themain difference between in their insights is that Myers and Majluf,(1984) suggests that debt is more preferable source of capital thanthe equity. Debt is the cheapest source of finance and firms will aimat using debt to finance their new projects. However, according toJensen (1984), increasing the leverage ratio in the firms will resultto agency problem. The debt holders may dilute the powers of theshareholders and hence increasing the agency cost. The managers arealso most likely to act for their own interest rather than that ofthe shareholders and thus increasing the agency cost.

Myersand Majluf (1984) also provides an insight on how firms should usealternative floatation techniques so as to minimize the informationasymmetry. On the other hand this is regarded as increasing theagency cost according to the Jensen’s argument.

Question4) Aspect corporate governance

Corporategovernance refers to the attempt of collaborating the interest of theshareholders to those of the managers and ensuring that companies areoperated in the interest of the shareholders. There is a need tomonitor the actions of the managers to ensure that they are notacting to serve their interest. This process of monitoring the actsof the managers in the organization is what we refer to the corporategovernance. Agency problem arises when the management acts towardsthe accomplishment of their individual objectives rather than thoseof the firm.

Corporategovernance involves hiring of external investigators and auditors tomonitor the conduct of the management. This may be challenging to theprofitability of the firm since it is an additional cost to the firmand thus making the process of corporate governance to be difficult.Also, corporate governance may imply a lack of trust to the managers,and this can eventually lead to a reduction in the morale of themanagers towards their duties.

Corporategovernance is intended to minimize the agency problem that may arisebetween the management and the shareholders. Therefore, in improvingthe corporate governance practices, the board of directors will berequired to develop strategies that will discourage the managers fromserving their own interest and instead focus on achieving theorganizational goal.

Question5) Dividends policy and modelling

  1. Refer to final exam F2011 Q 1 b)

  2. If the dividends irrelevance holds, it would invalidate the dividends growth modelling approach to valuing the stock of the firm. This is because the decision makers will need to assess the dividends’ policies in assessing the performance of the firm. A growth in the stock indicates a good performance of the firm.

  3. Circumstances that may invalidate dividends policy results by Modigliani &amp Miller’s

Ifthe performance of the firm is measured based on the stock’s value,then this situation will invalidate the dividend policy. For dividendpolicy to hold, itis assumed that financial markets operate in a perfectly competitiveindustry. However in most cases, this may not be the case because inmost circumstances, firms are faced by imperfect circumstances andhence invalidating the dividend policy.

  1. The Gordon constant growth dividend valuation formula

Vo=

Replacingrk with g – Gordon’s

Vo=(This expression is known as the Gordon’s model of growth.

Question6 (Optional)

Finalexam: F2004-kopi

ECO422 – Advanced Corporate Finance

Question1

  1. Beta of the firm’s equity

Expectedreturns rj:UsingCAPM equation

ρ= rf+ (rm+ rfu

  • 15 = 5 + (15 – 5)ßu

  • 15 – 5 = 10ßu

  • ßu = 1

Therefore,the beta of the equity of the firm = 1

  1. Projects cost of equity

WACC= wd*kd+ we*keWhere, wdisthe weight of debt = ,kdisthe cost of debt. Weisthe weight of equity = ,keisthe cost of equity.

Costof debt = 5% since it is riskless debt

  • 0.15 = 0.4*0.05 + 0.6* ke =&gt 0.15 – 0.02 = 0.6ke

  • 0.13 = 0.6ke =&gt ke = 0.13/0.6 = 0.2166667 = 21.67%

Therefore,the cost of equity for this project is 21.67%

  1. Project’s WACC if the expected rate of return = 16%

At16% required rate of return

WACC= wd*kd+ we*ke=0.4*0.05 + 0.6*0.16 = 0.116 = 11.6%

Question2

  1. Impact of the split

State

A&ampB

A

B

UU

1,100

900

400

UD

1,000

500

500

DD

900

100

1,000

Debt

800

400

400

  1. VoAB = 0.5[(0.5 × 1,100) + (0.4 × 1000)] + 0.4[(0.5 × 1000) + (0.4 × 900)] = 819

VoA=0.5[(0.5 × 900) + (0.4 × 500)] + 0.4[(0.5 × 500) + (0.4 × 100)] =505

VoB=0.5[(0.5 × 500) + (0.4 × 500)] + 0.4[(0.5 × 500) + (0.4 × 500)] =405

Gain/loss= (VoA+ VoB)-VoAB=505 + 405 – 819 = 91

Yesthere is something gained from the split, there is a gain of 19million dollars and therefore, the split is recommended.

  1. Impact of the split to the value of equity

eforesplit face value = 800

BoAB=0.5[(0.5 × 800) + (0.4 × 800)] + 0.4[(0.5 × 800) + (0.4 × 800)] =648

BoA=0.5[(0.5 × 400) + (0.4 × 400)] + 0.4[(0.5 × 400) + (0.4 × 400)] =324

BoA=0.5[(0.5 × 400) + (0.4 × 400)] + 0.4[(0.5 × 400) + (0.4 × 400)] =324

BoA+ BoBBoAB=324 – 324 + 648 = 0

Therefore,there is an impact on the value of equity after the split. Theintuition made here is that the split increases the value of equityby the full amount. That is the split increases the value of equityby the full 91 million dollars.

  1. Impact of the split to the value of debt

Beforesplit face value = 800

BoAB=0.5[(0.5 × 800) + (0.4 × 800)] + 0.4[(0.5 × 800) + (0.4 × 800)] =648

BoA=0.5[(0.5 × 400) + (0.4 × 400)] + 0.4[(0.5 × 400) + (0.4 × 400)] =324

BoA=0.5[(0.5 × 400) + (0.4 × 400)] + 0.4[(0.5 × 400) + (0.4 × 400)] =324

BoA+ BoBBoAB=324 – 324 + 648 = 0

Thereforethere is no impact on debt resulting from the split. The intuitionmade here is that the gain on value has an impact to the firm’sequity only.

  1. Conflict of interest

Theabove may result in a conflict of interest between the shareholdersand the bondholders. Shareholders are the owners of a firm while thebondholders are the lenders in the firm. In this case, the split offirm A&ampB may result to a conflict of interest since thebondholders are gaining nothing from the split while the onlybeneficiaries of the split are the shareholders. From the aboveworkings in part (a) and (b), we have seen that its only equity thatis gaining value from the split but debt is gaining nothing. Thisimplies that only shareholders are going to benefit from the split,but bondholders will not. Therefore, the bondholders are most likelygoing to oppose the split. The possible modification to support thedeal above is to come up with strategies for sharing the gains withthe bond holders. Bondholders will also need to be assured of thesecurity of their owings and also the credit rating of the newlycreated firm.

Splittingthe debt

Yesit is possible to split the debt between the two new firmsmaintaining the same market value of the debt in the new firms. Ifthe same conditions are maintained and the debt split into halfs,that, is 400 million for firm A and 400 million dollars for firm B,then the market values will be the same throughout.

Marketvalue of debt in firm A = market value of debt in firm B

Therefore,the corresponding equity values will be as follows

Equityin firm A = 505 – 324 = 181

&ampfirm B = 405 – 324 = 81

Question3

  1. Value

State 1

State 2

Assets-in-place

a = 200

a = 50

(Project NPV)

b = 20

b = 30

Wheres = 0, E = I = 100

VI= 0.5(200 + 20) + 0.5(50 – 30) = 100

Therefore,the old shareholders share of profit after issue = = 0.33333

Issue and invest

E = 100

Do nothing

E = 0

Vold state 1

0.333(200 + 20 + 100) = 106.67

200 = (a)

Vold state 2

0.33(50 + 30 + 100) = 60

50 = (a)

Thefirm should issue stock under state 2 to undertake the project.Issuing stock and investing under state 2 will help in achievinghigher value of the firm.

State 1

State 2

Assets-in-place

a = 200

a = 50

(Project NPV)

b = -20

b = -20

Wheres = 100 and E = I = 100

VI= 0.5(200 + -20) + 0.5(50 – 20) = 105

Therefore,the old shareholders share of profit after issue = = 0.0476

Issue and invest

E = 25

Do nothing

E = 0

Vold state 1

0.0476(200 -20 + 100 +100) = 18.1

200 = (a)

Vold state 2

0.0476(50 -20 + 100 +100) = 10.95

50 = (a)

Theoptimal use of debt is to issue 100 of debt and raise to undertakethe project under state 2.

  1. If the firm must issue a debt of 100, then it implies that the firm can full finance the project under the two states without raising additional stock.

  2. When a firm announces that it will repurchase equity, the market price of equity is expected to go up. This is because the most common purpose of repurchasing equity is to raise capital and therefore, the firm must repurchase equity at higher prices so as to achieve this objective.

Question4

  1. Corporate governance

Corporategovernance refers to the attempt of collaborating the interest of theshareholders to those of the managers and ensuring that companies areoperated in the interest of the shareholders. The primary goal of thefirms is to maximize the wealth of the shareholders. However, in somecases, managers may behave in a way that is contrary to what isexpected from them and therefore, creating what called agencyproblem. There is a need to monitor the actions of the managers toensure that they are not acting to serve their interest. This processof monitoring the acts of the managers in the organization is what werefer to the corporate governance. Agency problem arises when themanagement acts towards the accomplishment of their individualobjectives rather than those of the firm.

Corporategovernance plays a vital role in making intelligent decisions on howfirms are operated. Corporate governance involves adhering to therules and internal control of the business and more especially indecision-making process. It also acts as the underpinning on whichfirms must follow to achieve their goals.

TheEnacted Sarbanes-Oxley Act of 2002 provides that the corporatedirectors should be responsible to their principals who are theshareholders. This primary responsibility of the directors is knownas Fiduciary duty. The Act therefore, minimizes the possibilities ofconflict of interest.

Themost difficult governance duty of the board of directors is theimpeachment of the CEO of the company. This normally occurs when theboard representing the interest of the shareholders differs with thestrategic directions taken by the CEO. Corporate governance involveshiring of external investigators and auditors to monitor the conductof the management. This may be challenging to the profitability ofthe firm since it is an additional cost to the firm and thus makingthe process of corporate governance to be difficult. Also, corporategovernance may imply a lack of trust to the managers, and this caneventually lead to a reduction in the morale of the managers towardstheir duties.

  1. Recent failures of corporate governance

Failuresin corporate governance have been experienced day after the other inmost of the organizations across the world. One of the famousgovernance scandals that has been recently experienced is that ofCarly Fiorino, the former CEO of Hewlett – Packard commonly knownas HP. Her inability to deliver the profit that she had promised forthe company made her to be voted out by the board of directors. Shealso refused to undertake the suggested measures of the board and theshareholders and therefore decided to act on her own interest. Heractions led to a huge downfall of the stock prices and a reduction inthe company’s profit. For the company to solve this agency problem,Fiorino was fired and a new CEO was elected to replace her. With thenew reforms, the company was capable to recover its profitabilitywithin two years even though the price of share took a long time toits recovery. It is therefore clear that the board of directors haveauthority to exercise their powers and take relevant actions wheneverthey feel that the management is not adhering to the provisions ofthe corporate governance.

  1. Suggested improvements in corporate governance practices

Corporategovernance is intended to minimize the agency problem that may arisebetween the management and the shareholders. Therefore, in improvingthe corporate governance practices, the board of directors will berequired to develop strategies that will discourage the managers fromserving their own interest and instead focus on achieving theorganizational goal. The suggest measures to improve the corporategovernance practice may include the following

Useof market forces – Managerial competence and its value should bedetermined in the market and the shareholders should exploit thesemarket forces by using their voting rights to select the mostcompetent managers in the market.

Managerialincentive – this involves motivating managers to work honestly forthe best interest of the shareholders. Such incentives would be basedon the performance bonuses, executive stock options, etc.

Peggingremuneration to performance – Mangers should be compensated basedon the performance of the organization. This will help to ensure thatthey act to improve the general performance of the organization.

Directintervention by the shareholders – The shareholders during AGM mayprovide guidelines on how they may wish the management to be ruled.

Incurringagency cost – This in the cost incurred by the shareholders todiscourage the managers from their selfish interest. A good exampleof such cost include the internal audit which is essential inenhancing corporate governance.

Finalexam F2006

ECO422 Advanced Corporate Finance

Question1

rf=3%

rj=12%

WACCB= 20%

rm=10%

rj= rf+ (rm+ rf

Where,rfisthe risk free rate, rmis the risk of the market and ß is the market beta.

0.12= 0.03 + (0.10 – 0.03)*ß

0.09= 0.07ß =&gt ß = 1.2857

Andthe cost of equity of firm A = 0.03 + (0.2 – 0.03)*1.2857 = 0.2486= 24.86%

Question3

  1. Value

State 1

State 2

Assets-in-place

a = 400

a = 200

(Project NPV)

b = 50

b = 20

Wheres = 0, E = I = 150

VI= 0.5(400 + 50) + 0.5(200 + 20) = 335

Therefore,the old shareholders share of profit after issue = = 0.55

Issue and invest

E = 100

Do nothing

E = 0

V state 1

0.55(400 +50 + 150) = 330

400 = (a)

V state 2

0.55(200 + 20 + 150) = 203.5

200 = (a)

Also,when X = 50, the firm should still issue stock under state 2 andundertake the project. And the stock price should be set at 0.55 ×150 = 82.5

Thefraction of the equity is = 66.7%

State 1

State 2

Assets-in-place

a = 400

a = 200

(Project NPV)

b = -10

b = 20

Wheres = 0, E = I = 150

Issue and invest

E = 100

Do nothing

E = 0

V state 1

0.55(400 – 10 + 150) = 297

400 = (a)

V state 2

0.55(200 + 20 + 150) = 203.5

200 = (a)

Thefirm should still issue stock under state 2 to undertake the project.Issuing stock and investing under state 2 will help in maximizing thevalue of the firm. And the stock price should be set at 0.55 × 150 =82.5

  1. Equilibrium level

Bayesianequilibrium

E/V`=0.55 =&gt V`=E=540/150(200+20+150) = 1332

Therefore,this project cannot achieve equilibrium since the value is less than1332 in both states. There should be no situation when the value ofthe firm should be lower than 1332 as this is penalized as lowvaluation.

PerfectBayesian Equilibrium (PBE) provides that the firm is said to be off –equilibrium path if the value of the frim deviates from theequilibrium value. In determining the equilibrium status I have setthe P(state 1 : issue &amp invest) = 1 and the valuation was foundto be 370.

  1. Yes the firms decision depends on X. Investment decision are commonly based on the net present value. A project with higher positive NPV is preferable. However, it is not in all cases where profitable projects with high positive NPV are given priority. In some cases, there are other factors that financial analysts in a firm need to consider when assessing the projects apart from the NPV. Such factors include the investment amount. Firms should not accept projects that requires hung investment amount even if they have got a high NPV.

Question4

Therelationship between capital structure and agency problem

Thecapital structure of the firm plays a vital role when it comes to theagency problem. When mitigating the conflict between the shareholders(principals) and the managers (agents), capital structure influencesthe control rights in the lack of corporate governance. That is, thefirm with high leverage ratio or high debt to equity ratio may denythe shareholders the freedom of making critical decisions concerningthe corporate governance or how firm are being managed. A study hasproved that the control effect of gearing is normally confined tovarious forms of debt capital and depends on specific marketcharacteristics.

Thewealth effect of the firm from the borrowed capital may trigger themanagement to undertake an exclusive decision on expenditure and thuslevering the cash flow rights into a big control right. This leads toindirect holding and the lender have a larger control right over theoperations of the firm.

Therelationship between the capital structure and the agency problemtells us that debt capital plays an essential role in that it createsa dispersed ownership and thus restraining motives of control rightsand cash flow rights. The extent to which the debt capital createsjoint value is determined by the nature of the agency problem.

Agood example of a case where capital structure compromised with thecorporate governance is that of McConnell and Servaes (1995). It wasfound that bank related agreement leads to significant impact on thereturns of the firm. The bank (lender) took the greatest role incontrolling and monitoring the firm on behalf of the shareholders.The case revealed that there is a direct positive correlation betweenthe capital structure of a firm and the agency problem. Theunderlying agency problem is much common across those firms that arehighly geared and experience a separation of powers.

Thepresence of debt capital and the management nature of cash flowsright, and the controls right add up to determine the effect ofshareholder’s value and the influence on the agency problem. Theshareholders are reduced to a minority while the lenders become theholding or the controllers of the firm.

Finalexam: F2008

ECO422:Advanced Corporate Finance

Question2

  1. Value

State 1

State 2

Assets-in-place

a = 200

a = 50

(Project NPV)

b = 30

b = 20

Wheres = 0, E = I = 150

VI= 0.5(200 + 30) + 0.5(50 +20) = 165

Therefore,the old shareholders share of profit after issue = = 0.091

Issue and invest

E = 100

Do nothing

E = 0

Vold state 1

0.091(200 +30 + 150) = 34.58

200 = (a)

Vold state 2

0.091(50 + 20 + 150) = 20.02

50 = (a)

Ifthe firm can only issue stock to raise the capital to finance theproject, then state 2 will be more preferable. This is because itrequires less equity capital.

  1. If the firm can obtain both debt and equity to finance the project, then the optimal selection should be used 50 of debt and 45 of equity in state a and debt worth of 50 and 5 of equity.

State 1

State 2

Assets-in-place

a = 200

a = 50

(Project NPV)

b = 30

b = 20

Wheres = 100, s = 50, E = I = 150

Issue and invest

E = 100

Do nothing

E = 0

Vold state 1

0.091(200 +30 + 150 + 100) = 43.68

200 = (a)

Vold state 2

0.091(50 + 20 + 150 + 50) = 24.57

50 = (a)

  1. The firm should issue stock under state 2 to undertake the project. If the firm can obtain both debt and equity to finance the project, then the optimal selection should be used 50 of debt and 70 of equity in state a and debt worth of 50 and 17.5 of equity for optimality.

Question3

Howmoral hazards and agency problem arise

Jensenand Meckling’s (1976) attempts to provide an explanation in thearea of corporate governance and the agency theory. The scholars havetried to provide more description onto why such problems arise in thenode of contracts. They have also described some remedies on how theshareholders and the management should act to mitigate the problem.Jensen and Meckling developed a theory based on agency problembetween various contracting parties which involve the corporatemanagers, shareholders and the debt holders. They argued that aconflict of interests in organizations is inevitable and thereforeone should come up with prescribed measures of resolving suchconflicts.

Jensenand Meckling (1976) referred the concept of agency as therelationship binding two parties (principal and the agent) toundertake some roles on behalf. The shareholders who are theprincipal will delegate the role of decision-making to the corporatemanagement who acts as the agent. According to Jensen and Meckling,the agency problem results from lack of perfect contracting terms andconditions governing the agents on the welfare of the principle. Mostimportantly, there should be prescribed descriptions on how managersshould operate the organizations for the best interest of theshareholders. The managers are held responsible for the entire costthat may result from their failure or caused by pursuing their owngoals. Jensen and Meckling have also suggested that agency problemcan be minimized by offering some incentives to the managers. Thiswill help in maximizing on the decisions made by the managers andfocus on maximizing the profitability of the firm.

Moralhazards and agency problem may also arise due to lack of effectiveinternal control. Shareholders and the debt holders are required totake their responsibility by ensuring that managers are continuouslymonitored to ensure that they do not act to serve their own personalinterest.

Partb) Distinctionbetween exante andexpost situations

Ex-Anteis a Latin word that means ‘before the even’. The term is used torefer to the planned or predicted outcomes in an organization.Ex-ante analysis is important tool of management as it provides aclear view of ideas concerning future impact of the decision that themanagers are about to make or have made. On the other hand, ex-postis a Latin word that means ‘after the fact’. It is used to referto the actual outcome in the firm. The future outcome is developedbased on the historical trend.

Whenit comes to corporate governance, the incentives are establishedbefore entering into the agency relationship (ex-ante). However,after entering into the agency contract, the managers may misalignthe incentives set by acting for their benefit and hence end up withagency problem (ex-post). The shareholders are therefore required totake effective control measures to regulate the conduct of themanagers.

Knowingthe distinction between these two terms is important when it comes toenhancing corporate governance and managing moral hazards. Comparingthe planned and actual outcome helps the shareholders in assessingthe effectiveness of the management of the organization. Thecomparison will give revel the variances between the planned and theactual outcome. If these variances are unreasonable, then theprincipal who is the shareholders will seek an explanation of thesame from their agents (the management). The variances may show thatthe managers are acting contrary to the interest of the shareholderswho are their bosses. Negative deviations may also imply poorcorporate governance.

Partc) The financial and economic crisis

i)The capital crisis experienced by the firms included thefollowing capital wastage there was no optimal allocation of thecapital. Secondly there was also a lack of response to policies andregulatory within the firm. There was also a crisis when thecontraction in the financial industry and the presence of financialmarket turmoil. The Economic crisis was also experienced due to thehigh recession and depression in the real economy.

ii)The major cause of crisis described in this case is moral hazardsin financial institution leverage. Most firms are much levered whichleads to high risk due to severe asset distribution. The firms alsolacked solidity due to high risk and therefore, resulted in afinancial crisis. A moral hazard was also experienced failure of thefaked risk shifting. There was also a credit default obligations(CDO) and lack of adequate diversification.

Finalexam: F2009

ECO422 – Advanced Corporate Finance

Question1

Leverageand risk

a)As the percentage of leverage increases from 0% to 100%, the betaof debt increases while that of equity decreases. However, the rateof increase of the debt beta is lower than the rate of decrease inthe equity debt and therefore, the overall beta of the market loweras the leverage ratio increases from 0% to 100%.

b)As the betas of firm’s assets increases, the beta of debtreduces while the beta of equity increases.

c)When the beta increases while the risk remains unchanged, thevalue of the debt and equity also increases. This is because betaacts as a multiplicative factor in the equation determining the valueof the firm. On the other hand, if beta remains unchanged but therisk increases, the value of the debt will reduce while the value ofequity increases.

Question2

Corporategovernance and equity

a)Importance of writing contracts before establishing the principal– agent relationship

Thecontract in the principal – agent relationship contains aprescribed code of conduct that explain the roles of each party inthe agency contract. The expressed contract, therefore, provides aprecise description of how managers are supposed to operate theorganization. It describes the objectives of the organization and,therefore, helps in preventing managers from acting to serve theirinterest. Therefore, writing a contract before entering intoprincipal – agent relationship is important as it helps inminimizing the agency problem. The contract also provides anevaluation criterion that is used in assessing the efficiency andeffectiveness of the management. The shareholders who are theprincipal agree with the mangers on how they want their company to beoperated and in a case of deviations they are held liable for breachof contract.

b)Three important concept or issues in corporate governance

Oneof the most important concepts in corporate governance is the agencyproblem. Agency problem arises when there is conflicting interestbetween the shareholders (principal) and the managers (agent).Mangers are expected to run the organization on behalf of theshareholders. The primary objective of the managers is to maximizethe wealth of the shareholders. However, in some cases, managers mayact to serve their own and personal objective hence resulting to theagency problem.

Anotherimportant concept in the corporate governance is the capitalstructure. Capital structure refers to the various source of capitalthat a firm may use to finance its project. The major categories ofsources of finance to the firms are debt and equity. Debts are thefinances raised from the external sources while equity is raised frominternal sources. Equity is raised by the shareholders who are theowners while debt is obtained from the debt holders. A firm is saidto be highly levered if debt dominates its capital. Such firm iscontrolled by debt holders, and the shareholder has less power overthe decision – making the process of the firm, and, therefore,agency problem is more likely to occur.

Anotherimportant concept in corporate governance is the concentrationownership. This is an important concept in corporate governance as itplays a vital role when it comes to monitoring of the welfares of acompany. Jensen and Meckling also provided that concentration ofownership has a great influence on the corporate governance.

c)Corporate governance lessons from the financial crisis

Thefinancial crisis has been always experienced by firms due to theirpoor corporate governance. Firms with poor corporate governance lackcontrol of the management and, therefore, creating more chances offrauds and misconduct within the management. Some of the capitalcrisis experienced in this case included capital wastage. If thereare no good corporate governance, the managers and the workers aremore likely to misappropriate the capital of the firm, and therefore,there will be no optimal allocation of the capital. Whoever, withcorporate governance, the management will be monitored, and this willensure the most efficient use of resources and hence reducing theimpact of such crisis.

Anothercrisis that was discovered was the lack of response to policies andregulatory within the firm. There were also a crisis when thecontraction in the financial industry and the presence of financialmarket turmoil. Non-compliance with company’s policies andprovisions of regulatory bodies are due to the results of poorcorporate governance.

Themain cause of crisis described in this case is moral hazards infinancial institution leverage. Most firms are much levered whichleads to high risk due to severe asset distribution. The firms alsolacked solidity due to high risk and therefore, resulted in afinancial crisis. A moral hazard was also experienced failure of thefaked risk shifting. There was also a credit default obligations andlack of adequate diversification. Therefore, corporate governancecould help in minimizing the identified financial crisis andimproving the efficiency of the management.

d)Why the challenges in achieving good corporate governance varybetween companies, countries, and continents

Differentorganizations operate in the different environment and therefore, thechallenges faced by the organizations in achieving good corporategovernance also vary. Different countries and continents also havedifferent provisions for the corporate governance. However, agencyproblem has remained the same across the companies in all over theworld. In most cases, managers are found to act in a manner that isconflicting with the interest of the shareholders. The dilution ofownership concentration has left the shareholder powerless inmonitoring the decision-making of the firm. Institutionalshareholders have also shown a significant extent by which theyundertake to ensure the firms in which they have invested in aremanaged to the best of their interests.

Question3

Asymmetricinformation

a)Mimicking

i.Who is mimicking whom

Theassumption of asymmetric information provides that market isanonymous, and, therefore, the uninformed firms want to mimic theinformed firm to attain asymmetry of the information in the model.

ii.What is the motive behind mimicking

Themotive behind mimicking is to achieve asymmetry of information in themodel.

iii.Meaning of mimicking

Mimickingrefers to the process of following the decisions made by othersuccessful individuals or groups. Myers &amp Majluf explained theconcept of mimicking the process by which firms with bad prospectbridges the gap between them and the firms with a good prospect.

b)Signalling

i.Who wants to signal?

Thefirms with the good prospect and information want to signal to thepublic and other outside investors.

ii.What is the motive behind signaling

Themotive behind signaling is to attract more and more investors and beable to exploit the market before the mimicking companies comes torealize the potential.

iii.Meaning of signalling

Thesignalling means communicating the information to the investors. Ininvolve giving the outside a highlight of the performance of anorganization.

c)Reconciliation of mimicking and signalling

Theneed for asymmetric information, in the industry, creates anincentive to mimic high type and well-selling stocks in the openmarket. This, therefore, leads to a state of equilibrium whereby allfirms a capable of raising capital and investing in operations at thesame time. The asymmetric information, therefore, results to adecline in the value of best performing firms by increasing the costof investment. This leads to a delay in investment for good firmswhile bad firms speed up their investment due to the availability ofperfect information that they obtain through benchmarking with thesuccessful firms. Sinceasymmetryinformation increases the cost of external funds for good firms, theytries to separate themselves by imposing higher mimicking cost on thefirms performing poorly (bad firms). The process of mimicking andtrying to attain asymmetric information intends to achieveequilibrium in the industry.

Finalexam: F2010

ECO422:Advanced Corporate Finance

Question2 Myers&amp Majluf (1984)

State 1

State 2

Assets-in-place

a = 200

a = 100

(Project NPV)

b = 40

b = 20

Wheres = 0, E = I = 100

VI= 0.5(200 + 40) + 0.5(100 + 20) = 180

Therefore,the old shareholders share of profit after issue = = 0.444

Issue and invest

E = 100

Do nothing

E = 0

Vold state 1

0.444(400 +40 + 100) = 240

400 = (a)

Vold state 2

0.444(100 + 20 + 100) = 97.8

100 = (a)

Thefirm should therefore issue stock to raise the capital to finance theproject and state 1 will be more preferable. This is because it has ahigher NPV and it also helps in maximizing the value of the firm.

  1. Impact of the decision made in state 1 depends on probability p and 0 &lt p &lt 1

Ifstate 1 depends on the probability p, then this would influence thedecision made for this project. The firm`s value will also changedepending on the value of p.

Sinceprobabilities add up to 1,

Letthe probability of state 2 be x

Thisimplies that, p + x = 1

Makingx the subject of the formula

x= 1 – p

Andtherefore, the probability of state 2 will be 1 – p

Forthe firm to have obeyed the Bayesian law, there should be nosituation when the value of the firm should be lower than 133.33 asthis is penalized as low valuation. Perfect Bayesian Equilibrium(PBE) provides that the firm is said to be off – equilibrium pathif the value of the frim deviates from the equilibrium value. Indetermining the equilibrium status, I have set the P(state 1 : issue&amp invfest) = 1 and the valuation was found to be 540.

Question3

Jensenand Meckling (1976)

Howthe model of Jensen and Meckling (1976) explains how agency problemsarise for a 100% equity financed firm.

A100% equity financed firm means that the firm is wholly owned bythe-the shareholders, and therefore, the shareholders have the fullcontrol over the operations of the firm. The shareholders contractthe managers to undertake the role of operating the task of the firmon behalf of the principals. The managers as the agent are requiredto serve the best interest of the shareholders and maximize theutility of the shareholders. However in some cases, the managers maymake decisions for the firm based on their personal interest. Thiseventually results to agency problem that Jensen and Meckling (1976)referred to as the conflict of interest. They also explained that thecost associated with the divergence of the interest of the principalsas the agency cost. The agents (managers) are required to bear fullresponsibility for this agency cost.

Apartfrom the monitoring and controlling cost incurred, this is alsoadditional expenditures incurred when deviations have been noticed bythe management. Jensen and Meckling also suggested that there is aneed for incentives for the managers to motivate them acting towardsthe accomplishment of the organizational goals and objectives ratherthan serving for their personal objectives. The theory of agency isconcerned with ownership structure and the conflicting interests ofthe managers and the shareholders or the debt holders. The conflictis much likely to occur for the firms that are highly levered thanthe ones with low leverage ratio. This is because the lenders mayacquire the holding of the firm and therefore, influencing the waythe company is managed.

Thefigure below illustrates the explanation of Jensen and Mecklingargument on the

agencytheory.

Asit is indicated in the figure above, corporate governance involvesvarious theories such as agency theort, stakeholders/shareholderstheory, stewardship theory and institutional theory.

Jensenand Meckling’s (1976) attempt to provide an explanation in the areaof corporate governance and the agency theory. The scholars havetried to provide more description onto why such problems arise in thenode of contracts. They have also described some remedies on how theshareholders and the management should act to mitigate the problem.Jensen and Meckling developed a theory based on agency problembetween various contracting parties that involve the corporatemanagers, shareholders and the debt holders. They argued that aconflict of interests in organizations is inevitable, and, therefore,one should come up with prescribed measures for resolving suchconflicts.

Question4

Possiblereasons value that may be created by merging two firms

Mergersact as the main source of value creation for the firms. When the twomore firms combine, they became more capable of improving theircapability for extended growth. However, for the firms to achieveexpansion of its value, the merger must be between two or more firmswith some identifiable similarities, or the firms are having somerelationship.

Themain reason behind merging and acquisition of firms is the expansionof the operations. In simple terms, merging refers to the process bywhich two or more firms combines assets and operates together as onecompany. By this process, the firms are capable of expanding theiroperations by increasing their tender offer. Therefore, there shouldbe a similarity in the firms for it to be able to combine assets andcontinue with the similar extended productivity after the merger. Thefirms should be in the same industry for them to be able to combinetheir values after the merger.

Anotherreason behind mergers is the economies of scale. Economies of scalerefer to the ability of the firm to enjoy benefits of reduced costthat result from bulky production. When firms combine through theprocess of mergers, they are capable of producing their products andservices in large scale in a combined plant. However, for thisbenefit to be effective, the firms merging needs to have beenproducing the same product line. It is, therefore, very essential forthe merging firms to be in the same industry or having a relationshipfor them to derive high value from the merging activity.

Mergersand acquisition also help the firms concerned in combining effort incritical activities such as management, research and development,marketing, and financing. The merging companies are capable ofselecting the best performing managers from the two companies thathave combined to work together. The firms are also capable of hiringand maintain the most competent employees. However, as it wasmentioned earlier, the merging firms needs to have a relationship intheir operations for them to be able to increase their overall value.A good example of two related firms that successfully merged isbetween Volve and Geely in the year 2010. The two firms are in theautomotive industry, and they merged to acquire higher competitiveadvantage than they were before. The firms were also capable ofcombining their capital and the equipment to expand theirmanufacturing of cars.

Question5

Price= 0.5

t= 2

Andinitial cash outlay at (t = 0) = 100

  1. Determing the NPV

State

Project A

Project B

Project C

UU

300

0

160

UD

100

100

100

DD

0

300

0

Total value

400

400

260

NPV= Total present value of cash flows cash – the initial cash outlay.

Presentvalue of cash flows = CF(1 + r)-n

Assumingan interest rate of 10%

Presentvalue project A 400 × (1 +0.1)-2= 330.58

Therefore,the NPV of project A will be 330.58 – 100 = 230.58

Presentvalue project B 400 × (1 +0.1)-2= 330.58

  • The NPV of project B will be 330.58 – 100 = 230.58

Presentvalue project C 260 × (1 +0.1)-2= 214.88

  • The NPV of project C will be 330.58 – 100 = 114.88

ProjectA &amp B have the same net present value however, project B is morepreferable since its value is maximized with the optimal debtallocation.

Finalexam: F2011

ECO422:Advanced Corporate Finance

Question1

  1. Why a firms dividend policy may be irrelevant

Dividendspolicy may not be relent to the firm because

Thechanges in the dividend policy have no effect on the investmentpolicy of the firm. Secondly, the dividend policy is considered asirrelevant to the firm since it is assumed that financial marketsoperate in a perfectly competitive industry. Also, the dividendpolicy may be irrelevant to the firm because there are no personaltaxes, moral hazards or even asymmetry of information that isrequired.

b)Irrelevance of dividend policy as explained by differentresearchers

Modiglianiand Millers (M&ampM) described the irrelevance of dividend policiesto the firm. He argues that most of the assumptions made on dividendpolicies have no significant impacts on the firms. Other scholarshave argued that firms issue dividends based on the net profitdistributable to the shareholders. Shareholders are mainly the ownersof the business and therefore, they should share profits and loses asper their respective holding. It is not possible to estimate theexpected profit of firm and to prospect exactly what each of theshareholders should earn as dividends. For this case, most companiestend to ignore the dividends’ policy and distribute the earningsaccording to the current situation of the firm. However, dividends’policy is important as it provides more information concerning thecriteria applied in distributing the net income of the firms. Thepolicies also help in minimizing conflicts among the shareholders andthe management of the firm.

Question5

Question5 Myers&amp Majluf (1984)

State 1

State 2

Assets-in-place

a = 200 + x

a = 200 -x

(Project NPV)

b = x

b = y

Wheres = 0, E = I = 100

Supposingx = y = 50 then the Bayesian equilibrium can be arrived at asfollows

State 1

State 2

Assets-in-place

a = 250

a = 150

(Project NPV)

b = 50

b = 50

VI= 0.5(250 + 50) + 0.5(150 + 50) = 250

Therefore,the old shareholders share of profit after issue = = 0.6

Issue and invest

E = 100

Do nothing

E = 0

Vold state 1

0.6(250 +50 + 100) = 240

250 = (a)

Vold state 2

0.6(150 + 50 + 100) = 180

150 = (a)

Thefirm should, therefore, issue stock to raise the capital to financethe project and state 1 will be more preferable. This is because ithas a larger NPV and it also helps in maximizing the value of thefirm. For the firm to have obeyed the Bayesian law, there should beno situation when the value of the firm should be lower than 150 asthis is penalized as low valuation. Perfect Bayesian Equilibrium(PBE) provides that the firm is said to be off – equilibrium pathif the value of the firm deviates from the equilibrium value.However, in this case, the firm has obeyed the Bayes Law.

a.If x = 100 and y = 25 follows

State 1

State 2

Assets-in-place

a = 300

a = 100

(Project NPV)

b = 25

b = 25

Issue and invest

E = 100

Do nothing

E = 0

Vold state 1

0.6(300 +25 + 100) = 255

300 = (a)

Vold state 2

0.6(100 + 25 + 100) = 135

100 = (a)

Inthis case the value of the project if lower than in previous working.However, the project is profitable and this firm should still equityand raise capital to undertake this project. Undertaking the projectin state A will help to obtain a higher value from the project.

Finalexam: F2012

ECO422:Advanced Corporate Finance

Question1

  1. The market value of debt is

750(1+0.03) -5= 646.96

Marketvalue of equity from the parameters and the formula provided, d1= 0.93396 and d1=0.48675

S= )

47= 428.95

  1. Instantaneous beta of debt and instantaneous beta of equity.

ßu=N (d1v

=N (d1v

=0.8413

0.8413= 1.96

ßB=N (d1v

=N (-d1v

=- 0.8413 * 0.9339

=-0.7857= 1.83

Therefore,the beta of the equity, ßu=1.96anddebt beta ßB=1.83

  1. Instantaneous betas with ∞ of 0.3, d1 becomes 0.809 and d2 = 0.138

Thenew value of equity

=&gtS =

== 579.47

Andthe betas of equity and debt

ßu=N (d1v

=N (d1v

=0.8413

0.8413= 1.45

ßB=N (d1v

=N (-d1v

=0.8413 * -0.809

=-0.7857= 1.17

Therefore,when standad=rd deviation changes to 0.3, the beta of the equity, ßu=1.45anddebt beta ßB=1.17

  1. If t = 0.4

Themarket value of debt is

B= D(1-t)

750× (1 – 0.4) = 450

d1= 0.93396 and d1=0.48675

S= )

    1. 48 = 433.20

  1. Instantaneous beta of debt and instantaneous beta of equity.

ßu=N (d1v

=N (d1v

=0.8413

0.8413= 1.813

ßB=N (d1v

=N (-d1v

=- 0.8413 * 0.9339

=1.03

Therefore,the betas of the equity and the debt would change. This is becauseincreases the risk of the debt finance.

  1. Beta of the assets

Balance Sheet

Assets

Liabilities

Debt

Equity

Values and betas

Assets

Liabilities

V, ßv

B, ßB

S, ßS

Thebeta of the assets = the beta of the firm ßv

ks= rf+ (rm+ rfL

Question3

  1. Value

State 1

State 2

Assets-in-place

a = 130

a = 55

(Project NPV)

b = 20

b = -5

S= 0 = E = I = 100

VI= 0.5(130 + 20) + 0.5(55 – 5) = 100

Therefore,the old shareholders share of profit after issue = = 1

Issue and invest

E = 100

Do nothing

E = 0

Vold state 1

(130 +20 + 100) = 250

130 = (a)

Vold state 2

(55 – 5 + 100) = 150

55 = (a)

Itis optimal for the firm to raise capital and undertake the project atstate 1. It is in this state that the firm will be able to maximizeits value. The project is also acceptable I this state and notacceptable in state 2, this is because the net present value of theproject is negative under state 2.

Inequilibrium 50/100(130 + 20 + 100) = 125.

Forthe firm to have obeyed the Bayesian law, there should be nosituation when the value of the firm should be lower than 125 as thisis penalized as low valuation. Perfect Bayesian Equilibrium (PBE)provides that the firm is said to be off – equilibrium path if thevalue of the firm deviates from the equilibrium value. Therefore, inthis case, the firm has obeyed the Bayes Law. In the equilibrium, ashare of 100/150 is sold for 100 and then 50/100 for the old equity.

b)If the is the case, then there will be no Bayesian equilibrium.The firm will therefore not to issue equity and undertake theproject.

Question4

Discusswhether firms should build cash reserves

Cashreserves refer to the short-term highly liquid investment that isavailable to the company (Copeland Weston, &amp Shastri, 2005). Cashreserve has got a little return attached to it. Cash reserves incompanies refer to the money set aside by the management to caterfrom any urgent obligations that may arise instead of was wastingmuch of time doing bank transaction. Companies are therefore expectedto maintain a considerable amount of money that has quick access tomeet their emergency need. However, the decision of management andthe business owners should consider in a minimum level of cashreserves that a firm should maintain.

Sometheories developed have argued that there is nothing simple inmanaging the activities of the firm. The business owners orshareholders are, therefore, required to set aside a considerableamount of money known as emergency cash. The cash reserves also needto be monitored with much care because the reserves may have apositive or negative implication to the company depending on thepurpose that the cash has been kept for.

Thefirms are also required to maintain a specified limit of the cashreserves. The theory concerning cash reserves provides that any cashthat is more than the required cash reserve should be distributed tothe shareholders to top up the dividends. The cash can also be usedby investing in short-term investment opportunities so as to maximizethe returns.

Someof the good reasons of maintaining cash reserve is that it representsa good financial performance of the company. The financial principlessuggest that it is much prudent to for firms to show some cashreserves in their balance sheet. Also, companies with a lot ofcapital expenditure will need to have and maintain a significantamount of cash reserves. This will help to cater for the urgentexpenditures that may arise and therefore, it will help to ensure thecontinuous flow of activities within the organization. However, ifthe management has put more money cash, the shareholders should seekthe explanation about it.

Tobe on safer side, the investors should look at the cash positionthrough the sieve of the financial statements and compare it with theprescribed appropriate cash level. Cash budgets also need to bereviewed in ascertaining how much a company may require for thespecific period. There could be excess cash recorded on the balancesheet, but this may be due to lack of investment opportunities forthe company.

Question5

a)Causes of moral hazards

Moralhazards and agency problem arises due to lack of effective internalcontrol. Shareholders and the debt holders are required to take theirresponsibility by ensuring that managers are continuously monitoredto ensure that they do not act to serve their personal interest.Another major cause of moral hazard described in this case is thefinancial market turmoil. Most firms are much levered which leads tohigh risk due to severe asset distribution. The firms also lacksolidity due to high risk and therefore, resulted in a financialcrisis. A moral hazard was also experienced due to the failure of thefaked risk shifting. There was also a credit default obligations(CDO) and lack of adequate diversification. That may result in moralhazards and agency problem.

b)Jensen &amp Meckling (1976) model in pricing shares

Ifthe manager sets aside the cash generated by the sold equity andwants to allow, outside shareholders to sell their shares back to themanager at the price they paid for their shares. This could becontrary to the provisions of the corporate governance. The prices ofshares should be quoted as the market price of shares, and there themanagers should not influence the decision of the shareholders whenissuing stocks.

Question6

a)Corporate Charter – dilution of minority

Theshareholders retain the right to vote and to influence the decisionmade by their agents in the organizations where they have invested.The powers are allocated depending on the value that individualshareholders own in the organization. Modigliani &amp Miller arguesthat the powers of each shareholder are determined by the proportionof the equity capital that he or owns. However, the articles ofassociation of every public company provide that the rights ofminority shareholders should also be observed. Granting powers tominority shareholders would lead to loss of corporate governance thatmay eventually result in conflicting of interest. It is, therefore,that the shareholders will want the dilution of the minority interestto be explicitly stated in the Corporate Charter.

b)The reason shareholders may not want to include in the Corporate

Chartera provision that allows its shareholders to buy cheap, additionalshares when a corporate raider makes a bid for the equity of the firmis to avoid the reduction in the concentration of ownership. Theshareholders are allowed to purchase stock among themselves, theconcentration of ownership may be directed towards the some specificshareholders and, therefore, depriving the powers of the existingshareholder even up to minority.

Question8

Corporategovernance markets

Themarket mechanism is concerned about the financial institutions as oneof the instruments used to manage the agency problem between managerand the investors. Corporate governance is weaved of institutions andmechanisms protecting the interest of the investors. This, therefore,increases the risk of potential mismanagement and thus leading to anagency problem.

Question8 Debt covenant

Dueto the financial crisis, various debt covenants have been madeessential. The interactions between various debt covenants are meantto reduce the risk of lending and borrowing. According to the scholarThomson Reuters LPC explained that apart from reducing the risk ofborrowing, debt covenants also helps to minimize the conflict and theparties involved.

Question9 Current Events

Themost current events discussed in this course include capitalstructure, Game theory and corporate governance.

Finalexam: F2013

ECO422:Advanced Corporate Finance

Question1

Myers&amp Majluf (1984)

State 1

State 2

Assets-in-place

a = 280

a = 90

(Project NPV)

b = 20

b = 10

S= 0 = E = I = 100

VI= 0.5(280 + 20) + 0.5(90 + 10) = 200

Therefore,the old shareholders share of profit after issue = = = 0.5

Issue and invest

E = 100

Do nothing

E = 0

Vold state 1

0.5(280 +20 + 100) = 200

130 = (a)

Voldstate 2 0.5(90 + 10 + 100) = 100 55 = (a)

Inequilibrium 100/200(90 + 10 + 100) = 100.

Therefore,the Perfect Bayesian Equilibrium (PBE) is at 100, and the firm shouldnot accept the project with less than this value.

b)S, 0 &lt S &lt 100

Theamount of slack that determines to determine the pooling of PBE forboth states to be viable can be determined as follows.

E= I – S =&gt 100 – S = 100

S= 0.5 × 100 = 50

Therefore,slack should be at 50 so as there is a pooling of PBE.

Question2

Keyissues in corporate governance

Corporategovernance refers to the attempt of collaborating the interest of theshareholders to those of the managers and ensuring that companies areoperated in the interest of the shareholders. The primary goal of thefirms is to maximize the wealth of the shareholders. However, in somecases, mangers may behave in a way that is contrary to what isexpected from them and, therefore, creating what called agencyproblem. There is a need to monitor the actions of the managers toensure that they are not acting to serve their interest. This processof monitoring the acts of the managers in the organization is what werefer to the corporate governance. Agency problem arises when themanagement acts towards the accomplishment of their individualobjectives rather than those of the firm.

Corporategovernance plays a vital role in making intelligent decisions on howfirms are operated. Corporate governance involves adhering to therules and internal control of the business and more, especially inthe decision-making process. It also acts as the underpinning onwhich firms must follow to achieve their goals.

Finalexam: F2013

ECO422:Advanced Corporate Finance

Question1

Grossmanand Hart (1980)

Freerider problem and equity dilution

Themajor focus of the Grossman and Hart (1980) is on how the problem offree-rider excludes the external raider from acquiring or capturingthe surplus gained by the firm. Takeover bids act as a disciplinarytool in the market place. The external raiders may take theopportunity of acquiring or taking over a firm when its value islower than its potential value and improves its stock valuation bychanging the operations. However, the big problem comes in decidingon who should receive the surplus. The insight of Grossman and Hart(1980) provides that the problem of the free rider is to eliminatethe external riders benefiting from the increased value. From hisargument, allowing equity dilution would help in solving the problemof free rider and sharing of the surplus.

Question2) Modiglian and Miller

Modigliani&amp Miller provided an analysis of the capital structure. Theyargued that corporations are assumed to operate in a perfect marketand the capital structure used by the firm to finance its operations.The market value of a corporation is therefore determined from itsearning power and from the risk of the assets. Modigliani &ampMiller emphasised that the value of the firm does not depend on thecapital structure. They also provided the following assumptions tosupport their argument first and foremost, is that there are notaxes, secondly, is that there is no bankruptcy and transaction cost,also, it is assumed that there is asymmetry of information in themarket and then finally, the earnings of the company are not affectedby its borrowings.

Howeverin most if not in all cases this may seem to be unrealistic in thereal life. For example, it is not possible for corporate to operatewith no taxes only if it is a non-profit making organization. Thevalue of the firm also depends majorly on the capital structure usedby the firm.

Question3) Miller (1977)

Grossingup effect

Grossingup is one of the benefits that comes to haunt the corporations.Grossing up results from the aspects of debt and tax. The interestpaid on borrowing is tax allowable. This makes the debt to be thecheapest source of finance. However, the debt finance may dilute thepowers of the shareholders and hence resulting to loss of control.This benefit attached to the haunt is what Miller referred to asgrossing up.

Question4

Changingthe game

Changingthe game refers to the situation where by one of the players maydecide to alter his or her strategies with an aim of increasing thepay offs. Corporations may as well wish change the game todifferentiate themselves from other corporations. This will alterwith the asymmetry of information and firms may consider changing thegame with an aim of gaining a competitive advantage.

Myers&amp Majluf (1984)

State 1

State 2

Assets-in-place

a = 190

a = 110

(Project NPV)

b = 10

b = -10

S= 0 = E = I = 100

VI= 0.5(190 + 10) + 0.5(110 + -10) = 150

Therefore,the old shareholders share of profit after issue = = = 0.333

Issue and invest

E = 100

Do nothing

E = 0

Vold state 1

0.5(190 +10 + 100) = 150

190 = (a)

Voldstate 2 0.5(110 – 10 + 100) = 100 110 = (a)

Inequilibrium 100/150(90 + 10 + 100) = 133.33

  1. Therefore, the Perfect Bayesian Equilibrium (PBE) is at 100, and the firm should not accept the project with less than this value. Therefore, there should be no situation when the value of the firm should be lower than 125 as this is penalized as low valuation. Perfect Bayesian Equilibrium (PBE) provides that the firm is said to be off – equilibrium path if the value of the firm deviates from the equilibrium value.

Reference

Copeland,T. S., Weston, F., &amp Shastri, K. (2005). FinancialTheory and Corporate Policy.

FourthEdition, Addison Wesley.