Rotterdam School of Management Erasmus University BM02FI – Corporate Finance Online test (non-proctored) General information Date test: Course coordinator: Time test: Test reviewed by Type test: Number of questions: Number of pages: Version: dd/mm/yyyy till open book x questions x pages (incl. cover sheet) 1/2 Instructions You are allowed to use a calculator. You are allowed to use a programmable calculator. You are allowed to use notes. You are allowed to use books. You are allowed to use a dictionary. You are allowed/ not allowed to use the question mark option on the MC answer sheet. Integrity Statement: Please read the following paragraph carefully. Furthermore, you are expected to adhere to the disciplinary rules for written examinations (please consult ‘Rules of conduct for online testing, Examination Board RSM – EUR). Your test will be scanned by plagiarism detection software. By taking this remote exam, we expect that you will adhere to the ethical standard of behaviour expected of you. This means that we trust you to answer the questions and perform the assignments in this exam to the best of your own ability, without seeking or accepting the help of any source that is not explicitly allowed by the conditions of this exam. Please be aware that if you do not comply with these terms and conditions and/or there is a suspicion of fraud, sanctions may be imposed by the Examination Board which could even extend to permanent termination of your student registration (Rules and Guidelines 2019-2020, Article 3.4). Please copy the following text in your exam if you agree: “I will make this exam to the best of my own ability, without seeking or accepting the help of others or use resources that are not explicitly allowed.” No part of this test may be reproduced, stored in a retrieval system or transmitted in any form or any means, without permission of the author or, when appropriate, of the Erasmus University Rotterdam. Good Luck! Remarks: Please read the Integrity Statement above in detail and take it very seriously. Please note that there will be different versions of the exam and we will also run plagiarism checks. The exam will consist of shorter questions (that may require a calculation or a short answer about theory) and longer questions. The long(er) questions could include calculations, questions about theory, and questions about an article not discussed in class of which you should be able to interpret the main results based on the material covered in class. [Please have a look at papers / slides to see examples of tables and figures. I won’t show you any table/figure of an assigned paper though given that the exam is open book.] The questions below will show you the type of questions you can expect in the final exam. I assume that they won’t come at a surprise to you as the format is close to the assignments and workshop questions. The exam will be representative of the chapters in the book, our discussions, assignments, workshops, cases, and additional material that was assigned or discussed. Please note that the exam will be quite long given that it is open book. It will contain several questions that are relatively close to questions you have seen before (but do not expect to just get old questions with different numbers). Moreover, it will also contain some questions that are new and very challenging, requiring from you to apply learnt theories and concepts to new settings. My advice for the exam is as follows: Start with the questions that you can answer more easily (and collect those points). If you are stuck, move on! You can go back to more difficult questions later if time permits. Question Type 1: Construction of payoff diagrams Metzka Bean has the following capital structure: Senior debt 100,000 EUR Junior debt 100,000 EUR 10 shares of Convertible preferred (total 100,000 EUR) • If not converted: 1.5x liquidation preference, junior to all debt but senior to common equity • Convertible into Common equity; 1 share of convertible preferred converts into 1 new share of common equity 90 shares of Common equity (Old / original common equity holders) Please provide the payoffs to the different claimants for the following values of the firm. i. Junior debt if the value of the firm is 50,000? [ ii. Convertible preferred if the value of the firm is 0.5M? [ iii. Old common equity holders if the value of the firm is 2.0M? [ Answer: Please see slides of Q&A session ] ] ] Question Type 2: Shorter questions a) Comment on the following statement: “Because of the negative effect of debt on the price/ earnings ratio, firm are pushed toward equity.” Answer: No. All that should matter to management is firm value, which is not causally affected by the firm’s P/E ratio. See discussions in textbook for more detail (you should explain those in the exam - a reference to the textbook is not sufficient). b) Explain three forces that can make equity cheaper than debt for corporate financing. Answer: Reduced likelihood of financial distress with associated deadweight costs, Less personal income taxes Less bond holder expropriation. See discussions in textbook for more detail (you should explain those in the exam - a reference to the textbook is not sufficient). Question Type 3: Longer questions A firm has expected free cash flow for the coming year of $15 million. There are no taxes. The risk-free rate is 4%, the firm’s unlevered (asset) beta is 1 and the market risk premium is 6%. Its free cash flows are expected to grow forever at 5%. [You can use the CAPM to calculate the expected return: r = r_f + beta * market risk premium.] a) A firm has excess cash of $100 million and zero debt and considers using this to fund an additional investment project which will either have a payoff in one year of $200 million with probability 0.75 or $50 million with probability 0.25. What is the NPV of the investment? What is the total present value of the firm if it undertakes the investment? Assume the cost of capital of the new project is the same as that of assets in place. Answer: If the cost of capital of the new project is the same as that of the asset in place, the expected payoff of the new project is 0.75*200 + 0.25*50 = 162.5 with a present value of 162.5/1.1 = 147.7 and an NPV of 47.7. (The cost of capital is 0.04+0.06 = 0.1). The assets in place are worth 15/(0.1-0.05) = 300. So the firm is worth 347.7. b) The firm undertakes the investment in part (a) and also issues debt (perpetuity) with a face value of $400 million and uses the proceeds to pay a dividend to its shareholders maturing at the same date as the project payoff is realized. If the beta of the debt is 0.2, what is the maximum dividend it can pay? Explain. (Assume for this and later parts that its assets in place can be sold for their present value.) Answer: Cost of debt is 0.04+0.2*0.06 = 0.052. In the good state, the firm has a total value in one year of 300 + 200 = 500 so the debt will be repaid in full. In the bad state the firm’s realizable value is 300+50 so the debt will default. The expected payoff on the debt is therefore 0.75*400 + 0.25*350 = 312.5. The present value of this expected payoff is 312.5/1.052 = $297.05 million, so this will be the proceeds of the risky debt issue and the maximum dividend the firm can pay out. YTM is defined by 297.05 = 400/(1+YTM) so YTM = 34.66% - a huge spread. c) Continuing from part (b), what is the cost of equity of the levered firm? What is the value of its equity? Again state any assumptions you need to make. Answer: Working backwards – this a M-M world with risky debt, because total firm payoffs are unaffected by the debt and there is no asymmetric information. Therefore E = Value of unlevered firm – Value of debt = 347.7 – 297.05 = 50.65. Thus Re = 0.1 + (0.1 – 0.052)*(297.05/50.65) = 0.1 + 5.87*0.048 = 38.15%. d) Continuing from parts (b) and (c), assume the firm can instead use $50 million from proceeds of its debt to invest in a second project, with a payoff of 60 in the state in which the first investment pays off $200 million and a payoff of $50 million in the state in which the first investment pays off $50 million. (Again assume the cost of capital of the additional project is the same as that of assets in place.) What is the NPV of this second project? Will the shareholders pursue it, or instead choose to include the $50 million in the dividend? Explain. Answer: The expected payoff of the project is: (0.75*60+0.25*50) = 57.5. At the unlevered cost of capital this project has moderately positive NPV of 2.27 so is worth undertaking. If firm pays full dividend, shareholders get an additional $50 on top of a dividend they receive in any eventuality of $247.05 for sure plus $100 = 500-400 in the good state or zero = max(0,350-400)=0 in the bad state next period. If they undertake the second investment they forego the additional $50 plus 100 + 60 in the good state versus max(0, 350+50-400)=0 in the bad state. Thus they compare PV(0.75*100=75) + 50 = 75/1.1946 + 50 = 112.78 (full dividend) versus PV(0.75*(100+60)=120). If the second investment is pursued, the debt becomes riskfree and so the cost of equity will fall, but obviously not back to 10% (the firm is still leveraged so equity beta is above 1) so it is sufficient to show that 120/1.1 = 109 to see that the second investment will not be pursued – the shareholders will pay out the full dividend of $297.05 million instead. This is an example of debt overhang – the bulk of the benefit of the additional investment accrues to the creditors by making them better off in the bad state where the firm otherwise defaults. Shareholders do not benefit sufficiently to choose to invest. Question Type 4: Interpretation of Figure/Table The table shows announcement returns of different types of deals to bidding shareholders. All-stock deal means that the bidder uses its stocks to pay for the target, while an all-cash deals means that the target shareholders are paid with cash only. Discuss differences of all-stock and all-cash deals. What theories might explain those differences? Explain the main arguments. Answer: Powered by TCPDF (www.tcpdf.org) CARs to stock bidders are smaller o Public targets -2.2% vs. -0.3% 1.9% smaller o Private targets 0.1% vs 0.26% 0.16% smaller Potential explanations: asymmetric information [Potential reasons for smaller returns in absolute numbers of private targets: their size?] In a world of market imperfections, markets may only be semi-strong efficient, and insiders (CEOs) may possess more information about the firm than the public o For instance, they may know whether the current stock price of the firm is under-/overvalued. o If the firm is overvalued, firms have incentives to use stock “as a currency” to pay for the stock of the targets o Markets will interpret this (at least partially) as negative information about the firm and the stock price will fall o This is directly linked to the discussion of general equity issues and the pecking order theory
