Question 1. (8 p.

One of the main conflicts of interest in corporate finance is the one between insiders
(management) and outside investors (non-controlling shareholders). This conflict can be mitigated
by different governance mechanisms, which vary widely in importance and effectiveness
depending on firm- and country-specific factors.

a) One such governance mechanism is delegated monitoring. Give examples of two types of
investor/stakeholder that may take on the role of delegated monitor, and for each one, briefly
outline how they can reduce the insider-outsider conflict (e.g. what powers do they have, via
what channels do they exert influence?). (4 p.)

b) Another governance mechanism is incentive alignment via performance-based compensation

to management. Suggest and briefly explain at least two potential problems/limitations with
this type of incentive alignment as a governance mechanism. (4 p.)

Answers:

a) Different answers possible. See Lecture Notes 1, pp. 21-33 (and Lecture Notes 6, pp. 14-15).
b) Different answers possible. See Lecture Notes 1, pp. 18-19.
Question 2. (6 p.)

A firm starts at 𝑡 = 0 and at 𝑡 = 1 can take on the following values with equal probability:

State, j State price, 𝜓𝑗 Firm value, 𝑉𝑗

1 0.37 55
2 0.29 100
3 0.26 115

a) What is the present value of the firm? (2 p.)

b) What is the risk-free interest rate? (2 p.)
c) Suppose the firm has debt with face value F=70. What is the cost of debt? (2 p.)

Answers:
a) 𝑉 = ∑3𝑗=1 𝜓𝑗 𝑉𝑗 = 0.37 × 55 + 0.29 × 100 + 0.26 × 115 = 79.25.
1 1
b) 1+𝑟
= ∑ 𝜓𝑗 = 0.37 + 0.29 + 0.26 = 0.92 ⇒ 𝑟 = 0.92 − 1 = 8.70%.
1
c) 𝐸(𝐵𝑗 ) = ∑3𝑗=1 𝑝𝑗 𝐵𝑗 = (55 + 2 × 70) = 65; 𝐵 = ∑3𝑗=1 𝜓𝑗 𝐵𝑗 = 0.37 × 55 + 0.29 × 70 +
3
𝐸(𝐵𝑗 ) 65 𝐸(𝐵𝑗 )
0.26 × 70 = 58.85; 𝑟𝑏 = ln ( 𝐵
) = ln (58.85) = 9.94%, alternatively 𝑟𝑏 = 𝐵
−1=
65
58.85
− 1 = 10.45%.
Question 3. (18 p.)

Please answer the following questions.

a) Acastus A.G., which operates in a world without frictions, was previously a levered
firm, financed by debt with a market value of 450 million and equity with a market
value of 350 million. Its cost of debt was 5 percent, and its weighted average cost of
capital was 13.75 percent. Just recently, Acastus decided to delever by repaying all of
its debt at fair market value, which it financed by issuing an equal amount of equity.
What was the effect of the delevering (direction and magnitude) on Acastus’s cost of
equity? (3 p.)

Answer:
With no frictions, the overall cost of capital is independent of capital structure. Previously: 𝑟𝑠𝑙 = 𝑟𝑠𝑢 +
𝐵 450 𝐵 𝑆
(𝑟𝑠𝑢 − 𝑟𝑏 ) = 13.75% + (13.75% − 5%) = 25%; alternatively, use 𝑊𝐴𝐶𝐶 = 𝐵+𝑆 𝑟𝑏 + 𝐵+𝑆 𝑟𝑠𝑙 to
𝑆 350
450 800
get 𝑟𝑠𝑙 = (13.75% − 800 × 5%) 350 = 25%. Now: since there is no longer any debt, the cost of
equity = 𝑟𝑠𝑢 = 𝑊𝐴𝐶𝐶, i.e., it drops from 25% to 13.75%.

b) Bucephalus S.A. operates in a world where corporate income tax is the only friction. It
generates perpetual (pre-tax) cashflows 𝑋 = 200, has an unlevered cost of equity
𝑟𝑠𝑢 = 0.15, and is able to borrow at the cost of debt 𝑟𝑏 = 0.03. The firm is initially
unlevered and faces the corporate income tax rate 𝜏 = 0.35. Suppose the firm can take
one of the following two actions (but not both): either it can (i) take on 500 in debt and
use the proceeds to repurchase equity, or it can (ii) relocate to a different tax
jurisdiction where the corporate income tax rate is 𝜏′ = 0.25. Which of these
alternatives would the firm’s shareholders prefer? (Motivate your answer carefully.) (3
p.)

Answer:
(1−𝜏)𝑋 0.65×200
(i) 𝑉𝑢𝜏 = 𝑟𝑠𝑢
= 0.15
= 866.67; 𝑉𝑙𝜏 = 𝑉𝑢𝜏 + 𝜏𝐵 = 866.67 + 0.35 × 500 = 1041.67; 𝑆 = 𝑉𝑙𝜏 −
𝐵 = 1041.67 − 500 = 541.67; shareholders also get 500 in cash from the repurchase, so alternative
(i) is worth 1041.67 to them.
(1−𝜏′)𝑋 0.75×200
(ii) Value to shareholders = 𝑉𝑢𝜏 = 𝑟𝑢 = 0.15 = 1000.
𝑠
So (i) ≻ (ii).
 c) Using the information in question (b), what would be the effect of alternative (i) on
Bucephalus’s weighted average cost of capital? (3 p.)

Answer:
Payouts: 𝑟𝐵 to debtholders and (1 − 𝜏)(𝑋 − 𝑟𝐵) to shareholders; so the overall cost of capital =
0.03×500+0.65(200−0.03×500)
WACC = 1041.67
= 12.98%. Alternatively, use MM2 with taxes to calculate the
𝐵
levered cost of equity, then use the WACC formula: 𝑟𝑠𝑙 = 𝑟𝑠𝑢 + (𝑟𝑠𝑢 − 𝑟𝑏 ) 𝑆 (1 − 𝜏) = 0.15 +
500 500 541.67
(0.15 − 0.03) ×
541.67
× 0.65 = 0.222; 𝑊𝐴𝐶𝐶 = 1041.67 × 0.03 + 1041.67 × 0.222 = 12.98%. So
alternative (i) reduces WACC from 15 to about 13%.

d) Charybdis, Inc. operates in a world with both corporate income tax and bankruptcy
costs. The firm has an unlevered asset value of 820, faces a corporate income tax rate
of 28 percent, and the present value of its expected bankruptcy costs is described by
the function 𝐶(𝐵) = 0.02𝐵 + 0.0005𝐵 2 (where B is the level of debt). Until now,
Charybdis has been optimally leveraged, but recently the firm has been entertaining
plans to double its debt level. What would be the effect of this action (direction and
magnitude) on shareholder value? (3 p.)

Answer:
𝑉𝑙 = 𝑉𝑢 + 𝜏𝐵 − 𝐶(𝐵) = 820 + 0.28𝐵 − 0.02𝐵 − 0.0005𝐵2 ;
0.26
𝑉𝑙′ = 0.26 − 0.001𝐵 = 0 ⇒ 𝐵∗ = 0.001 = 260;
𝑉𝑙∗ = 820 + 0.26 × 260 − 0.0005 × 2602 = 853.8 ⇒ 𝑆 = 853.8 − 260 = 593.8;
𝑉𝑙𝑑𝑜𝑢𝑏𝑙𝑒 = 820 + 0.26 × 520 − 0.0005 × 5202 = 820 ⇒ 𝑆 = 820 − 520 = 300.
So shareholder value drops by almost half from 593.8 to 300.
 e) Diogenia, Ltd. has a current value of 450, and debt with a face value of 375 that
matures in 5 years. Its asset value growth follows a symmetric binomial process and in
5 years its asset value can be either 1001.5 or 202.2 with equal probability. The risk-
free interest rate is 4 percent. What are the present values of Diogenia’s levered equity
and debt, respectively? (3 p.)

Answer:
𝑆𝑙𝑢 = max (𝑉 𝑢 − 𝐹, 0) = 1001.5 − 375 = 625.5; 𝑆𝑙𝑑 = max (𝑉 𝑑 − 𝐹, 0) = 0;
𝑉 𝑢 −𝑉 𝑑 1001.5−202.2
𝛼= = = 1.276;
𝑆 𝑢 −𝑆 𝑑 625.5
𝑉 𝑉 𝑢 450 1001.5
𝑆𝑙 = 𝛼 − 𝑒 −𝑟(𝑇−𝑡) ( 𝛼 − 𝑆𝑙𝑢 ) = 1.276 −
𝑒 −0.04×5 ( 1.276 − 625.5) = 222.96;
𝐵 = 𝑉 − 𝑆𝑙 = 450 − 222.96 = 227.04.

f) What is Diogenia’s annual cost of debt? (3 p.)

Answer:
𝐸(𝐵𝑗 ) = 0.5(375 + 202.2) = 288.6;
1/(𝑇−𝑡)
𝐸(𝐵𝑗 ) 288.6 𝐸(𝐵𝑗 )
𝑟𝑏 = ln ( 𝐵
)⁄(𝑇 − 𝑡) = ln (227.04)⁄5 = 4.8%; alternatively, 𝑟𝑏 = ( 𝐵
) −1=
288.6 1/5
( ) − 1 = 4.9%.
227.04
Question 4. (7 p.)

Echion Industries has an investment opportunity requiring the investment 𝐼 = 150. It initially
has assets in place A and “slack” (cash) 𝑆 = 20. To invest, Echion can use the cash, but has to
issue an additional 𝐸 = 130 in equity. The amount of cash it holds and the size of the
required equity issue are publicly known. At 𝑡 = 0, agents know only that the true values of
assets in place a and the NPV of the investment opportunity b are determined by which one of
two equally probable states of nature that occurs. For each of the states, the possible
realizations of a and b are:

Assets in place (a) Investment opp. NPV (b)

Good state 480 24
Bad state 240 5

At 𝑡 = 1, the true state of nature becomes known to Echion’s management, but not to
investors. Management now has to decide whether to issue equity and make the investment,
or pass up the investment opportunity. It is assumed that management will act in the best
interest of Echion’s existing (old) shareholders.

a) Explain carefully, or show numerically, why Echion’s management will only decide to
issue-invest in the bad state, even though the NPV of the investment opportunity is
much higher in the good state. (4 p.)
b) What is the inefficiency cost of the information asymmetry between Echion’s
management and outside investors? (1 p.)
c) Provide a brief explanation of why the inefficiency cost in the pecking-order model is
higher when investment has to be financed by new equity than when investment is
financed by new debt. (2 p.)

Answers:
a) Due to information asymmetry, the market’s estimate of firm value is the average of the good
and bad states. If management finds out that the good state has occurred, the firm is
undervalued by the market, and issuing equity implies selling claims on the firm’s assets at a
discount, which dilutes value for existing shareholders. If the value lost by issuing at a
discount exceeds the NPV of the investment, the firm won’t issue-invest. Conversely, if
management finds out the bad state has occurred, the firm is overvalued, which makes issuing
equity beneficial to existing shareholders. Consequently, the firm is more likely to pass up the
investment opportunity in the good state. Numerically, the ex-ante expected market value of
existing shareholders’ equity if the investment is made is: 𝑃′ = 0.5(480 + 240 + 24 + 5) +
20 = 394.5. Management will issue-invest only if existing shareholders’ part of total firm
value with the investment is greater than the value of the firm without the investment, i.e. the
𝑃′
decision rule is: 𝑃′ +𝐸 (𝐸 + 𝑆 + 𝑎 + 𝑏) ≥ 𝑎 + 𝑆. In the good state, the LHS is
394.5
524.5
(130 + 20 + 480 + 24) = 491.9, and the RHS is 500, so the inequality doesn’t hold
394.5
and the investment won’t be made. In the bad state, the LHS is 524.5
(130 + 20 + 240 +
5) = 297.1, and the RHS is 260, so management will go ahead and issue-invest.
b) The inefficiency cost is a 50% probability of passing up an NPV = 24 investment, i.e. 12.
Alternatively, since Echion will pass up the investment in the good state, an issue-invest
decision signals that the bad state has occurred. So the ex-ante expected market value drops
from 394.5 to 0.5(500 + 265) = 382.5, i.e. by 12.
c) The inefficiency is underinvestment, i.e. passing up NPV > 0 investments. Driving this is the
discount at which financing has to be issued in the good state, or in other words the capital
gain new claimants would enjoy if they got to invest, which crowds out the benefit to old
shareholders of investing. But because of the higher priority of debt, the capital gain is always
smaller for new debt-holders than for new equity-holders (debt value is less sensitive to
variations in underlying asset value) => NPV > 0 investments are passed up less often if new
debt is issued, and the inefficiency cost is therefore smaller.
Question 5. (15 p.)
Please answer the following questions.

a) Provide two examples, with brief explanations, of ways in which indirect bankruptcy
costs related to product markets can reduce value for a distressed firm’s shareholders.
(4 p.)

Answer:
Different answers possible. See Lecture Notes 3, pp. 19-20.

b) Explain why large, mature firms with dispersed ownership are more likely than other
firms to pay high and stable cash dividends to shareholders. (4 p.)

Answer:
Cash dividends are primarily used to distribute stable, permanent earnings, and large firms in mature
industries are more likely to have high and stable earnings. Large firms in mature industries are less
likely to have profitable alternative uses of internally generated funds (NPV > 0 investments/growth
opportunities). Large firms with dispersed ownership (and therefore free-riding/coordination problems
among investors) and high FCF are subject to more severe owner-manager agency conflicts; high and
stable dividends work as a disciplinary mechanism, reducing cash under management’s discretion. See
Lecture Notes 5, sections 3.1 and 4.2.
 c) Give two examples, with brief explanations, of debt contract features designed to
mitigate contracting inefficiencies stemming from asymmetric information between
borrower and lender. (4 p.)

Answer:
Different answers possible. See Lecture Notes 6, pp. 17-22.

d) Provide an explanation for the typical finding in short-term event studies on M&A that
target firms tend to gain (in terms of value creation/announcement effects), whereas
acquirer firms neither gain nor lose from merger announcements. (3 p.)

Answer:
Reasons include the necessity for the acquirer to pay a bid premium, the possibility of competing bids
driving up bid premiums, a tendency to overestimate synergy gains and underestimate merger costs,
size differences between acquirer and target, possible agency costs (primarily weak incentives for
acquirer management not to overpay using own stock), event studies only capturing unanticipated
value effects for (frequent) acquirers, etc. See Lecture Notes 7, pp. 13, 16-19.
Question 6. (6 p.)

At a stock exchange where there are regular initial public offerings, there are two types of
investors – informed and uninformed. Informed investors are able to distinguish between
profitable and unprofitable IPOs, and invest only in the profitable ones. Uninformed investors, on
the other hand, are unable to discriminate between IPOs. As a consequence, profitable IPOs are
always rationed, whereas uninformed investors always get full allocation in the unprofitable IPOs.
In this market, an uninformed investor commits to buying 1500 shares in all IPOs at an average
offering price of 80. Two thirds of all IPOs are profitable, oversubscribed 3 times, and the
investor gets rationed in proportion to the oversubscription. The remaining third of IPOs are
unprofitable and earn first-day returns of –12 percent.

a) What is the minimum average first-day return on profitable IPOs required for the uninformed
investor to be willing to invest in all IPOs? (4 p.)

b) With the average first-day return of profitable IPOs obtained in (a), what is the average level
of underpricing in the market as a whole? (2 p.)

Answers:
1500
a) Profitable IPOs: the allocation is = 500; the payoff is 500 × 80 × 𝑅 (where 𝑅 is the
3
first-day return). Unprofitable IPOs: the allocation is 1500; the payoff is 1500 × 80 ×
(−12%) = −14400. To be willing to invest in all IPOs, the uninformed investor must at least
2 1
break even in expectation: × 500 × 80 × 𝑅 − × 14400 = 0 ⇒ 𝑅 = 18%.
3 3
2 1
b) 3
× 18% + 3 × (−12%) = 8%.