Examination Papers

Examiners Reports

ME
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RN

M
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AL PROG RA

Examination papers and

Examiners reports

Corporate finance
Economics, Management, Finance
and the Social Sciences

2001, 2002, 2003 2790092

92 Corporate finance

Examiners report 2003

Zone A
General comments
1. This examination was set with the objective of testing students understanding of
the concepts and techniques used in corporate nance.
2. The questions selected by students were fairly evenly distributed.
3. While some of the questions might appear to be technical, most of the marks were
awarded for providing the economic reasoning and intuition.
4. Candidates are reminded that the examination for this subject may test any aspect
of the syllabus.
5. Students should spend more time studying the subject guide and the suggested
readings, focusing on both the economic reasoning and some of the
techniques/tools.
6. More detailed comments, as well as a detailed marking scheme, can be found on
the following pages.
Suggested answers and marking schemes
Section A
Question 1
a. Consider a portfolio with proportion of wealth x invested in asset A. It must then
2 2 2 2 2
be that E(x)= xrA + (1-x)rB and (x) = x A +2x(1-x)AB+(1-x) B .
(1.5 marks for expression for E(x) and 1.5 marks for expression for 2(x).)
5 marks for solving for the minimum variance portfolio:
2 2 2
The minimum variance portfolio hence satises d[ (x)]/dx = 2xA - 2(1-x) B
+2(1-x)AB 2xAB = 0.
2 2
Hence x = [B (B - A)]/[A -2AB+B ]= 76.1%.
2 marks for correct conclusion or/and excellence of exposition:
The portfolio of minimum variance consists of 76.1% of the investors wealth
invested in Asset A and the remaining proportion invested in Asset B, has an
expected return of 5.9%, and a standard deviation of 9.1%.
b. Shape of frontier: 2 marks.
Benets of diversication: 2 marks.
Inefcient portfolios: 2 marks.
c. For a given expected return, the variance increases (1.5 marks).
For a given variance, the expected return gets lower (1.5 marks).
2 marks for a diagram.
d. 2 marks for the argument.
2 marks for a derivation.
1 mark for diagram (if no derivation).

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 Examination papers and Examiners reports 2003

Question 2
a. The expected return of the market portfolio is 16.7% and the standard deviation of
the market portfolios returns is 24.6%. The equation of the CML is hence
(E(r) - rF)/ = (E(rM) - rF)/M = 6.7%/24.6%.
b. The expected return of Share A is 11.3%. The standard deviation of Share As
returns is 36.1%. Share A does not therefore lie on the CML as the equation
derived in the previous question is not satised.
The expected return of Share B is 15.6%. The standard deviation of Share Bs
returns is 25.4%. Share B does not therefore lie on the CML as the equation
derived in the previous question is not satised.
There is no reason for Share A and Share B to lie on the CML in the rst place.
c. The beta of a given share is dened as cov(r, rM)/var(rM). Given the information
provided, the beta of Share A is equal to 0.3 and the beta of Share B is equal to
0.9.
d. In equilibrium, all securities must lie on the Security Market Line (SML). The
expected returns for Shares A and B are inconsistent with the SML, whose
equation is (E(r) - r )/ = (E(r ) - r )/ = 6.7%. Prices of Shares A and B are
F M F M
therefore expected to adjust until A and B lie on the SML.
Question 3
a. This part requires a brief description of the fact that all comovements in returns
comes though the two factors (all the securities load positively on the rst factor
and, as such, will move in the same direction in response to this factor).
b. To nd the portfolios that track the factors, students were expected to write up the
set of equalities to solve:
2xA + 4xB + xC S 1, - xA - 2xB - xC S 0, xA + xB + xC S 1
xA = 3, xB= -1, xC=-1
E[r1] = 0.1*3 0.08 0.05 = 17%.

2xA + 4xB + xC S 0, - xA - 2xB - xC S 1, xA + xB + xC S 1

x = 5, x = -2, x =-2
A B C
E[r2] = 0.1*5 (2*0.08) (2*0.05) = 24%.
Setting the equation for P1: 3 marks.
Setting the equation for P2: 3 marks.
Attempt at solving any of them: up to 2 marks.
c. E[rD] = rF + 2(E[r1] - rF) +2(E[r2] - rF) = 12% +2*5% + 2*12% = 46%.
Risk-free portfolio:
2x + 4x + x S 0, - x - 2x - x S 0, x +x +x S1
A B C A B C A B C
xA = 2, xB = -1, xC = 0
rF = 0.1*2 0.08 = 12%.
d. Assuming a factor structure as above yields a set of no arbitrage relationships
between securities as we can view securities as bundles of the pure factor
portfolios. Calculating the factor risk premia and the risk-free rate, we can then
use the replication argument to show no-arbitrage implies that the following must
be true for any security: ri = rF + i11 + i22.
For a good step-by-step explanation: 5 marks.
For either a derivation or excellence of exposition: 2 marks.

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92 Corporate finance

Question 4
a. Consider the following strategies:
SX SX
P1 Call Option 0 S-X
P2 Share S S

Using no arbitrage arguments, cS.

1 mark for stating the upper bound.
2 marks for the derivation.
1 mark for explaining the no-arbitrage argument.
b. Consider the following strategies:
SX SX
P1 Call Option 0 S-X

P2 Share S S
P2 Borrow PV(X) X X
S-X S-X

Using no arbitrage arguments, c 0 and c S - PV(X).

2 marks for showing that c 0.
2 marks for considering the right portfolios to show that c S - PV(X).
2 marks for getting the state-contingent payoffs at maturity.
2 marks for the implications for the costs of the portfolios and no-arbitrage
arguments.
c.
SX X S 2X 2X S 3X S 3X
P1 c(X) 0 S-X S-X S-X
P1c(3X) 0 0 0 S-3X
0 S-X S-X 2(S-2X)

P2 2c(2X) 0 0 2(S-2X) 2(S-2X)

Using no arbitrage arguments, c(X) + c(3X) > 2 c(2X).

2 marks for considering the right portfolios to show that c(X) + c(3X) > 2 c(2X).
6 marks for getting the state-contingent payoffs at maturity (1.5 marks per
column).
2 marks for showing that S-X 2(S-2X) when 2X S 3X.
1 mark for the implications for the costs of the portfolios and no-arbitrage
arguments.
2 marks for a nice diagram, clarity of exposition.

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 Examination papers and Examiners reports 2003

Section B
Question 5
a. 2 marks for making the following statement:
A market is said to be efcient with respect to a given information set if no agent can
make economic prot through the use of a trading rule based on the information set,
where economic prot is dened as the return after costs adjusted for risk.
1 mark for the denition of each information set (weak, semi-strong, strong).
1 mark for elaborating on each information set (further comments, examples).
b. The diagram shows how the information about the earnings announcement fully
leaks before the announcement. This is probably a market that is efcient in the
strong form; the information is incorporated in the price even before the
announcement takes place. The degree to which this market is efcient in the
strong form depends on whether there were agents that knew about the increase in
earnings before it was leaked or not. One way to check if this market is fully
efcient in the strong form would be to see if agents that are likely to have better
access to private information made abnormal prots. That is, if they bought the
shares before the earnings announcement started to leak. After the announcement,
there is no further reaction of the price (the diagram is almost at); this means that
the market is also semi-strong efcient: all the information is incorporated after
the announcement. The previous results imply that the market is efcient of the
weak form too: that is, all past public information is incorporated in the prices.
2 marks for consistency with semi-strong form.
2 marks for stating that the information is fully leaked before the earnings
announcement.
2 marks for elaborating on the reasons for the leakage (announcements made by
competitors, nancial analysts forecasts, quarterly earnings announcements).
2 marks for suggesting that the diagram is also potentially consistent with the
strong-form of market efciency.
2 marks for potential tests of the strong form.
c. If all the information is already incorporated in prices, there is no incentive to
gather any further information, as no further prot can be made out of this
information. The paradox arises because if all the agents decided not to gather this
information, then there is no reason why markets should be strong form efcient
at all.
3 marks for the explanation of the paradox (facts).
3 marks for clarity of exposition and the implication that one has to assume that
markets are never fully efcient to give incentives to some agents to gather
information.
1 mark for citing Grossman-Stiglitz.
Question 6
a. Column 3 (No investment):
Total CF: 1 mark
Equity: 1.5 mark
Debt: 1.5 mark
Firm value: 1 mark

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92 Corporate finance

b.
No investment Project A Project B
boom crisis expected boom crisis expected boom crisis expected
total CF 120 60 90 140 80 90 160 0 80
(cash+projects)
Value of debt 80 60 70 80 80 80 80 0 40
Value of equity 40 0 20 60 0 30 80 0 40
Total value 90 110 80

Choice of project: 2 marks.

Value of debt, equity, and whole rm conditional (if P A and if P B): 5 marks.
Choice of project if 0 debt: 2 marks.
Total value of the rm if no debt: 1 mark.
c. Mark as mini essay (subject guide, page 76).
d. Students should relate the results of section (b) to the risk shifting problem: the
shareholders of the rm in part (b) decide to go for the risky project even though
the project decreases the overall value of the rm; the reason why they would do
it is that by doing so they can expropriate some value from the existing
debtholders. The problem would not arise if the rm had low levels of debt (1.5
marks).
However, low levels of debt would mean higher levels of outside equity, and those
would reduce the incentives for the insiders (managers) to exert effort that
maximises rm value (1.5 marks).
The optimal level of debt for the rm is therefore the one that balances the cost of
debt in terms of risk shifting with the benet of debt in terms of effort provision
(2 marks).
Question 7
a. See page 85 of the subject guide.
Students should list and explain Lintners four stylised facts (4 marks):
managers seem to have a target dividend payout level
payout level determined as a % of sustainable EPS
managers are more concerned with changes in dividends rather than the actual
level of dividends
managers prefer not to make dividend changes that might need to be reversed.
While the stylised facts found by Lintner show that rms try to smooth their
dividend changes, the Modigliani and Miller theorem implies that dividend policy
is irrelevant, so any systematic behaviour of rms with respect to dividends
indicates that one or more of the assumptions of the Modigliani and Miller
theorem is violated (2 marks).
Lintners empirical evidence reinforced by event studies (2 marks).
The existence of taxes, agency costs, and asymmetries of information are the most
likely factors behind this behaviour (2 marks).

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 Examination papers and Examiners reports 2003

b. See pages 86 and 87 of the subject guide.

Students should provide some empirical evidence on taxation of dividends and
capital gains (3 marks) and explain why taxation will generate clienteles between
rms and investors (3 marks): investors with a heavy taxation on dividends
(individuals) will specialise in the ownership of rms that pay low dividends, on
the other hand, investors that pay high taxes on capital gains (corporations) will
specialise in low dividend rms.
Institutions that are indifferent between both types of rms and will allow for the
market to clear (3 marks for stating so).
Allow 4 marks for an example or an excellent explanation for the clearing of the
market and 2 marks for highlighting similarities and differences with MM (last
paragraph of page 87).
Question 8
a. See page 93 of the subject guide.
4 marks for providing the main argument.
4 marks for stating clearly the assumptions:
the rm is subject to a takeover bid
the rm value will improve if the bid succeeds and the value improvement is
common knowledge
the equity of the target rm is held by many smalI shareholders
the raider incurs an administrative cost.
Up to 7 marks for either an analytical proof or excellence of exposition of the
steps involved.
b. See page 94 of the subject guide.
1 mark for writing dilution of non selling shareholders (and explaining
concretely what dilution means).
1 mark for writing existence of large shareholders.
Up to 3 marks for explaining how dilution can solve the free rider problem by
allowing the bidder to punish non selling shareholders.
Up to 3 marks for explaining how the presence of a large shareholder who
believes that he is pivotal (and therefore sells if he believes that his sale affects the
likelihood of success of the merger) can solve the free rider problem.
Up to 2 marks for either some proof (analytical derivation) or excellence in the
exposition of the argument.
Examination in 2004
There will be no changes to the style, format or content of the examination paper in
2004.