BE311 Corporate Finance Exam Paper

Answer TWO of FOUR questions July 4, 2010

BE311-5-AU/2 1. You consider a project which costs 100. The future cash ow next year is 5, and each year thereafter the projects cash ow is expected to grow at a rate of 2%. The beta of the project is 1.1, the expected return on the market index is 8%, and the risk free rate is 2%. (a) What is the cost of capital for the project? [10 marks]

(b) Dene the internal rate of return, and work out the internal rate of return for this project. Should you go ahead? Explain your decision. [20 marks]

(c) Suppose the project gives you access to borrowing below the market rate, specically you are able to obtain a 10-year loan to nance 100% of the investment cost at a rate of 1%, when the comparable business rate would be 5%. Explain why nancing should not normally matter for investment decisions, but that in this particular situation it does matter. Also work out the net present value of the project including the cheap loan. Should you go ahead? [20 marks] [Total 50 marks]

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2. You consider making an investment in an asset at a xed cost of 100. The present value of the future cash ows of the asset is currently 100, and you expect the present value to increase by 30% or decrease by 10% each year, each equally likely. There are no cash ows over the next two years. The risk free rate is 2%. (a) Explain what we mean by risk neutral probabilities, and what role these probabilities play in option pricing. Explain why option pricing is relevant, and work out the risk neutral probabilities, in the case above. [10 marks]

(b) Suppose you can invest at any time over the next two years. At what time, and in what circumstances, is it optimal to invest? Finally, taking into account the optimal timing of investment, what is the current value of this investment opportunity? [20 marks]

(c) Explain how your conclusions about timing of investment and the value of the investment opportunity would change if the asset did produce cash ows over the two year window. There is no need to use algebra an intuitive answer would sufce. [20 marks] [Total 50 marks]

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3.

(a) Modigliani-Millers Irrelevance Theorem of Capital Structure tells us that corporate borrowing does not matter. Explain, using the arguments of home-made leverage and un-doing borrowing, why borrowing policy at the corporate level is unlikely to create value at the level of investors. There is no need to use algebra. [17 marks]

(b) Explain the trade-off theory of capital structure. What does this theory predict about corporate borrowing for a company which is highly protable? [17 marks]

(c) Explain the pecking-order theory of capital structure. What does this theory predict about corporate borrowing for a company which is highly protable? Is this the same as trade-off theory? Explain. [16 marks] [Total 50 marks]

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4.

(a) Demonstrate that if the dividend payments per share of a stock is expected to grow by a rate of g percent per year, and next years dividend is equal to D1 , the current stock price equals P0 = where r is the discount rate.
D1 , rg

[10 marks]

(b) Consider an investment project which costs 1,000,000. You expect the cash ow for the next 10 years to be constant and equal to 100,000 per year, and for every year thereafter a constant 50,000 per year indenitely. Assume the discount rate is 9% and work out, ignoring taxes, whether the project is worth while. [20 marks]

(c) You are not certain about the future cash ow of the project. Carry out a sensitivity analysis where you assume the future cash ow is 10% greater than and 10% smaller than your best assumption in question (b). Should you consider making further investigations into the uncertainty regarding the future cash ows? [20 marks] [Total 20 marks] *** END OF EXAM ***

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Answers:

1.

(a) Cost of capital is 2 + 1.1(8 2) = 8.6%. which (b) The IRR is dened as the discount rate which delivers zero NPV, i.e. 0 = 100 + IRR5 0.02 implies IRR = 0.07. The IRR is less than the cost of capital so you should not go ahead. In this case the problems associated with IRR can be ignored there is a unique IRR; the NPV is decreasing in the cost of capital; and the alternative is not to make the investment (i.e. NPV of zero). (c) The NPV of the project is N P V = 100 +
5 0.0860.02

= 24. Financing doesnt matter as individual

preferences to the different forms of nancing should be made at the investor level at market rates. Therefore, nancing matters only if they can be made at non-market prices, as is the case here. The NPV of the nancing package is N P V = 100 1 100 1 = 100 t 10 1.05 0.05 t=1 1.05
10

1 1.0510

= 80(0.386) = 31

The positive NPV of the nancing package outweighs the negative NPV of the project as it stands, and you should take the project which yields a total NPV of 31 24 = 7. 2. (a) Risk neutral probabilities represent arbitrage-free derivatives prices which can be obtained by discounting the (risk neutral) expected payoff at the risk free discount rate. Here, the derivative is the investment opportunity in the asset i.e. a call option on the asset. The risk neutral probability of the up movement is q =
1.020.9 1.30.9

3 10

= 0.3 and for the down movement 1 q = 0.7.

(b) Since there are no cash ows, waiting and learning is free of cost, so you will invest at the end of year 2 if at all. The asset values are here either 100(1.32 ) = 169; 100(1.3)(0.9) = 117; or 100(0.92 ) = 81, so you invest in 2 years time unless there has been down successive down movements. The value of the call is C= 1 13.35 0.32 (169 100) + 2(0.3)(0.7)(117 100) + 0.72 (0) = = 12.83 2 1.02 1.022

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which is also the value of the investment opportunity. (c) In this case there is a cost to waiting and learning: you forego the interim cash ows of the assets. In this case you may consider investing early, therefore i.e. in year 1 (in the up-state, of course). If the net present value of investment, plus the year 1 cash ow, in the up state in year 1 is greater than the value of the investment opportunity in the up state in year 1 you would invest here, otherwise not. 3. (a) If leverage has value but the corporation does not borrow (i.e. it is believed that VL > VU ), then the investor can generate the levered equity claim free of cost through home-made leverage, i.e. by borrowing privately. (This must of course be ruled out in an arbitrage free market so VL VU .) If leverage is costly but the corporation has borrowed (i.e. it is believed that VL < VU ), then the investor can generate unlevered equity through privately un-doing the borrowing decision and buying levered equity and corporate debt in similar slices to make up unlevered equity. (This must also be ruled out in an arbitrage free market so VL VU .) Taking both together we nd nancing irrelevant (or VL = VU ). (b) Trade off theory recognizes both the tax benets of borrowing, measured by the present value of the tax shield of borrowing, and the deadweight bankruptcy costs in default, measured by the present value of the bankruptcy costs. The optimal capital structure maximizes the value of the unlevered rm plus the present value of the tax shield, minus the present value of bankruptcy costs. As borrowing becomes very high, the marginal tax benet is near zero and the marginal bankruptcy cost is high, and when the borrowing is very low, the marginal tax benet is high whereas the marginal bankruptcy cost is high, guaranteeing an interior solution. (c) The pecking order is: use internal capital before external capital, and safe external capital before risky external capital. The reason is adverse selection. When the company sells (issues) capital it needs to compensate the buyer for potential risks of which the buyer is unaware, therefore external capital is more costly than internal capital. The compensation is greater the more the risk, therefore, safe

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external capital is more attractive than risky external capital. This leads to the pecking order: retained earnings external debt external equity. A highly protable company is likely to have high present value of tax shield and low bankruptcy costs hence should borrow a lot according to static trade off theory. A highly protable company has high retained earnings, hence unlikely to use debt in the pecking order hence should borrow relatively little according to pecking order theory. 4. (a) P0 =
D1 +P1 , 1+r

P1 =

D2 +P2 , 1+r

and in general Pt = P0 =

Dt +Pt , 1+r

which implies

D1 D2 Dt + + + + 2 1 + r (1 + r) (1 + r)t

If dividends grow at a constant rate, we nd P0 = D1 (1 + g) D1 (1 + g)t1 D1 1+g D1 + + + + = + P0 1+r (1 + r)2 (1 + r)t 1+r 1+r
D1 . rg

which implies P0 = (b) Net present value is

N P V = 1, 000, 000 +

100, 000 1 1 50, 000 1 + = 123, 562 10 0.09 1.09 1.0910 0.09

No, the project is not worth while as it has negative net present value. (c) The present value is 876,438, and a 10% increase will yield 964,082 and a 10% decrease 788,794. Even in the most positive outcome here will not yield a positive net present value, which suggests that no further investigation is going to make you change your mind. The best option is to abandon the project with no further action.

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Learning outcomes: 1. Students should be able to explain the concepts of value and risk, and apply these concepts in exercises, specically: After going through the lectures and readings of Value topic you should be able to: explain what we mean by present value and net present value explain why the net present value is the optimal investment criterion for rms work out the present value and net present value of given cash ows work out the present value of perpetuities and annunities with and without constant growth explain why alternative investment criteria such as payback or IRR are not as good as the NPV criterion Question 1.b; 1.c After going through the lectures and readings of Risk you should be able to: explain what relationship between risk and return we observe in nancial markets explain why investors demand compensation for risk explain the capital asset pricing model (CAPM) explain what risk measure is relevant for CAPM and how it relates to the opportunity cost of capital for investment projects explain how we account for risk in capital budgeting Questions 1.a; 2. Students should be able to explain the principles behind the capital budgeting process, and to apply these in exercises, specically: After going through the lectures and readings of Capital Budgeting you should be able to:

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explain how we carry out sensitivity analysis in project analysis explain how we carry out Monte Carlo simulation in project analysis explain the importance of real options in project analysis explain how we can make use of market values in project analysis Question 4.c After going through the lectures and readings of Market Efciency and Behavioral Finance you should be able to: explain why we always use the NPV criterion for both investment and nancing decisions explain what we mean by efcient markets explain the three forms of the efcient market hypothesis explain what we mean by behavioral nance and why markets may become irrational or inefcient explain the lessons of efcient markets in corporate nance, and how we should respond if we think markets are not efcient explain the patterns of nancing and the process of security sales for corporations Question 1.c 3. Students should be able to explain the principles behind payout policy and capital structure decisions, and to apply these in exercises, specically: After going through the lectures and readings of Payout Policy and Capital Structure you should be able to: explain the methods by which companies payout cash to shareholders explain how companies decide on payout policy

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explain what information is conveyed in decisions on dividend and stock repurchases explain the Modigliani-Miller irrelevance theorems of dividend policy and capital structure explain how the nancial risk of equity is altered by leverage, and apply the WACC formula explain the effects of taxation on the leverage decision explain the static trade-off and pecking-order theories of capital structure explain and apply the adjusted present value method Question 3.a; 3.b; 3.c 4. Students should be able to explain the concepts related to real options in capital budgeting, credit risk, risk management, and mergers, takeovers, and corporate governance, and to apply these in exercises, specically: After going through the lectures and readings of Options you should be able to: explain what we mean by put and call options explain and apply the risk neutral valuation method for options in a binomial framework explain what is meant by, and give examples of, real options work out the value of a follow-on investment, timing exibility, and abandonment options, using option pricing theory Question 2.a; 2.b; 2.c After going through the lectures and readings of Debt Financing you should be able to: explain how we work out the yield on debt explain how credit risk can be expressed in terms of a default option explain methods for predicting default used in practice outline different types of debt

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explain how debt contracts are structured, and features such as security and seniority, repayment provisions, and other types of debt covenants explain what is meant by convertible debt explain how leasing works After going through the lectures and readings of Risk Management you should be able to: explain why companies should manage risk explain why adverse selection and moral hazard may make direct insurance expensive explain how we should structure a hedging programme using forwards or futures contracts After going through the lectures and readings of Mergers, Corporate Control, and Governance you should be able to: explain some sensible reasons, and some less sensible reasons, why rms merge explain how we can estimate the gains from mergers explain how mergers work explain what is meant by proxy ghts, takeovers, and leveraged buyouts explain what is meant by spin-offs and carve-outs explain how bankruptcy procedures work explain features of the corporate governance system