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92 Corporate finance Zone A

Important note

This commentary reflects the examination and assessment arrangements

for this course in the academic year 201011. The format and structure

of the examination may change in future years, and any such changes

will be publicised on the virtual learning environment (VLE).

Candidates should answer FOUR of the following EIGHT

questions: ONE from Section A, ONE from Section B and TWO

further questions from either section. All questions carry equal

marks.

A list of formulas, extracts from Present Value and Annuity Discount

tables, are given at the end of the paper.

A calculator may be used when answering questions on this paper

and it must comply in all respects with the specification given with

your Admission Notice. The make and type of machine must be

clearly stated on the front cover of the answer book.

Section A

Answer one question from this section and not more than a further

two questions. (You are reminded that four questions in total are to be

attempted with at least one from Section B.)

Question 1

a. Derive the risk of a N-asset portfolio in terms of the average variance of

the N assets and the average covariance across all assets. Discuss the

implication(s) of the number of assets (N) in portfolio management and

diversification of risk.

(10 marks)

Reading for the question

Subject guide, pp.2829.

Approaching the question

There are two parts in this question. First we should derive the risk

of a portfolio. Next we should discuss the implications. You should

start off with the general form. The portfolios risk with N-stock of

equal weighting in each stock is defined as:

2

(1) p =

1

N2

i =1

2

i

1

N2

ij

i j

between returns on stock i and j.

1

92 Corporate finance

summation of all covariances results in N(N1) terms. We can

simplify (1) as

2

(2 ) p =

N 2 N ( N 1)

1 2

1

+

C= + 1 C

2

2

N

N

N

N

As N goes to infinite, (2) can be simplified as

2p = C.

There are a few key implications:

i. As the number of stocks in a portfolio increases, the portfolios risk

tends towards the average covariance.

ii. As long as the stocks are not perfectly correlated, the portfolios risk

decreases as we include more stocks.

iii. In terms of portfolio management, one should try to balance out

(ii) above to the transaction costs of including additional stocks in a

portfolio.

b. Critically assess the validity of the Capital Asset Pricing Model in light of

Rolls critique and other anomalies.

(15 marks)

Reading for the question

Subject guide, pp.3439; BMA, Chapter 8, pp.22227.

Approaching the question

This question aims to test candidates ability to disseminate

ideas gathered from the subject guide and the relevant textbook

materials. The key points that should be clearly discussed are as

follows:

i. The validity of CAPM depends on whether the market portfolio is

mean-variance efficient

ii. The true market portfolio is not observable

iii. Proxies for the market portfolio are often taken from broad-based

equity indices which do not contain all the tradable securities or nonfinancial assets such as real estates, durable goods and even human

capital

iv. This renders the CAPM untestable

v. If the CAPM is untestable, then any empirical evidence as argued by

Roll would be inconclusive about the validity of the CAPM

vi. Other anomalies such as the size effect, book-to-market ratio and P/E

effect seem to suggest that there are risks that are not captured by the

CAPM.

Question 2

a. Explain clearly why it is impossible to successfully takeover a company

according to Grossman and Hart (1980).

(10 marks)

Reading for the question

Subject guide, pp.13940.

Approaching the question

This question was generally well answered. Candidates seem to be

able to memorise the materials from the subject guide. However, a

good answer should be one which reflects candidates understanding

of the arguments put forward by Grossman and Hart (1980).

2

Some key points that you might want to discuss would be as follows:

i. The acquired firms value will increase if the takeover is successful. The

gain is z.

ii. The equity of the acquired firm is held by many, small

shareholders.

iii. The acquiring firm pays a premium p and incurs a cost of takeover, c.

iv. Acquiring firm will take over the acquired firm provided that z > p + c.

v. But a minority shareholder will only be willing to sell his/her shares if

p > z; if thats not the case, he/she will wait for the others to sell their

shares and enjoy the free-ride to see his/her equity rise to value at z.

vi. As long as none of the minority shareholders perceive themselves to

be pivotal, everyone will free-ride on the improvement of the value

offered by the acquiring firm.

vii. Given that, the bid will fail.

b. Outline the arguments for the agency cost on debt. Explain how the use of

convertible bonds might mitigate the agency conflict between equity-holders

and debt-holders in financially distressed firms with high debt to equity ratios.

(15 marks)

Reading for the question

Subject guide, pp.11218.

Approaching the question

Key points:

i. The agency costs on debt arise in two folds:

a. The value of debt decreases due to sub-optimal managerial decision

b. Debt-holders impose more measures on corporate governance

structure and restrictive clauses in the debt covenants to safeguard

their interests.

ii. These costs rise as more debts are issued

iii. If corporate managers are not looking after the debt-holders interests,

then there might be cases when a firm might be over-investing in risky

projects in the expense of debt-holders, under-investing when small

but safe NPV projects are passed, and swapping for more risky projects

once a loan is obtained

iv. Convertible bonds might help mitigate these problems when the debtholders perceive that their interests are not being protected and risks

are being shifted from the shareholders to them.

Question 3

a. Explain clearly the 3 main conditions for debt to work effectively as a signal

of a firms value.

(9 marks)

Reading for the question

Subject guide, pp.11920.

Approaching the question

Many candidates simply reproduced the material from the subject guide

without clearly identifying and explaining those three key conditions.

The subject guide outlines the Ross model (1977) but what you need is to

understand how those equations in the model work. In general, there are

three key conditions:

3

92 Corporate finance

i. The market is adhering to the semi-strong form efficient but not strong

form. A firms true value is therefore not observable.

ii. Good quality firms have high future cash flows and low quality firms

do not. Good firms can issue relatively high percentages of debt and

still comfortably service the high interest payments.

iii. The penalty for the managers of a low quality firm to lie about its value

by issuing temporarily high levels of debt would need to outweigh the

benefit that those managers might derive from the short-term rise in

the firms value.

b. Critically assess the empirical evidence for the semi-strong form of market

efficiency.

(10 marks)

Reading for the question

Subject guide, pp.8183.

Approaching the question

To tackle this question, you should highlight the key points relating to the

testing of semi-strong form efficient markets. Some of the key points can

be summarised as follows:

i. The test for semi-strong form efficiency is about how fast and accurate

information from an event can be incorporated into prices.

ii. Identify a sample of firms for a particular event.

iii. Measure the ex ante expected return of each firm.

iv. Construct the average abnormal return by comparing the actual

average return to the average expected return.

v. The cumulative abnormal returns before and after the event is then

examined.

To improve the quality of the answer, you should provide a discussion

on the empirical evidence. For example, Asquith and Mullins (1983)

suggested that information incorporated within 510 minutes and share

prices moved up on unexpected dividend announcements. It seems to

suggest that such a market is adhering to the semi-strong form efficiency.

However, Ball and Brown (1968) argued that unexpected earnings may

not be fully incorporated in stock prices. This seems to suggest that

empirical evidence for or against market efficiency might be period

specific and methodology dependence.

c. Explain why Net Present Value is a better investment appraisal technique

than Internal Rate of Return.

(6 marks)

Reading for the question

Subject guide, pp.1819; BMA, Chapter 5, pp.13743.

Approaching the question

This part was generally quite well answered. The key points that should

be discussed are:

i. IRR does not account for the size or magnitude of the project. It is not

a good tool to rank projects.

ii. Cost of capital may vary over time but IRR assumes that any spare cash

can be re-invested at the same rate. This might not be realistic.

iii. IRR is not additive and therefore the total IRR of all projects need

to be re-computed. NPV has an additive property and therefore the

combined effect can be determined easily.

Question 4

a. Explain, with the aid of a diagram, why a firms dividend policy is independent

from its investment policy in a perfect and complete market. You should

include a discussion of the Fishers Separation Theorem in your answer.

(10 marks)

Reading for the question

Subject guide, pp.914.

Approaching the question

In a perfect and complete capital market where there is no transaction cost

and information is widely available to everyone, it is argued that a firms

investing, financing and dividend decisions are not interlinked. This can be

illustrated in the following diagram.

W1

B

Individual 1

y1

C1*

A

C0*

y0

Individual 2

W0

C0

period 1) with an initial cash flow of Y0. It has the opportunity to invest in

two types of investments. The first type of project relates to investments

which require an initial investment outlay, CFi,0 and deliver CFi,1 in the

next period for each investment i. Thereafter it is referred to as production

investment projects. The second type of investment is essentially financial

which allows the firm to borrow and lend an unlimited amount at an

interest rate of r. In this case, if a firm borrows (or lends) W0 in period 0, it

will pay back with interest (or receive with interest) W1 = W0(1 + r).

Investing decision

What should the firm do in terms of its investments?

A firm will logically rank and invest in production investment projects

in descending order of their profitability (Ri for each i). A production

opportunity frontier can be obtained (such as the curve Y0Y1). A firm will

invest up to the point where the marginal investment i* yields a return that

equals to the return from the capital market (i.e. interest rate r). The total

investment outlays, the amount represented by C0Y0, is the sum CFi,0 for all

i (i = 1 to i*). Once the investment plan is fixed, the firm will have C*0 in

period 0 remaining and a cash return of C*1 in period 1.

Dividend policy

In this setting, how much should the firm give out as dividend to its

shareholders in each period? The answer is simple. It should give out C0 and

C1 in period 0 and 1 respectively. However, would shareholders be satisfied

with these amounts in each period? Suppose we have two individual

shareholders 1 and 2. Each of them has their unique utility function of

5

92 Corporate finance

curves in the diagram above. For individual 1, he prefers to consume less

in period 0 and more in period 1. Given the current firms dividend policy,

how would he be satisfied? There are two ways to achieve it.

The firm will pay C0,a and invest any excess cash flow (i.e. C*0 C0,a ) at

r in period 0 and give out C*1 + (C*0 C0,a)(1 + r). Mathematically, it can

be proved that it is equal to C1,a. Therefore the firm will pay the exact

dividend in each period to individual 1.

Alternatively, the firm pays C*0 to individual 1 and he can invest any

excess cash flow after his consumption in period 0 in the financial

investment earning a return of r and receive the same combined cash flow

of C1,a.

This reasoning applies to any individual shareholders with any unique

utility functions. Take Individual 2 as an example. Her consumption

pattern does not match the firms dividend payout. Similarly, there are two

ways we can satisfy her consumption pattern.

The firm will borrow C0,b C*0 at r in period 0 and pay out C0,b to

individual 2. In period 1, the firm will pay out C*1 (C0,b C*0)(1 + r).

Mathematically, it can be proved that it is equal to C1,b. Therefore the firm

will pay the exact dividend in each period to individual 2.

Alternatively, the firm pays C*0 to individual 2 and she borrows any

shortfall to make up to her consumption C0,b in period 0. In period 1, she

will receive C*1 less the loan and interest she takes out in period 0. This

will leave her with a net amount exactly equal to C1,a.

The above argument indicates that financial managers do not need to

consider shareholders consumption patterns when fixing the investment

plan or the dividend policy. The easiest way is to maximise the firms

cash flows and distribute the spare cash flows as dividends. Shareholders

will use the capital markets to facilitate their consumption patterns

accordingly.

Financing decision

In the beginning, we assume that the firm has an initial cash flow of

Y0 and requires a total investment outlay of C0Y0. If any part of Y0 is

not contributed by shareholders, the firms dividend in period 1 will

be reduced by the fund raised from borrowing (at a cost of r) and the

interest. However, shareholders can offset this shortfall of dividend in

period 1 by investing the fund not contributed in the firm in the capital

market and earn a return exactly equal to r.

The above argument illustrates the Fisher separation in which the

investing, financing and dividend decisions are all unrelated. However,

if the capital market is imperfect, such external funding is restricted; this

might break the Fisher separation. For example, to increase investment, a

firm might need to raise extra borrowing. If borrowing is restricted, then

the firm will have to reduce the dividend payout. This might affect the

shareholders consumption and hence investment plan and dividend policy

become intertwined.

Candidates need to explain the key concepts above. A good answer

should highlight why a firm can simply maximise its value by

investing in NPV projects and shareholders can use the capital

markets to facilitate their consumptions regardless of what the firm

pays out as dividends.

b. Using the arguments for the signalling and tax clientele effects of dividends,

to what extent would you conclude that dividend policy is relevant to

corporate value?

(15 marks)

Reading for the question

Subject guide, pp.12932.

Approaching the question

This question requires candidates to carefully explain the signalling

effect and the tax effect of dividend policy. A good answer should

provide a balanced view on how a change of dividend policy might

affect a firms value based on these two theories.

Some of the key points which might be discussed are as follows:

i. Discuss the stylised facts of dividend by Lintner (1958).

a. Some kind of target payout ratio

b. No change to dividend payout unless it is sustainable

c. Short term increase in earnings does not necessarily prompt

managers to increase payout.

ii. Market is not consistent with the strong form and the quality of a firm

is not observable; and hence dividend may serve as a signal.

iii. Unexpected rise in dividend may indicate that a firm has a better

ability to generate future cash flows. Its value will rise accordingly. On

the other hand, an unexpected dividend cut may signal the financial

problem a firm is facing. Share price may fall as a result.

iv. Tax shareholders pay different marginal tax rates on dividend income

and capital gain. Therefore those who have a higher tax rate on capital

gain would prefer firms to pay a higher dividend while those who pay

a lower capital gain tax will prefer the firms to pay a lower dividend.

v. However, the tax clientele effect will disappear in equilibrium. The no

arbitrage ensures that any difference in value of firms with different

payout ratios will disappear.

Section B

Answer one question from this section and not more than a further

two questions. (You are reminded that four questions in total are to be

attempted with at least one from Section A.)

Question 5

a. Tiger plc has the following projects:

Projects

A

B

C

D

Initial Investment,

NPV (after tax),

100,000

10,000

150,000

25,000

75,000

5,000

50,000

6,000

investment opportunity for the firm with any spare cash which is not

invested in the above 4 projects.

i. Assume that all projects above are infinitely divisible. Explain, with supporting

calculations, which projects the company should choose to maximise its

value? What is the optimal NPV of the investment plan? (3 marks)

[For the full question, please refer to the examination paper.]

92 Corporate finance

BMA, Chapter 5, pp.14347.

Approaching the question

To tackle this problem, one should first calculate the profitability

index (defined as NPV/initial investment) for each project.

Projects

A

B

C

D

Initial Investment,

100,000

150,000

75,000

50,000

10,000

25,000

5,000

6,000

PI

1.10

1.17

1.07

1.12

Ranking

3

1

4

2

half of A, i.e.:

Total NPV = 25,000 + 6,000 + 0.5 10,000 = 36,000.

If investments are not infinitely divisible, then we should invest in B and

A, i.e. Total NPV = 35,000.

b. CM Ltd has been presented with the following project:

A new machine for 100,000 is required at the beginning of the first year. The

machine will last for 4 years and thereafter can be disposed of for 20,000.

The companys policy is to depreciate this type of machine over its economic

life on a straight-line basis.

The demand for the product CF depends on the states of the economy in the

future. In the good state, CM Ltd expects to sell 12,000 units per year for the

next 4 years. If the economy is bad, sales will fall to 8,000 units per year. Each

state of the economy has an equal probability to materialise.

[For the full question, please refer to the examination paper.]

A suggested solution to part (i) is given below:

Year

0

Machine

(100,000)

Revenue

4

20,000

300,000

300,000

300,000

300,000

(250,000)

(262,500)

(275,625)

(289,406)

50,000

37,500

24,375

30,594

(7,500)

(5,625)

(3,094)

3,478

(100,000)

42,500

31,875

21,281

34,072

DF

0.909

0.826

0.751

0.683

PV

(100,000)

38,633

26,329

15,982

23,271

50,000

37,500

24,375

30,594

(25,000)

(18,750)

(14,063)

(42,188)

25,000

18,750

10,313

(11,594)

7,500

5,625

3,094

(3,478)

Costs

NCF before tax

(100,000)

Tax

NCF after tax

NPV

NCF = Taxable profit

Capital allowances

Taxable profit after CA

Tax (@30%)

4,215

i. If the demand is dependent on the states of the economy (like in this

question), you are expected to consider ONLY the expected demand in

the numerical analysis (unless it is stated otherwise in the question).

ii. Non cash items should not be included in the NPV calculations. You

should also clearly mention why those non cash items should be

excluded from the analysis.

iii. Capital allowance must be calculated in accordance with the rule given

in the question.

Year

0

Written down value

100,000

Capital allowance

75,000

56,250

42,188

25,000

18,750

14,063

42,188

Part (ii) requires candidates to re-work the NPV if the project is to defer by

one year.

Year

0

Machine

360,000

360,000

(330,750)

(347,288)

45,000

29,250

32,713

(6,000)

(3,150)

7,061

(100,000)

39,000

26,100

39,774

0.909

0.826

0.751

0.683

(90,900)

32,214

19,601

27,165

Tax

1

PV

(11,919)

Capital allowances

Taxable profit after CA

Tax

Written down value

Capital allowances

20,000

360,000

(100,000)

(315,000)

costs

NPV

(100,000)

Revenue

DF

100,000

45,000

29,250

32,713

(25,000)

(18,750)

(56,250)

20,000

10,500

(23,538)

6,000

3,150

(7,061)

75,000

56,250

25,000

18,750

56,250

Assumptions:

i. We assume that the machine will be purchased in one years time if the

project is to be deferred. The resale value remains the same by the end

of year 4.

ii. The annual cost will still rise at 10% per annum.

iii. The firm will only (potentially) engage in this project if the good state

of the economy is realised.

Since there is a 50% chance that the good state of the economy will

realise, the expected NPV of deferring the project until year 2 is 5,960

(0.5 11,919). The deferment is not advantageous.

92 Corporate finance

Question 6

a. The last 5 years returns on Vjay plc and on the broad market index are as

follows:

Year

Vjay, %

Market, %

2010

2009

2008

10

2007

13

10

2006

14

15

If the risk free rate is expected to be 3% per annum in the foreseeable future,

estimate Vjays beta using the covariance method and its expected return

according to the Capital Asset Pricing Model (CAPM).

(10 marks)

Reading for the question

BMA, Chapter 7, pp.20205 (especially Table 7.7).

Approaching the question

This is a straightforward textbook type question.

I

II

III

IV

VI

VII

Vjays rtn, %

Markets rtn, %

I - mean

II - mean

III2

IV2

III x IV

2010

2009

2008

2007

2006

2

0

10

13

14

5

2

7

10

15

Sum

Mean

Variance

Covariance

Standard deviation

Beta = Cov/Var(M)

Expected return

35

7

25

5

Year

9

7

3

6

7

10

7

2

5

10

81

49

9

36

49

100

49

4

25

100

90

49

6

30

70

224

278

245

56

69.5

61.25

7.48

61.25/69.5

0.88

4.76

two-factor model:

rx = 0.2 + 2 F1 F2 = 5%

ry = 0.16 + 4 F1 + 2 F2 = 7%

rz = 0.1 + 1F1 + F2 = 9%

i. Determine the portfolio weights you need to place on x, y and z in order

to replicate the portfolio returns on F1 and F2 respectively.

(10 marks)

Reading for the question

Subject guide, pp.4850.

Approaching the question

Let w1, w2, and w3 be the weights in x, y and z respectively.

Forming the first factor loading, we have:

1. w1 + w2 + w3 = 1

2. 2w1 + 4w2 + w3 = 1

10

8.34

3. w1 + 2w2 + w3 = 0

We can either solve the three equations simultaneously using a matrix or

solve each pair of equations at a time.

(2) (3) => 3w1 + 2w2 = 1

(2) (1) => w1 + 3w2 = 1

=> w2 = 2/7

=> w1 = 11/7

=> w3 = 9/7

Forming the second factor loading, we have

1. w1 + w2 + w3 = 1

2. 2w1 + 4w2 + w3 = 0

3. w1 + 2w2 + w3 = 1

=> w2 = 1/7

=> w1 = 3/7

=> w3 = 2/7

ii. The return on Stock M is known to follow the factor model below rm = 0.5

F1 + 1.5F2. It is currently traded with a return of 10%. Explain if any arbitrage

opportunity arises in this case.

(5 marks)

F1 = 0.43r1 + 0.417r2 + 0.194r3 = 0.43 5 +0.417 7 + 0.194 9 = 2.515

F2 = 0.333r1 + 0.667r3 = 0.333 5 + 0.667 9 = 4.338

rm = 0.5 F1 +1.5F2 = 0.5 2.515 + 1.5 4.338 = 4.492

Since the return based on the factor model is well below the

observed return (10%), an arbitrage opportunity seems to exist.

However, if the factor representation is not a true model, then such

a price difference might not be reconciled.

Question 7

Blue Shark plc, a quoted company in the UK, is considering a takeover of Black

Seal Ltd. Both companies are 100% equity financed. The following information is

available for these two companies:

Blue Shark

Number of shares

Black Seal

10,000,000

1,000,000

10

Not available

0.8

Share price

Dividend per share (latest)

You discover the following additional information:

i. Black Seal Ltd. has been paying a constant dividend for the last 5 years to its

shareholders.

ii. The Directors of Black Seal have been using a discount rate of 15% to

appraise its projects.

iii. It is believed that if the takeover is successful, Black Seals dividend per

share will grow at 10% per year.

[For the full question, please refer to the Examination paper.]

Reading for the question

BMA, Chapter 31, pp.82933.

11

92 Corporate finance

Cash consideration

Cost of acquisition = 15,000,000

Net cost = 15,000,000 5,666,667 = 9,666,667

Gain = 17,600,000 10,666,667 = 12,266,667

Net gain = 12,266,667 9,666,667 = 2,600,000

Share exchange

Value of the combined company = 100,000,000 + 17,600,000 =

117,600,000

New share price = 117.6m/11m = 10.69

Cost of acquisition = 10.69 1m = 10,690,909

Net cost = 10,690,909 5,333,333 = 5,357,576

Gain = 12,266,667 (same as the cash consideration)

Net gain = 12,266,667 5,357,576 = 6,909,091

The advantages and disadvantages of cash and share exchange in M&A

can be summarised as follows:

Cash

Acquired

Acquiring

Advantages

cash flow when they sell their

shares to the acquiring firm. It

implies that they will obtain a

certain return on their investment

will have full control over the

combined operation.

Disadvantages

to a disposal of shares which

will attract capital gains tax and

shareholders will lose ownership

There is a liquidity

implication. Acquiring firm

needs to raise sufficient cash

flows for the acquisition.

Advantages

will maintain some form of

ownership in the combined

operation.

this type of acquisition.

Disadvantages

the combined operation might be

uncertain.

need to share ownership with

the shareholders from the

acquiring firm.

Share exchange

Question 8

a. Mojito plcs share price, S, can either go up to SH or down to SL in the next

period. Derive the price of a call option written on S in terms of a position in

the stock and a risk free asset.

(7 marks)

b. Mojito plcs shares are currently traded at 10 each. Its share price is

expected to go up to 13 or down to 8 in three months time. The effective

interest rate for the next three months is 2%. What is the price of a call

option on Mojitos share with an exercise price of 10?

(5 marks)

c. Explain clearly why the price of a call option does not depend on the

investors risk preference and the probabilities of the future states of the

economy. Determine the risk neutral probabilities of the two states of the

economy in (b).

(13 marks)

12

Subject guide, pp.6063.

Approaching the question

a. Derive the option price.

Form a portfolio with a% in S and b in risk-free asset. This portfolio

mimicks the payoff of a call option:

CH = aSH + b(1 + rf)

CL = aSL + b(1 + rf).

Solving the two equations we have:

a = CH CL / SH SL

b = SLCH SHCL / (1 + rf)(SL SH)

The value of a call, C = aS + b.

b. Given the information in the question, we can determine that:

CH = 3

CL = 0

SH = 13

SL = 8.

Substituting into the two equations in (a) we have:

a = (3 0)/(13 8) = 3/5 = 0.6

b = (8 3 13 0) / (1.02 5) = 4.706

The value of the call, C = 0.6 10 4.706 = 1.294.

c. If SH = uS (u percentage of S) and SL = dS (d percentage of S), then:

a = (CH CL)/(u d)S

b = (uCL dCH)/(u d)R

C = aS + b = (CH CL)/(u d)+ (uCL dCH)/(u d)R.

= [pCH + (1p)CL]/R where p=(R d)/(u d), the risk neutral probability.

Using the information in (b), R = 1.02; d = 0.8; u = 1.3, p = 1.02 0.8 / 1.3

0.8 = 0.44.

Information about the probability and risk are already priced in the

underlying asset. Therefore the option prices which derived their values

from the underlying assets would reflect this information. To see this, we

can express the current stock price as the probability weighted average

of future prices of the two states:

S = qSH (1 q)SL / 1 + rf

q = R d / u d.

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