retake_CF2018_versionA.pdf - School of Business and...

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Unformatted text preview: School of Business and Economics Exam: Corporate Finance 2.5 Code: E_EBE2_CF Examinator: Jan Schnitzler Co‐reader: Tanja Artiga Gonzalez Date: July 6, 2018 Time: 11:45 Duration: 2 hours Calculator allowed: Yes Graphical calculator allowed: No Number of questions: 14 Type of questions: Multiple Choice/Open Questions Answer in: English only Remarks: This is a closed book exam. Mark your answers to multiple choice (MC) questions on the separate MC‐answering form. Only one answer is correct (a, b, c, or d). For questions 9‐10, only write your final result in the assigned space (for percentages report two digits after the decimal point). Regarding open questions 11‐14, write your answers into the indicated spaces and make sure that it is legible. You may use disposable sheets for preliminary notes if necessary. Credit score: The maximum number of points that can be reached is 100. Since guessing in MC questions gives 2/8 correct answers in expectation, this part of the exam includes an adjustment factor. Therefore, you can obtain a maximum score of 35 MC points even though there are 8 MC questions. Grades: July 20, 2016 Inspection: to be announced on blackboard Number of pages: 14 (including front page) Good luck! 1 Question 1 (5 points, Multiple Choice): Consider perfect capital markets, which of the following statements is true? a. Debt financing is preferred over equity financing because interest rates on debt are lower than the required return on equity. b. Earnings per share are higher if a company uses relatively more debt financing. c. Issuing new shares dilutes existing shareholders’ claims to cash flows, leading to a lower stock price. d. None of the above. Question 2 (5 points, Multiple Choice): Consider a company with strictly positive corporate tax rates. The company intends to change its capital structure by increasing its debt/equity ratio. In which direction will the (after‐tax) WACC change? a. The WACC declines. b. The WACC remains constant. c. The WACC increases. d. The change in WACC is undetermined. Question 3 (5 points, Multiple Choice): Which of the following is not an indirect cost of financial distress. a. Loss of customers. b. Asset sales at fire sale prices. c. Loss of suppliers. d. Fee for trustee overseeing bankruptcy process Question 4 (5 points, Multiple Choice): Which statement describes the pecking order theory in corporate finance? a. A firm’s cash flows can be distributed according to strict seniority schedules in the following order: secured debt, wages, unsecured debt, equity. b. Firms have preferences about their funding sources in the following order: internal financing, debt financing, equity financing. c. Over the life cycle, companies’ equity funding sources change in the following order: from seed financing, to VC financing, up to public equity. d. None of the above. 2 Question 5 (5 points, Multiple Choice): Which statement about the introduction of an initial dividend is incorrect? a. According to tax aspect, it could lead to negative stock returns because excess cash kept inside the firm creates a valuable tax shield, just like debt. b. According to a life cycle model, it could lead to negative stock returns because it indicates the end of a high growth period. c. According to agency theory, it could be positive news because it signals that the company does not suffer (anymore) from a free cash flow problem. d. None of the above. Question 6 (5 points, Multiple Choice): Which of the following is not an advantage for firms deciding to list their equity publicly in an IPO process? a. The transparency that comes along with a public listing imposes stock market discipline on managers. b. A more dispersed ownership after the IPO improves monitoring incentives. c. A public listing gives potential access to large amounts of capital. d. An IPO allows a firm’s initial shareholders to diversify their wealth. Question 7 (5 points, Multiple Choice): Consider capital markets with strictly positive corporate tax rates and no other frictions. When comparing the terms of a true tax lease to purchasing the asset, which of the following statements is correct? a. Using relatively more equity to finance the purchase makes a purchase more attractive. b. Using relatively more debt to finance the purchase makes the lease more attractive. c. Financing the purchase with an amount of debt equal to the lease‐equivalent loan leads to indifference between leasing and purchasing the asset. d. None of the above. Question 8 (5 points, Multiple Choice): Which statement about corporate governance is true? a. Directors in public companies are supposed to support executive managers in any way due to the fiduciary duty that they owe to executive managers. b. Dutch co‐determination refers to CEOs also serving as chairman of the board, which is commonly observed in the Netherlands. c. If shareholder activists have the backing of a majority of shareholders, they have the natural right to fire executive managers. d. The Dutch Corporate Governance Code encourages managers to apply good governance standards on a comply‐or‐explain basis. 3 Question 9 (5 points, Open Question): Under its current capital structure, a company’s cost of equity are 12%, the cost of debt 4%, and the corporate tax rate 25%. The firm maintains a fixed debt/equity ratio, and intends to increase that ratio from 1/3 to 1/2. Assume that this change does not affect the cost of debt. What is the company’s cost of equity after adjusting its capital structure? Answer: ________ Question 10 (5 points, Open Question): An all‐equity company has a stock price of $25/share and 800,000 shares outstanding. The company has excess cash of $2 million that it uses to repurchase shares in the market. What is the stock price after the share repurchase? Assume perfect capital markets. Answer: ________ Question 11 (18 points, Open Question): a. State three assumptions of the Modigliani Miller Theorem. For each assumption, briefly explain why the theorem breaks down should the assumption not be satisfied. 4 b. Describe the Free‐cash‐flow problem and explain how it relates to a company’s capital structure. 5 c. State at least 4 common characteristics of a bond contract that have an impact on a bond’s market price. Provide a brief explanation. Question 12 (6 points, Open Question): Consider a one‐period model: the firm value will be either 200 or 50 with equal probability at the end of the period. The firm has bonds outstanding with a face value of 100. In a recent board meeting, managers discussed the option to decrease the amount of debt to a face value of 80 by repurchasing bonds in secondary markets. Suppose bondholders are only willing to sell at a price that reflects the new capital structure (i.e. a price at which they are indifferent between selling or holding on to the bond). If managers strictly act in the interest of maximizing the equity value, will they consider repurchasing bonds? Assume that the firm would have to raise the required funds for the bond repurchase from shareholders. Everyone is risk‐neutral and there is no discounting. 6 Question 13 (14 points, Open Question): Consider an all‐equity firm that is run by a manager who acts in the best interest of existing shareholders. The value of the firm’s assets in place is either $40M or $140M. The firm has an investment project that requires an investment of $24M. Assume that the only way to finance this project is by issuing equity to new investors in a competitive stock market. The new project generates a certain, risk‐free cash flow of $30M next year (i.e. this cash flow does not depend on the value of assets in place). Everyone is risk‐neutral and there is no discounting. a. Suppose that everyone, including the manager, believes that assets are worth $40M with probability ½ and $140M with probability ½. What fraction ∝ of the firm’s equity has to be issued to new investors to raise $24M. Does the manager want to issue equity? 7 b. Suppose now that there is asymmetric information. While the manager knows the true value of the assets in place, investors continue to view both possibilities as equally likely. Suppose that investors believe that the manager always issues equity regardless of the true value of assets in place, does a manager want to issue equity if assets in place are worth $140M? c. Suppose that there is asymmetric information as in part b). What should investors conclude if the manager agrees anyways to issue equity? Would they demand a different fraction α of the firm’s equity to provide financing? 8 d. Suppose that there is asymmetric information as in part b), i.e. only the manager knows the true value of assets in place. Furthermore, suppose now that the managers also have access to debt financing and can issue either debt or equity to raise the $24M. Will a manager with assets worth $140M want to issue debt? What about a manager with assets worth $40M? Question 14 (17 points, Open Question): You are interested in the valuation of VUnited, a promising private firm. Your consultants suggest to use ABC LLC as a comparable firm to estimate the cost of capital. ABC’s capital structure policy is to maintain a fixed debt level of $200M. ABC has an equity market 9 capitalization of $600M, an equity beta of 1.2, and a debt beta of 0.2. The corporate tax rate of both companies is 25%. The CAPM holds with a risk‐free rate of 2% and a market risk premium of 5%. a. What is ABC’s asset beta? And what are its corresponding unlevered cost of capital? VUnited is a quickly growing firm: for the upcoming two years analysts forecast 22 and 36, and NWC increases by $2 million in each of the two periods. Thereafter, you expect EBIT to continue to grow at a rate of 3% p.a. in perpetuity. Capital expenditures balance depreciation expenses at all times, and there is also no increase in NWC in later periods. b. What are VUnited’s expected free cash flows for the next three years? 10 c. What is VUnited’s unlevered firm value? Assume VUnited maintains a fixed debt level of $200M on which it pays 2.5% interest. d. What is the present value of all future tax shields? What is the levered value? 11 e. What happens to the tax shield and the unlevered firm value if the government decides to decrease the tax rate to 15%? Assume that the unlevered cost of capital do not change. (If you can’t compute it, you also get partial points for verbal explanations.) Extra Space: 12 13 14 ...
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