THELONDON SCHOOL

OFECONOMICS AND
POLITICAL SCIENCE ■

Mock Exam 2

FM213
Principles of Finance

Suitable for all candidates

Instructions to candidates
This paper contains four questions: two in Section A and two in Section B. Answer two questions from
Section A and two questions from Section B. All questions will be given equal weight (25%).

Time Allowed Reading Time: None

Writing Time: 3 hours

You are supplied with: No additional materials

You may also use: No additional materials

Calculators: Calculators are allowed in this examination

© LSE ST 2019/FM213 Page 1 of 5

b. Briefly describe how one would test whether the CAPM is empirically valid. Proceed to discuss the
evidence on the CAPM's validity and to suggest alternative asset pricing models that fit the data
better. (1 O marks)

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 Section B: Answer two questions from this section and another two from Section A

1) M&A and Payment Methods

Your company has earnings per share of £4. It has 1 million shares outstanding, each of which has a price
of £40. You are thinking of buying DeltaCo, which has earnings per share of £2, 1 million shares
outstanding, and a price per share £25. You will pay for DeltaCo by issuing new shares. The synergy as a
result of this acquisition will increase your original company's EPS and share price both by 25%.

a. If you pay no premium to buy DeltaCo, what will your earnings per share be after the acquisition? (4
marks)

Starting from this point, suppose you pay a 20% premium to buy DeltaCo.

b. What will your earnings per share be after the acquisition? (6 marks)

c. Are you better off with this acquisition? What is the maximum percentage premium you are willing to
pay before DeltaCo becomes too expensive to acquire? (7 marks)

d. Instead of using pure equity to pay for the deal, now assume you pay the deal with 50% cash coming
from your old company and 50% newly issued shares. What is the number of shares issued? (8
marks)

2) Conflict between Debt and Equity Holders and Security Design

a. Briefly explain the risk-shifting problem. (2 marks)

Consider a risk neutral entrepreneur who has two investment opportunities. Both require an investment of
£100 upfront with the following payoffs in the next year:

A pays: £200 with probability 0.4 and £0 with probability 0.6.

B pays: £120 for sure.

The risk free rate is normalized to 0 for xour computational convenience.

b. If the entrepreneur has £100 in cash to fund the investment, which project will he choose? Show
your calculations. (2 marks}

c. Now, suppose the entrepreneur has no cash and must issue straight deb� with one year maturity to
raise the required investment of £100. If the entrepreneur can commit to take project B, what is the
required face value of debt such that the market value of debt is £100? After the debt is in place,
which project will the entrepreneur choose? Show your calculations. (4 marks)

d. If you were a sophisticated bank, expecting the entrepreneur's choice of investment after taking the
loan, would you make .the loan at any face value? If not, why? If so, at what face value can you
break even? (2 marks}

Now consider an alternative world in which the entrepreneur issues convertible debt (one year maturity).
Suppose the company has 10 shares outstanding at the time of debt issuance. The convertible debt has a
face value of £100. It can be converted into 40 shares at maturity if the debt investor wishes.

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 e. Should the investor convert if project A is taken and £200 is realized? Should the investor convert if
B is taken and £120 is realized? (5 marks)

f. Given the conversion decision in e), what is the entrepreneur's expected pay-off with project A? How
about the pay-off with project B? Which project will the entrepreneur choose under convertible debt
financing? (5 marks)

g. Compare your findings in c) and d) with e) and f). What can you say about straight debt financing
and convertible debt financing under conflict of interest between debt and equity? (5 marks)

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