Final Exam - Advanced Corporate Finance

MSc Master in Finance Prof. Dr. Burcin Yurtoglu

Student:

Family First Matriculation

name name number

Permitted resources:
 You are permitted to have at your desk: pens, a ruler, a drink and your student ID card.
Pencils are only permitted for sketching. Please don’t use red ink pens.
 Foreign language dictionaries are permitted, as long as they contain no annotations.
 All calculators are permitted.

Examination documents:
 In addition to the examination, you will receive WHU answer sheets. Mark each sheet with
a page number and your last name.
 Use only the WHU answer sheets for your answers. Answers written on task sheets will not
be counted.
 Once finished, turn in all pages of the examination along with the answer sheets.

Writing time and the scope of work:

 The examination consists of 5 questions. Question 1 is compulsory. You have to answer
three of the remaining four questions (of your choice). If you answer more than the
required number of questions, I will discard your answer on the one you performed best.
 You have 90 minutes to answer the questions.
 The maximum number of points is 50.
 Points on each question are given below:

Question 1 2 3 4 5 Total
Points 14 12 12 12 12 50

Answers:
 Please keep in mind that I have to be able to read your answers so that I can grade. Hence,
I can only grade legible answers and I will not interpret answers that I am not able to read.

Questions formulated in text form:

 If not indicated otherwise, questions formulated in text form must be answered in complete
sentences. Bullet point answers are reluctantly permitted, but must be clear and significant.
[Please bear in mind that “normal” people do not communicate using bullet points.]
 Structure your answers. Keep them concise.
 If a question asks for a specific number of instruments, constructs, arguments or the like,
only the required number of arguments will be graded.

Good luck!

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 Question 1 is compulsory. You have to answer three of the remaining four questions (of your
choice).

Question 1 (14 Points)

a) Mr. Johnson and Mr. Williams are the CEOs of similar textile manufacturing companies.
Johnson is 64 years old and will retire next year. Williams is 50 years old and expects to remain
with the firm for some time. Both firms have announced a 10% increase in earnings. Which firm
is more likely to experience a stock price increase? Why? (2 Points)

Mr. Williams is expected to remain with the firm for some time and should care more about
intrinsic value, while Mr. Johnson is expected to care more about current stock price. Hence, Mr.
Williams announcement is more credible. Therefore, Mr. Williams’s firm should expect the
greater stock price increase.
Other plausible reasons:
Higher uncertainty induced by an incoming CEO. Note that this is a less important effect
working through the cost of capital channel.

b) On average, stock prices react positively to announcements that firms will be distributing cash to
shareholders and to announcements that firms will increase their leverage. Stock prices react, on
average, negatively to announcements that will be raising cash and to announcements that firms
will decrease their leverage. State two theories that are capable to explain these patterns and
briefly explain why they do so. (4 Points)

Free-cash-flow Theory / Agency Theory: Managers tend to overinvest, which is bad for investors.
Hence the market reacts positively (negatively) if they distribute (raise) cash.

Asymmetric Information Theory: Such events convey information about the fundamental value of
the assets in place and investment opportunities. Increasing leverage signals that the firm has
good investment opportunities, otherwise managers who are avers to bankruptcy would not
increase leverage (leverage increase, cet. par. increases bankruptcy risk).

Capital market discipline (Easterbrook, 1984): Firms which distribute cash need to go more often
to capital markets, which subjects them to monitoring and discipline by external market
participants.

c) Define „credit rationing”. Why is credit rationing an equilibrium phenomenon? (3 Points)

We reserve the term credit rationing for circumstances in which either (a) among loan applicants
who appear to be identical some receive a loan and others do not, and the rejected applicants

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 would not receive a loan even if they offered to pay a higher interest rate; or (b) there are
identifiable groups of individuals in the population who, with a given supply of credit, are unable
to obtain loans at any interest rate, even though with a larger supply of credit, they would.

Early discussions of credit rationing viewed it as a non-equilibrium phenomenon, arising either

because of exogenous interest rate rigidities (e.g., interest rate ceilings or usury laws) or because
of a lack of competition in the loan market. Later authors made a distinction between temporary
credit rationing, in which market interest rates are slow to adjust to exogenous shocks such as
changes in the lender’s cost of funds or borrower demand, and ‘equilibrium’ credit rationing,
which persists after the market has fully adjusted to these shocks. Clearly the more interesting and
difficult to explain phenomenon is equilibrium credit rationing.

Stiglitz and Weiss (1981): the first model that fully endogenized contract choices with a stable,
rationing equilibrium. In the Stiglitz–Weiss framework, credit rationing occurs because the
lender’s expected return is not monotonically increasing in the interest rate. Instead, adverse
selection or moral hazard problems eventually cause the lender’s expected return to decline as the
interest rate rises.

d) The following results are from Table 4 of Fazzari, Hubbard and Petersen (FHP, 1988) who study
the investment behavior of US firms by estimating a variant of the following regression equation:

Iit / Ki t−1 = α + β CFit / Kit−1 + γ qi t−1 + λt + εit

where I: Investment Expenditures, K: Capital Stock, CF: Cash Flow, q: Tobin‘s Q, i: index of
firms, and t: index of time.

They focus on two different samples of firms (firms with and without dividend payments) and
compare the differential impact of CF in these two samples. The coefficients on CF and Tobin’s q
from such regressions are reported below:

Firms with small or no dividend payments Firms with high dividend payments

(CF it /K it-1) 0.461 (0.027) 0.230 (0.01)

Tobin’s Qit-1 0.0008 (0.0004) 0.0020 (0.0003)

a) Define Tobin’s Q. Why is Tobin’s Q included in such investment equations? (2 Points)

b) How do FHP (1988) interpret the difference in the CF coefficients to infer financing constraints (3
Points)

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Part a:

Tobin’s Q = The Market Value of the Firm / Replacement Cost of the Firm’s Assets

The market value equals the market yalue of the firm’s debt and equity (i.e., the number of shares
outstanding times their market price + price of bonds times bonds outstanding (or an estimate of non-
bond debt).

The replacement cost of assets depends on the business cycle. If the demand for capital goods is
strong, the price of capital goods will rise.

If Tobin’s Q >1, then firms have an incentive to increase their capital stock because capital once
installed and producing goods and services is priced more highly than its cost.

If Tobin’s Q <1, then firms should scrap capital, close plants etc.

Hence, Tobin’s Q is used in investment equations such as used by FHP as a control for investment
opportunities to minimize the concern that CF (which also captures current profitability) is reflecting
investment opportunities.

Part b:

The coefficient on CF it /K it-1 is 0.461 for firms with small or no dividend payments, twice as much for
firms with high dividend payments.

If information problems in capital markets lead to financing constraints on investment, they should be
most evident for the classes of firms that retain most of their income. If internal and external finance
are nearly perfect substitutes, however, then retention practices should reveal little about investment
by the firm. Firms would simply use external finance to smooth investment when internal finance
fluctuates.

Question 2 (12 points)

Consider the relationship between a principal and an agent in which the principal contracts the agent,
whose effort determines the result (say, a measure of output). Assume that the uncertainty present is
represented by three states of the nature (εi, i=1, 2, 3). The agent can choose between two effort levels.
The results are shown in the following table:

States of Nature
Effort Levels ε1 ε2 ε3
e=6 60000 60000 30000
e=4 30000 60000 30000

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The principal and the agent both believe that the probability of each state is one third (pi = 1/3, where i =
1, 2, and 3). The objective functions of the principal and the agent are, respectively:
The principal: 𝐵𝐵(𝑥𝑥, 𝑤𝑤) = 𝑥𝑥 − 𝑤𝑤

The agent: U ( w, e) = w − e2

Where x=x(e, ε) is the monetary result of the relationship and w=w(x) is the monetary pay-off that the
agent receives. Assume that the agent will only accept the contract if he obtains an expected utility of at
least 114 (his reservation utility).
a) What can be deduced from the participants’ utility functions (in terms of their attitudes towards
risk)? (3 points)
b) What would be the effort and the wage in a situation of symmetric information? (3 Points)
c) What happens in a situation of asymmetric information? What pay-off scheme allows an effort level
of e=4 to be obtained? What pay-off scheme allows the effort level of e=6 to be obtained? Which
effort level does the principal prefer? (6 points)

(a) The principal is risk-neutral and the agent is risk averse: UAgent’’ < 0, UPrincipal’’ = 0.

(b) The optimal contracts are derived from (i) the principal accepts all the risk, and (ii) the
participation constraint binds.

If e= 6, then w is such that w1/2 - 62 = 114, which is w = 22,500. In this case, Up= 50,000 - 22,500 =
27,500.

If e = 4, then w = 16,900 and Up= 23,100. The symmetric information solution is: e*= 6, w*= 22,500.
If the principal was not risk-neutral, then both participants would share the risk inherent in the
relationship.

(c) The optimal contract if e = 4 is the same as before: w= 16,900, since given a constant wage the
agent will always choose the lowest effort level. In order to achieve e = 6, the principal must offer a
contract that is contingent on the result. She will pay w(60) if the result is 60,000 and w(30) if the
result is 30,000. The contract must simultaneously satisfy the participation and the incentive
constraints:

𝟐𝟐 𝟏𝟏
[𝒘𝒘(𝟔𝟔𝟔𝟔)]𝟏𝟏/𝟐𝟐 + [𝒘𝒘(𝟑𝟑𝟑𝟑)]𝟏𝟏/𝟐𝟐 − 𝟑𝟑𝟑𝟑 ≥ 𝟏𝟏𝟏𝟏𝟏𝟏
𝟑𝟑 𝟑𝟑
𝟐𝟐 𝟏𝟏 𝟐𝟐 𝟏𝟏
[𝒘𝒘(𝟔𝟔𝟔𝟔)]𝟏𝟏/𝟐𝟐 + [𝒘𝒘(𝟑𝟑𝟑𝟑)]𝟏𝟏/𝟐𝟐 − 𝟑𝟑𝟑𝟑 ≥ [𝒘𝒘(𝟑𝟑𝟑𝟑)]𝟏𝟏/𝟐𝟐 + [𝒘𝒘(𝟔𝟔𝟔𝟔)]𝟏𝟏/𝟐𝟐 − 𝟏𝟏𝟏𝟏
𝟑𝟑 𝟑𝟑 𝟑𝟑 𝟑𝟑

Both restrictions will bind in the solution to the principal's problem of' spending the least possible
amount'. We have two equations in two unknowns that lead to the solution w (60) = 28,900 and w (30)

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= 12,100. The principal's expected utility is Up= 26,700. Under asymmetric information the principal
also chooses e = 6, since 26,700 > 23,100, but with an efficiency loss measured by the reduction in the
expected profits of the principal (the agent always obtains his reservation utility).

Question 3 (12 points)

Assume that a country which aims to reform its laws governing the board of directors in its
corporations introduces the following legal rule which becomes effective in an unexpected manner:

All “large” companies have to have at least 50% independent directors.

The country in question has a large economy and there are several thousands of firms listed at the
stock exchange. There are three types of firms in this country:

Large: companies with asset size exceeding $10 Bn.

Medium: companies with asset size between $1 Bn. and $9.99Bn.

Small: companies with asset size less than $1 Bn.

a) Propose two empirical designs which can be used to understand (and to quantify) the effect of
having independent directors on firm value. (6 points)

b) Briefly explain how such an empirical design can be employed in this setting. (6 points)

Both DiD and RDD designs can be used.

With DiD:

Treatment group is the set of large firms.

Control group is the set of medium-sized firms.

Whatever happened to the control group over time is what would have happened to the treatment
group in the absence of the program. DiD design takes into account pre-existing differences between
Treatment and Control groups and the general time trend)

Before Change After Change Difference

Group 1 (Treatment) Yt1 Yt2 ΔYt = Yt2-Yt1

Group 2 (Control) Yc1 Yc2 ΔYc = Yc2-Yc1

Difference ΔΔY = ΔYt – ΔYc

DiD design is reasonable if

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  The treated and controls are similar prior to treatment (ideally, highly similar on a rich set of
observed characteristics);
 Assignment to treatment is due to an “exogenous” shock;
 The shock is “relevant” -- significantly changed behavior or incentives,
 We have reason to believe that the apparent effect of the shock on the outcome came only
through the shock

RDD (Regression discontinuity design) exploits the fact that some rules are quite arbitrary and
therefore provide good quasi-experiments when you compare firms who are just affected by the rule
with firms who are just not affected by the rule. In this case the new legal rule affects large firms and
not medium-sized or small firms. Legal change affects firms above/below $10 Bn. (sharp cut at a
certain date).

Comparison of the effect of the change in rule for the two groups is similar to a random assignment
and hence is uncorrelated with firm/individual characteristics. Intuitively, there is no reason to expect
any systematic difference between a firm which has $10.1 Bn in assets vs another one with $0.998 Bn
in assets. Accordingly, these rules provide a source of random variation which can be used to estimate
the causal effect of the rule on the variable of interest.

RDD Scatterplot: Positive Treatment Effect RDD Scatterplot: No Treatment Effect

Question 4 (12 points)

Consider an economy with three different (types of) firms that we will refer to as A, B and C. The firm
type is known only to the manager, who acts in the best interest of the firm’s original shareholders.
The uninformed investors consider all three types equally likely (type A, type B, and type C are each
encountered with probability 1/3).

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Each firm has access to an investment project that requires an investment outlay of $3million. The
firm types differ in terms of the NPV of this investment project, as well as in terms of the value of
their assets in place (all numbers represent $ million):

Value of Assets in Place Investment NPV

(VAi) Ii NPVi
Firm A 8 3 2
Firm B 10 3 -1
Firm C 3 3 -1

Firms are all-equity financed. The only way to raise capital for the new investment project is by
issuing equity to the public. A firm that issues equity has to undertake its investment project.

a) Assume initially that all firm types issue equity and invest. What fraction of the firm’s equity has to
be offered to the public to raise $3 million in the equity offering? (3 Points)

b) Based on your answer in part a), which firms will find it profitable to undertake the equity offering?
(3 Points)

c) Now suppose that managers decide whether to issue equity or not. Based on your answer in part (b)
What fraction of the equity will the issuing firms now have to give to the outside investors in order to
be able to raise $3 million? (6 Points)

Call firm A the Good firm, firm B the Bad firm, and firm C, the Ugly for ease of notation below.

The firm type is known only to the manager. This means that the outside investors who are supposed
to purchase the issue will not know whether an individual firm is good, bad, or ugly. They will have to
act based on the assumption that they deal with the “average” firm.

The average firm value after the offering is equal to 7 + 3 + 0 = 10 ($ million). [Mean VA + Mean I +
Mean NPV]

This means that the new shareholders will demand at least 3/10 (or 30%) of the firms’ equity in order
to break even, in expectation.

To see whether it is profitable to undertake the equity offering we have to compare the original
shareholders’ wealth after the offering (70% of the total firm value after the investment), with their
wealth if no offering takes place (100% of the assets in place):

Good: 7/10 * (8 + 3 + 2) = 9.1 > 8 Issue and invest!

Bad: 7/10 * (10 + 3 - 1) = 8.4 < 10 Don’t issue!

Ugly: 7/10 * (3 + 3 – 1) = 3.5 > 3 Issue and invest!

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Only the Good and the Ugly type are going to issue and invest. The shareholders of the Bad type are
better off without the new investment.

Investors will realize that the Bad type will not issue. This means that the “average” firm that issues
equity now consists to 50% of the Good, and to 50% of the Ugly type.

After the issue, this average issuing firm will therefore be worth

0.5 * (8 + 3 + 2) + 0.5 * (3 + 3 -1) = 0.5 *(13 + 5) = 9

In order to raise $3 million, the issuing firms will therefore have to offer

3/9 = 1/3 = 33.3% of the equity to the new shareholders.

Question 5 (12 points)

Consider the following stylized facts about dividends:

a) Short run price reactions to omissions are greater than for initiations.

b) In the post announcement period (ranging from one to three years), there is a significant

positive market-adjusted return for firms initiating dividends and a significant negative

market-adjusted return for firms omitting dividends.

c) Managers seem to be primarily concerned with the stability of dividends.

With which economic / corporate finance theories are these stylized facts consistent? Please explain
your reasoning. If you believe that two (or more) competing theories explain the stylized fact, please
state them all. (4 Points each)

Part a:

Asymmetric Information Theory

Managers know more than outside shareholders, and dividends and repurchases changes provide some
information on future cash flows (Bhattacharya 1979, Miller and Rock 1985), or about the cost of
capital (Grullon, Michaely and Swaminathan 2002, Grullon and Michaely 2003).

Agency theory

When contracts are incomplete, higher payouts can sometimes be used to align management's interest
with that of shareholders’ Grossman and Hart (1980), Easterbrook (1984), Jensen (1986).

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M&M argue that if management's expectations of future earnings affects their decisions about current
dividend payouts, then changes in dividends will convey information to the market about future
earnings. This notion has been labeled as "the information content of dividends“ and can be formalized
in two ways:

-- Dividends are used as an ex-ante signal of future cash flow as, for example, in Bhattacharya (1979).

-- Dividends provide information about earnings as a description of the sources and uses of funds
identity as, for example, in Miller and Rock (1985).

The market has an asymmetric response to dividend increases and decreases (and for initiations and
omissions), which implies that lowering dividends carries more informational content than increasing
dividends, perhaps because reductions are more unusual, or because reductions are of greater
magnitude. The price impact may explain, to some extent, why managers are so reluctant to cut
dividends.

Part b:

i) it shows that dividend changes have some useful informational content.

ii) but also problematic, because it implies that even if firms try to signal through dividends, the
market does not "get it" or at least it does not get the full extent of the signal.

iii) Investors and firms use the information at their disposal in the best possible way. The long-term
drift does not support this assumption. In other words, if investors do not understand the signal, there
is no incentive for those firms to use a costly signal.

(ii) and (iii) put EMH into question

Part c:

Smoothing of dividends can be consistent with both AIT and Agency theories. Both explanations –
given that they are explained in some rough way will work.

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