Examiners’ commentaries 2020

Examiners’ commentaries 2020

FN2191 Principles of corporate finance

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2019–20. 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).

Information about the subject guide and the Essential reading

references

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2018).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.

General remarks

Learning outcomes

At the end of the course and having completed the essential reading and activities you should be
able to:

explain how to value projects, and use key capital budgeting techniques (for example: NPV
and IRR)

understand and apply real option theory as an advanced technique of capital budgeting

understand and explain the relevance, facts and role of the payout policy, and calculate how
payouts affect the valuation of securities

understand the trade-off firms face between tax advantages of debt and various costs of debt

calculate and apply different costs of capital in valuation

understand and explain different capital structure theories, including information

asymmetry and agency conflict

understand how companies issue new shares, and calculate related price impact in security
offerings

discuss why merger and acquisition activities exist, and calculate the related gains and losses

understand risk, hedging, and numerous financial securities as tools to manage risk.

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FN2191 Principles of corporate finance

What are the examiners looking for?

In general, the examiners are looking for a solid demonstration of understanding of the above
learning outcomes from candidates. Typically, the examination questions cover a wide range of topics
from the syllabus. They are often set in such a way as to enable candidates to be tested on their
understanding of the concepts and techniques and their ability to apply them in different scenarios.

Candidates should read widely around each topic covered in the subject guide. Essential and
supplementary readings are important if you wish to achieve high grades. Typical weaknesses which
examiners have identified in this examination are as follows.

Candidates’ answers are often too general or narrow. When you are asked to critically assess
a theory or concept, you should provide a descriptive list of what the theory or concept is
about. A critical assessment of a theory or concept should indicate how logically it is
derived and how well it fits into the real world.
You should not regurgitate material from the subject guide. Consequently, you may be
giving either descriptive or irrelevant material in your answer. Rather, you should carefully
consider what the examination question is in fact asking and respond accordingly.
Avoid writing excessively long, verbose answers. Keep your discussion relevant and focused.
Tailor your answer to the specific requirements of the examination question. Inclusion of
irrelevant material suggests a lack of understanding.
Candidates often spot questions and focus narrowly on a few topics in the hope that these
topics cover enough material to pass the examination. However, the empirical evidence
shows that this tactic often backfires badly. As corporate financial theories are often
inter-related, the examination questions will also cover materials from different chapters in
the subject guide. For example, when evaluating a real-life project, we need to know which
discount rate to use and how to identify the relevant cash flows. The choice of the
appropriate discount rate depends on how the project is funded and how risky it is.
Therefore, a question on capital budgeting can easily involve materials covered in Chapters
1, 2, 3 and 4.

Examination revision strategy

Many candidates are disappointed to find that their examination performance is poorer than they
expected. This may be due to a number of reasons, but one particular failing is ‘question
spotting’, that is, confining your examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious consequences.

We recognise that candidates might not cover all topics in the syllabus in the same depth, but you
need to be aware that examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required number of
examination questions.

The syllabus can be found in the Course information sheet available on the VLE. You should read
the syllabus carefully and ensure that you cover sufficient material in preparation for the
examination. Examiners will vary the topics and questions from year to year and may well set
questions that have not appeared in past papers. Examination papers may legitimately include
questions on any topic in the syllabus. So, although past papers can be helpful during your revision,
you cannot assume that topics or specific questions that have come up in past examinations will
occur again.

If you rely on a question-spotting strategy, it is likely you will find yourself in difficulties
when you sit the examination. We strongly advise you not to adopt this strategy.

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 Examiners’ commentaries 2020

Examiners’ commentaries 2020

FN2191 Principles of corporate finance

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2019–20. 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).

Information about the subject guide and the Essential reading

references

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2018).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.

Comments on specific questions

Candidates should answer FOUR of the following SIX questions. Note that if you attempt more
than the required number of questions, the first four answers will be marked, not the best ones. This
is to discourage ‘hedging’ of solutions by attempting more questions than required.

Question 1

The firm Lando expects cash flows in one year’s time of $90 million if the economy
is in a good state or $40 million if it is in a bad state. Both states are equally likely.
The firm also has debt with face value $65 million due in one year.

Lando is considering a new project that would require an investment of $30 million
today and would result in a cash flow in one year’s time of $47 million in the good
state of the economy or $32 million in the bad state.

Investors are all risk neutral and the risk free rate is zero.

(a) What are the expected values of the firm’s equity and debt without the new
project?
(4 marks)

Lando can finance the project by issuing new debt of $30 million. If the firm goes
bankrupt the new debt will have a lower priority for repayment than the firm’s
existing debt.

(b) If the new project is accepted, what will be the value of the firm’s cash flow in
each state after paying the original debtholders? What payment must Lando
promise to the new debtholders in the good state of the economy?

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FN2191 Principles of corporate finance

(6 marks)
(c) What will be the expected value of Lando’s equity? Will Lando’s managers
choose to accept the project? Why/why not?
(4 marks)

Alternatively, Lando can issue new equity of $30 million to finance the project.

(d) What proportion of its equity must Lando give to the new equityholders? Will
Lando’s managers choose to accept the project now? Why/why not?
(5 marks)
(e) Briefly discuss the agency problem of debt overhang with reference to your
answers to the previous parts of the question. (120 words)
(6 marks)

(Total = 25 marks)

Reading for this question

See the subject guide, chapter 5.

Approaching the question

This question is an example of the problem of debt overhang. The firm is considering a project
with a positive net present value which will be rejected by managers acting in the interests of the
existing shareholders. Financing the project with new equity is no solution as it still leads to the
same problem: accepting the new project leaves the existing shareholders worse off.

(a) We have:

$m
Value of debt, good state: 65
Value of debt, bad state: 40
Expected value of debt: 52.5

Value of equity, good state: 25

Value of equity, bad state: 0
Expected value of equity: 12.5

(b) We have:
Good state cash flow = $90m + $47m = $137m.
Bad state cash flow = $40m + $32m = $72m.
After repaying debt of $65m:
Good state cash flow = $137m − $65m = $72m.
Bad state cash flow = $72m − $65m = $7m.
New lenders require an expected payment of $30m.
Payment to new lenders in bad state = $7m.
The payment to the new lenders in the good state must be P , where:

(0.5 × $7m) + (0.5 × P ) = $30m

hence P is $53m.

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 Examiners’ commentaries 2020

(c) Payment to equity holders in the good state = $72m − $53m = $19m.
Payment to equity holders in the bad state = $0.
Expected equity value = 0.5($19m) + 0.5(0) = $9.5m.
Accepting the project changes equity value by −$3m. The project will be rejected by
managers as it reduces the wealth of the equityholders.

(d) If the project is accepted, the firm’s cash flows after debt payment will be:
Good state: $72m
Bad state: $7m
Expected: $39.5m

The new equityholders want a payment of $30m. The proportion of equity held by the new
equityholders must be 30m/39.5m = 0.7595.
Again, accepting the project changes equity value by −$3m. $9.5m will be left for the
existing equityholders. Managers acting on their behalf will again reject the project.

(e) The debt overhang argument is that managers of firms with large levels of debt outstanding
will choose to reject some positive NPV projects because little of the payoff goes to the
shareholders.
In this question there is a positive NPV project that would add value to the firm. It will not
be accepted because the benefits go to the providers of new finance only, whether equity or
debt. Some wealth is transferred away from the existing equityholders. Managers acting in
the interests of the existing equityholders reject the project.
New funds to invest in the project require costly returns regardless of whether new debt or
new equity is issued. As a result there is underinvestment and firm value is suboptimal.

Question 2

(a) The manufacturing firm Rebo is considering a new capital investment project.
The project will last for five years. The anticipated sales revenue from the
project is $3 million in year 1 and $4.2 million in each of years 2 – 5. The cost
of materials and labour is 50% of sales revenue and other expenses are $1
million in each year. The project will require working capital investment equal
to 20% of the expected sales revenue for each year. This investment must be in
place at the start of each year. Working capital will be recovered at the end of
the project’s life.
The project will require $2.5 million to be spent now on new machinery which
will have zero value at the end of the project and will be depreciated each year
at 20% of the original cost. The tax rate is 25%. Rebo uses a discount rate of
11% to evaluate its capital investment projects.
i. What is the net income in each year?
(4 marks)
ii. What is the free cash flow in each year and the net present value (NPV)?
(5 marks)
iii. You discover the following additional information:
• The project will utilise a building that the firm leases. No other activities
take place in it. If this project does not go ahead the firm will terminate
the lease in one year’s time if no other use for it has been found.
• Part of each year’s cash flows from the project will be used to increase the
dividend payment to shareholders.

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For each of these items, explain briefly whether or not you would incorporate
the information into your analysis of the project’s value.
(4 marks)
(b) Zuti has a capital investment project that could start immediately. The project
will require a machine costing $2.4 million. The total discounted value now of
the cash inflows from the project will be either $2.6 million or $1.9 million with
equal probability. The risk-free rate is 3%.
Instead of starting immediately the project could be delayed until one year from
now to gain more market information. Its total discounted cash inflows at that
time will be known as either $2.6 million, or $1.9 million, with certainty.
i. What is the present value of the option to delay?
(5 marks)
ii. The supplier of the machine has offered to deliver it (if required) in one
year’s time at a price of only $2 million, if Zuti pays a non-refundable deposit
now. What is the maximum the firm should pay as a deposit now? What
type of real option does this represent for Zuti? Identify the specific
components of the option contract.
(7 marks)

(Total = 25 marks)

Reading for this question

See the subject guide, Chapters 1 and 2.

Approaching the question

(a) i. We have:
($000)
Year 0 1 2–5
Sales revenues 3000 4200
Cost of goods sold −1500 −2100
Other expenses −1000 −1000
Depreciation −500 −500
Earnings before tax 0 600
Taxes at 35% 0 −150
Net Income 0 450
ii. We have (all quantities in $000):
Year 0 1 2 3 4 5
Net income 0 450 450 450 450
Depreciation 500 500 500 500 500
Capital expenditure −2,500
Working capital −600 −240 840
Free cash flow (FCF) −3,100 260 950 950 950 1,790

Present value (FCF) −3,100 234.23 771.04 694.63 625.79 1062.3

Net present value 287.98
iii. The first point is relevant. The present value of the lease payments that might be saved
after year 1 are an opportunity cost of undertaking the project. The analysis should
consider the probability that another use for the building might be found in one year’s
time.
The second point is not relevant to the value of the project. The net present value
analysis does not take into account what use will be made of the specific cash flows
generated by the project.

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 Examiners’ commentaries 2020

(b) An important point to recognise in this part of the question is the flexibility given by the
option to delay investment. The firm’s losses are limited to any ‘premium’ paid.
i. The net present value of the project without the option to delay is:

−$2.4m + 0.5($2.6m) + 0.5($1.9m) = −$0.15m.

With delay, the firm will go ahead with the project only in the good case. The total
discounted value at t = 1 of the cash flow will be $2.6m. After subtracting the machine
cost of $2.4m, the cash flow value is $0.2m.
Its present value at t = 0 is ($0.2m/1.03) = $0.1942m with probability 0.5. The net
present value of the project with the option to delay is therefore
0.5($0.1942m) = $0.0971m.
The value of the option to delay = $0.0971m − ($0.15m) = $0.2471m.
ii. Again, the firm will only go ahead in the good case. At t = 1 the value of the cash flow,
less the machine cost = $0.6m. The present value at t = 0 is $0.5825m with probability
0.5. The maximum to pay = 0.5($0.5825m) = $0.2913m.
This option corresponds to a European call option with the deposit as premium, the
project cash flows as the underlying asset, and exercise price $2m.

Question 3

Trefor, a US firm, has a sterling (£) receivable of £300,000 from a UK customer due
one year from now. Trefor has no use for sterling currency and will exchange the
receipt into US dollars ($). The spot exchange rate now is £1 = $1.34 and the
one-year forward exchange rate is £1 = $1.31. Assume the forecasted spot rate in
one year’s time is £1 = $1.28 or £1 = $1.38, with equal probability. The discount
rate is zero.

(a) What is the expected dollar value of Trefor’s receivable if it chooses:

i. not to hedge the receipt?
ii. to use a forward hedge?
(4 marks)
(b) One year sterling put options and sterling call options are available at a cost of
$0.03 per £with an exercise price of £1.32.
i. How could Trefor make use of an option hedge for its sterling receivable?
(3 marks)
ii. What will be the expected value in dollars of the outcome of the option
hedge?
(5 marks)
(c) If Trefor is concerned only about downside risk, is it better to choose the
forward hedge or the option hedge? Explain. (60 words)
(4 marks)
(d) An alternative hedging strategy for Trefor is to use futures contracts. Are there
any advantages to using futures instead of a forward exchange extract? Explain.
(60 words)
(4 marks)
(e) Briefly discuss the implications of the Capital Asset Pricing Model for the
relationship between the current spot price of an asset and the discount offered
by the seller of a futures contract. (100 words)
(5 marks)

(Total = 25 marks)

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FN2191 Principles of corporate finance

Reading for this question

See the subject guide, Chapter 9.

Approaching the question

(a) i. The unhedged outcome per unit of sterling is the weighted average of the future spot
exchange rates:
0.5($1.28) + 0.5($1.38) = $1.33.
The total receipt will be 300,000($1.33) = $399,000.
ii. The receipt from the forward hedge = 300,000($1.31) = $393,000.

(b) i. Trefor expects to be selling sterling in one year’s time so will wish to hedge against a fall
in the value of sterling relative to the dollar. The firm can buy sterling put (sell) options
now for a premium of 300,000($0.03) = $9,000. The options should be exercised in one
year’s time if the spot rate at that time is lower than the exercise price of $1.32.
ii. If the spot rate one year from now is $1.28 Trefor will exercise the option and receive
300,000($1.32) = $396,000. If the spot rate is $1.38 it is preferable to let the option lapse
and sell sterling in the market at the spot rate, receiving 300,000($1.38) = $405,000.
The two outcomes are equally probable and in either case the option premium will have
been paid. The value of the expected outcome from the option hedge is:

0.5($396,000) + 0.5(414,000) − 9,000 = $396,000.

(c) The better choice is the forward hedge which provides a minimum receipt of $393,000. The
option exercise price is higher than the forward rate but the premium reduces the net
receipt below that of the forward if the exchange rate movement is adverse. Since Trefor is
concerned only about avoiding downside risk the upside potential of the option is
unimportant.

(d) One advantage of futures is that counterparty risk is much less than for forward contracts.
So, the futures market is more accessible than the forward market for small firms or firms
whose credit record is poor. For uncertain transactions, a futures hedge is more flexible than
a forward. The firm can close out its position earlier than planned if the transaction falls
through.

(e) The CAPM quantifies the risk premium that compensates futures contract participants.
From CAPM, the futures price of a commodity with a positive beta (pro-cyclical) will be
lower than the spot price. This compensates the buyer with the required higher rate of
return for their acquisition of risk. The seller accepts lower prices because they pass on risk
by selling the futures contract. Conversely, the futures price of a commodity with a negative
beta (counter-cyclical) will be higher than its spot price. This compensates the seller for
their lost opportunity to gain from the commodity price increase in an economic downturn.

Question 4

The firm Hill is planning to acquire Dale, another firm in the same industry.
Relevant financial information for the two firms is shown below.

Hill Dale
Price per share, $ 4.50 1.90
Number of shares 28,000,000 10,500,000
Dividend payout ratio 0.65 0.20

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 Examiners’ commentaries 2020

Both firms are financed entirely by equity. The acquisition will result in expected
cost savings for the merged (post-acquisition) firm with a total present value of $38
million.

(a) Assume for this part of the question that Hill’s shares are valued at $4.50 each.
How many new shares would Hill issue to Dale’s shareholders in exchange for
the whole 10.5 million of Dale’s shares? What is the total value and price per
share of the merged firm? Should Hill pay for the acquisition on this basis?
Explain briefly.
(7 marks)

Assume now that Dale’s shareholders will agree to the acquisition for a premium of
$4.05 million.

(b) What is the minimum number of shares Hill should offer, such that Dale’s
shareholders will participate in the acquisition?
(5 marks)
(c) Assume Hill decides to acquire Dale by issuing the minimum number of shares
as in part (b). In the first year the total earnings of the merged firm will be
$15.87 million. Hill’s dividend payout ratio will be maintained in the merged
firm. What change in dividend payment will a former Dale shareholder get in
the first year of the merged firm, if they had 1000 shares in Dale before the
acquisition?
(5 marks)
(d) What does clientele theory predict about the relationship between a firm’s value
and a change in its dividend policy? Does this theory have any implications for
the success of the acquisition? Explain. (150 words)
(8 marks)

(Total = 25 marks)

Reading for this question

See the subject guide, Chapters 7 and 8.

Approaching the question

(a) Number of shares in Hill to give stock to Dale shareholders = 19,500,000/4.50 = 4,433,333.
Number of shares after merger = 28,000,000 + 4,433,333 = 32,433,333.
Value of the merged firm is:

value of Hill+value of Dale+synergy = $126,000,000+$19,950,000+$38,000,000 = $183,950,000.

Value per share = $183,950,000/32,433,333 = $5.67.

This approach shares the synergy of the acquisition proportionally between Hill and Dale
shareholders according to their pre-merger values, which are the basis of the exchange ratio.
Hill’s shareholders will be better off than before so the acquisition is worthwhile. However,
Hill should negotiate a premium that would be acceptable to Dale’s shareholders rather
than proceeding on this basis.

(b) The value of the merged firm including the synergy = $183,950,000.
Dale requires a premium of $4.05m and the current market value of Dale
shares = 10.5m($1.90) = $19.95m. Hill will have to give Dale stock worth
$4.05m + $19.95m = $24m.
The proportion of equity given up by Hill = 24,000,000/183,950,000 = 0.1305.

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FN2191 Principles of corporate finance

The proportion of merged firm shares held by former Dale stockholders is:
new shares issued new shares issued
= 0.1305 = .
old shares + new shares issued 28,000,000 + new shares issued
Rearranging gives the number of new shares as 4,201,313.

(c) The exchange ratio is 4,201,313 : 10,500,000 = 0.4 : 1.

After the acquisition, a former shareholder of Dale with 1000 shares now has 400 shares in
Hill.
The total number of shares in Hill post-acquisition is 28m + 4,201,313 = 32,201,313. The
shareholder’s dividend is:
400
(0.65)($15.87m) = $128.14.
32,201,313
The earnings of Dale if the acquisition did not take place can be estimated. Both firms are in
the same industry and entirely equity financed. Assuming the weighting of the former Dale’s
earnings in the total year 1 earnings reflects the weightings in the combined firm’s value:
 
19.95
earnings = $15.87m = $1,721,102.
19.95 + 38 + 126
The shareholder’s dividend would be:
 
1000
(0.2)($1,721,102) = $32.78.
10,500,000
The increase in dividend as a result of the acquisition is $95.36, or 391%.

(d) The answer to this part should recognise that clientele theory does not predict that dividend
policy is relevant to firm value. The supply of and demand for different payout ratios will
result in an equilibrium pricing.
Individual investors will prefer a portfolio that suits their requirements. If a firm changes its
dividend policy, some investors will prefer to sell and reinvest in other firms with their
preferred payout policy. Other new investors will now be attracted to the firm for the same
reason.
A former shareholder of Dale will be accustomed to a payout ratio of 20% but as a
shareholder of Hill will receive a much higher payout ratio of 65%. If this does not suit
them, for example for tax reasons, they can sell the shares and adjust their portfolio to
restore their dividend/capital gain preferences. Other investors with the opposite preference
will now purchase the shares. Overall, clientele theory predicts no significant issues for the
success of the acquisition.

Question 5

The firm Ragnar has announced an initial public offering of shares (IPO). The
shares are being offered in the IPO at a price of $6 each. All potential investors
know that at this price the share is either undervalued by $0.50 (probability 60%)
or overvalued by $0.30 (probability 40%).

‘Informed’ investors such as banks are able to distinguish whether the share is
overvalued or undervalued. ‘Uninformed’ investors are not able to do this. Demand
from uninformed investors is sufficient to take up all the shares offered in the IPO.
If the demand for the shares is greater than the number offered, the shares will be
rationed.

You are an uninformed investor with $12,000 to invest. If rationing occurs you will
only be able to buy 800 of Ragnar’s IPO shares.

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 Examiners’ commentaries 2020

(a) By what percentage is the IPO underpriced/overpriced?

(3 marks)
(b) What would be your expected profit if you were able to buy 2,000 of the IPO
shares? Do you expect to be able to do this? Why/why not?
(5 marks)
(c) As an uninformed investor, what is your expected profit from participating in
the IPO?
(5 marks)
(d) What would your expected profit be if the undervaluation is only $0.20 per
share instead of $0.50, and everything else unchanged? What is the
underpricing percentage now?
(5 marks)
(e) Explain what is meant by the ‘winner’s curse’ in the context of IPOs, with
reference to your answers for the previous parts of the question. Briefly discuss
one other possible reason for the empirically observed underpricing of IPOs.
(140 words)
(7 marks)

(Total = 25 marks)

Reading for this question

See the subject guide, Chapter 6.

Approaching the question

(a) The expected true value of the stock is $6.50(0.6) + $5.70(0.4) = $6.18. The undervaluation
therefore is (6.18 − 6.00)/6.18 = 3%, approximately.

(b) If you could buy 2000 shares of the stock your expected profit would be $0.18(2000) = $360.
You would not expect to be able to do this. If the informed investors know the share value
is higher than the IPO price they will want to participate in the IPO and the shares will be
rationed. You would be able to buy 2000 shares only if the informed investors are not
interested in the IPO, because they know the shares are not profitable to buy.

(c) If informed investors know the IPO is undervalued the issue will be rationed and you can
only buy 800 shares. Your profit in the undervalued case = 800($0.5) = $400 with
probability 0.6.
If the informed investors know the IPO is overvalued they will not apply for any shares and
you will buy all the 2000 shares you ask for. Your profit in the overvalued
case = 2000(−$0.3) = −$600 with probability 0.4.
Your expected profit is $400(0.6) − $600(0.4) = $0.

(d) Now your profit in the undervalued case is 800($0.20) = $160, with probability 0.6. In the
overvalued case, your profit is 2000(−$0.3) = −$600 with probability 0.4. Your expected
profit is:
$160(0.6) − $600(0.4) = −$144
i.e. a loss. The underpricing is −$0.20(0.6) + $0.30(0.4) = $0.

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(e) The key to the winner’s curse problem is information asymmetry.

If the IPO is a good deal, uninformed investors get a small allocation in the issue because
informed investors also participate and rationing occurs. When the IPO is bad, informed
investors withdraw. The uninformed get a large allocation in a bad firm, for which they pay
a higher price than the fair one, as in part (c).
At a fair price their expected return is negative, as seen in part (d), so they will only bid at
a discount. This leads to IPO underpricing to ensure the shares are bought.
Other explanations for IPO underpricing include underwriter price supports, the benefits of
a low IPO price to the underwriter, and risk averse owners.

Question 6

The firm Kappa has just decided to undertake a major new project. As a result, the
value of the firm in one year’s time will be either $120 million (probability 0.25),
$250 million (probability 0.5) or $360 million (probability 0.25). The firm is
financed entirely by equity and has 10 million shares. All investors are risk-neutral,
the risk-free rate is 4% and there are no taxes or other market imperfections.

(a) What is the value of the company and its share price?
(4 marks)

Kappa decides to issue debt with face value $146 million due in one year and use the
proceeds to repurchase shares now. Assume now that bankruptcy costs will be 15%
of the value of the firm’s assets in the event of default on debt repayment.

(b) What is the value of the debt now? What is its yield?
(5 marks)
(c) What is the expected value of the firm and the price per share? How many
shares will be repurchased?
(5 marks)
(d) Assume Kappa decides instead to issue debt with face value $100 million due in
one year and repurchase shares with the proceeds. What is the firm’s value
now? Why? What is its share price?
(5 marks)
(e) Explain how the presence of corporate taxes would influence Kappa’s
restructuring decision. (100 words)
(6 marks)

(Total = 25 marks)

Reading for this question

See the subject guide, Chapters 3 and 4.

Approaching the question

(a) As a weighted average the value of the firm in one year is:

0.25($120m) + 0.50($250m) + 0.25($360m) = $245m.

The present value is $245m/1.04 = $235,576,923 and the share price is $23.56,
approximately.

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 Examiners’ commentaries 2020

(b) In the lowest cash flow state (probability 0.25) there is default and 15% of the firm value is
lost in bankruptcy costs. In the other cash flow states the debt can be paid in full and
bankruptcy costs are zero.
The present value of the debt is:

$120m(0.25)(1 − 0.15) + $146m(0.75)

= $129,807,692.
1.04
The yield is:
$146m
− 1 = 12.47%.
$129,807,692

(c) The firm value after bankruptcy costs is:

$120m(1 − 0.15)(0.25) + $250m(0.5) + $360m(0.25)

= $231.25m.
1.04
Price per share is $23.125.
The number of shares repurchased is the present value of the debt divided by the price per
share. $129,807,692/$23.125 = 5, 613, 306 shares repurchased.

(d) The firm’s value will be $235,576,923 and share price $23.56. Expected bankruptcy costs
will be zero because the debt can be paid in all states of the world. All investors are
risk-neutral and there are no taxes or other market imperfections. Given this information,
the MM(I) conclusions apply. The value of Kappa as a levered firm is the same as its
unlevered value: VL = VU .

(e) If expected bankruptcy costs were zero the MM(II) conclusions would apply here. With
corporate taxes the debt interest tax shield increases firm value linearly with increasing
leverage. Kappa’s optimal capital structure would be 100% debt, or as close to it as legally
possible.
Kappa’s bankruptcy costs become greater than zero at a certain level of leverage and so its
optimal capital structure is less than 100% debt.
With both bankruptcy costs and corporate taxes but no other market imperfections,
Kappa’s optimal capital structure will be at the point where the marginal increase in
bankruptcy cost equals the marginal increase in the value of the debt tax shield.

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