Finance 2 (2023) – Problem Set 4 (Week 5)

University of Amsterdam

Answers to IN CLASS exercises do not need to be handed in

The parts of exercises marked [IN CLASS] (e.g. 2h-2j) will be completed during the tutorial
and answers to these parts do not need to be handed in via Canvas. Answers to the other
questions need to be completed before the deadline (see Canvas) and students need them to
participate in the tutorial.

Grading: only first problem set and bonus

We will only grade the first homework set in Canvas and then at the end of the course
determine if you have received the bonus or not. You will therefore not see a grade for each
homework set you have handed in. Feedback is possible during the tutorials.

Question 1 | Chapter 16 – Financing under Asymmetric information

Consider the financing problems of a firm confronted with asymmetric information. Assume that the
corporation has more information about its own quality than the market (and that the corporation
and the market know this). The corporation is trying to attract new funding in the presence of such
asymmetric information.
a. Why does this information problem make obtaining funding by issuing shares (equity) more
troublesome than attracting debt financing?

To illustrate the effect of the information problem mentioned above, consider the situation below.
A Pharmaceutical company discovered a new drug against Obesity. In order to test this drug and
bring it to the market, the firm needs to raise 350 million euro to fund the investment. Currently the
firm is all equity financed and there are 10 million shares outstanding. In funding the investment the
company has the opportunity to fund with debt or equity.

The drug has a 50% chance of having potential negative side effects. These side effects will affect the
value of both the project as well as the existing assets of the firm as listed in the table below. All
numbers are market values and in millions of euros.

With side effects Without side effects Average

Existing assets 1,200 1,600 1,400
Present value 500 900 700
free cash flows drug
NPV drug 150 550 350

Assume that there is asymmetric information: the firm knows for sure whether there are side effects
or not and the market does not know if there are side effects. The market does know that the firm is
better informed. Ignore any other effects of the capital structure (like tax shields).
b. If the firm decides to fund the project with equity, what will the price of the shares be once
the firm announces that it will issue equity?
Hint: share price = (value of existing assets + NPV) / number of shares. And check for which
types of firms (i.e. with or without side effects) issuing equity is more attractive than issuing
debt.
c. Is the share price under b. different from the share price under symmetric information
(where neither the firm nor the market knows if there are side effects)? Motivate your
answer.

1
Question 2 | Chapter 18 – Capital Budgeting and valuation with leverage

Company ABC has no excess cash and an enterprise value of $13 million. The company has a market
capitalisation of $10 million and $3 million in debt. The debt cost of capital is 5% and its equity cost
of capital is 10%. The marginal tax rate is 35% and taxes are the only capital market imperfection.
a. What is ABC’s after tax WACC?

Assume ABC maintains a constant debt-equity ratio equal to the ratio it currently has. Consider a
project with the same risk as the existing business and the following expected free cash flows (in
thousands of dollars): -80 at time 0 and +50 at time 1 and +70 at time 2. Assume the tax shield has
the same risk as the underlying assets.
b. What is the levered value of this project at time 0?
c. What is the continuation value of this project at time 1?
d. What is the debt capacity of this project at time 0, 1 and 2? Use your answers to b. and c.
e. What is ABC’s pre-tax WACC (unlevered cost of capital)?
f. What is the unlevered value of the project?
g. What is the interest tax shield from the project in each year? Assume interest is paid at the
end of each year based on the debt level at the beginning of each year.
h. Show that the present value of the interest tax shields is $0.614. What do you need to
assume about the tax shields to get this result? [IN CLASS]
i. Show that the levered value of the project using the APV is equal to that using the WACC
method. [IN CLASS]
j. In what situations is it not possible to use the WACC method to calculate VL? [IN CLASS]

Question 3 | Chapter 17 – Payout policy

Corporation Ray has $90 million in excess cash, no debt and 350 million shares outstanding with a
current market price of $10 per share. Ray’s board has decided to pay out the excess cash as a one-
time dividend. Assume a perfect capital market.
a. What is a one-time dividend often called and why is it important to have a separate name for
one-time dividends?
b. What is the ex-dividend price of a share of Ray? Does the number of shares outstanding
change when the share goes ex-dividend?

Assume the board instead decides to use the excess cash to do a one-time share repurchase at the
current market price.
c. What is the price of a share of Ray once the repurchase is complete? How many shares are
outstanding?
d. Which policy (dividend or share repurchase) makes investors in the firm better off? Explain
why.
e. Does payout policy matter in a perfect capital market? Explain why or why not. [IN CLASS]
f. What effects make payout policy relevant in the real capital market? Explain your answer. [IN
CLASS]