Question 1. (6 p.

a) Explain the intuition behind the Modigliani-Miller capital structure irrelevance

proposition (MM1). (2 p.)

Answer:
2 main ways of explaining the intuition:
- The value of the firm is determined by expected future cashflows (asset side), which in
turn determines the value of debt and equity claims (liability side). But the
composition of the types of claim is irrelevant for the stream of cashflows – the “size
of the pie” is not affected by how you slice it.
- In frictionless capital markets, anything the firm does, the investor can undo by an
appropriate combination of investing, short-selling, lending and borrowing.
Therefore, any differences in value between firms based only on capital structure
imply the existence of arbitrage opportunities, which will be immediately eliminated.

b) Give two examples, with brief explanations, of how taxes may affect the capital
structure decision. (4 p.)

Answer:
Different answers possible, e.g.:
- With corporate income taxes, combined with tax deductibility of interest payments,
firms are incentivized to increase leverage (equivalent to reducing tax), as firm value
increases linearly in the amount of debt.
- With personal taxation on capital income, the effect on capital structure of corporate
income tax can be reduced or even reversed if interest income is more heavily taxed
than income from equity.
- Taxation on income from equity can also reduce firms’ willingness/incentives to pay
cash dividends to shareholders or repurchase stock, with the effect that more equity
(retained earnings) is kept inside the firm, i.e. reduced leverage.
- Etc.
Question 2. (5 p.)

Suppose the firm ABC Corp. has an asset value of 778 and debt with a principal of 600 that
matures in 3 years. Further suppose that the value of the company 3 years from now is 1300
with probability 0.7 and 467 with probability 0.3. The risk free rate of interest is 3%.
Calculate the present values of levered equity and debt.

Answer:
Future equity value, 𝑆(𝑇) = 𝑚𝑎𝑥⁡(𝑉(𝑇) − 𝐹, 0), is either 700 or 0. Construct a riskless
portfolio by going long in the firm’s assets and short in equity. The size of the short position,
𝛼, must satisfy 1300 − 700 × 𝛼 = 467 − 0 × 𝛼 ⇒ 𝛼 = 1.19. The investment cost of the
portfolio is 778 − 1.19 × 𝑆𝑙 , and since the portfolio is riskless, this must equal
778−𝑒𝑥𝑝(−0.09)×(1300−1.19×700)
𝑒𝑥𝑝(−0.03 × 3) × (1300 − 1.19 × 700) ⇒ 𝑆𝑙 = = 295.1.
1.19
778 1300
Alternatively, use the binomial formula directly: 𝑆𝑙 = 1.19 − 𝑒𝑥𝑝(−0.09) × ( 1.19 − 700) =
295.1. 𝐵 = 𝑉 − 𝑆𝑙 = 778 − 295.1 = 482.9.
Question 3. (18 p.)

For each of the following questions, indicate if the statement in italic is TRUE or FALSE, and
motivate by demonstrating how the answer is calculated. (3 p. each)

a) Using the numbers in Question 2, ABC Corp’s annual cost of debt is approximately
5%. (3 p.)

Answer:
TRUE. 𝐵(𝑇) = 𝑚𝑖𝑛⁡((𝑉(𝑇), 𝐹) is either 600 or 467. 𝐸(𝐵(𝑇)) = 0.7 × 600 + 0.3 ×
560.1 560.1 1/3
467 = 560.1. 𝑟𝑏 = 𝑙𝑛 (482.9) /3 ≈ 0.05. Alternatively, 𝑟𝑏 = (482.9) − 1 ≈ 0.05.

b) A firm starts at t=0 and at t=1 can take on the values 150 or 50 with equal probability.
The state price for the good state equals 0.40 and for the bad state it is 0.51. The firm
has outstanding debt maturing at t=1 with face value 80. The firm’s cost of equity is
approximately 33%. (3 p.)

Answer:
FALSE. 𝑆(𝑇) = 𝑚𝑎𝑥⁡(𝑉(𝑇) − 𝐹, 0) is either 70 or 0. 𝐸(𝑆(𝑇)) = 0.5 × 70 + 0.5 × 0 =
35 35
35.⁡⁡𝑆 = 0.4 × 70 + 0.51 × 0 = 28.⁡ 𝑟𝑠 = 𝑙𝑛⁡(28) ≈ 0.22 or 𝑟𝑠 = 28 − 1 = 0.25.

c) XYZ Plc., which operates in a frictionless world, was previously an all-equity firm, with a
market equity value of 500 million and a cost of capital of 12.5%. Just recently, XYZ
decided to issue debt to a value of 200 million, where all the proceeds were used to
repurchase equity. The cost of debt is 7%. With the new capital structure, XYZ’s cost of
levered equity is approximately 23%. (3 p.)

Answer:
𝐵 200
FALSE. 𝑟𝑠𝑙 = 𝑟𝑠𝑢 + (𝑟𝑠𝑢 − 𝑟𝑏 ) 𝑆 = 0.125 + (0.125 − 0.07) 300 ≈ 0.16. Alternatively,
200 300
use WACC and unchanged overall cost of capital: 0.125 = 500 × 0.07 + 500 × 𝑟𝑠𝑙 ⇒
5 7
𝑟𝑠𝑙 = 3 (0.125 − 250) ≈ 0.16.
d) Smith & Jones, Inc., which operates in a world with corporate income taxes, has an
unlevered firm value of 300, but has perpetual debt outstanding with a value of 150,
on which it pays 7% interest. The corporate income tax rate is 34%, and the combined
payouts to debt- and equity-holders (after tax) is 40 per annum into perpetuity. The
firm’s levered cost of equity is approximately 14.7%. (3 p.)

Answer:
TRUE. 𝑉𝑙𝜏 = 𝑉𝑢𝜏 + 𝜏𝐵 = 300 + 0.34 × 150 = 351. Overall cost of capital is 𝑟𝐴𝜏 =
40 150
= 0.114.⁡ 𝑆𝑙 = 𝑉𝑙 − 𝐵 = 351 − 150 = 201.⁡⁡Use in WACC: 0.114 = 351 × 0.07 +
351
201 21 351
× 𝑟𝑠𝜏 ⇒ ⁡ 𝑟𝑠𝜏 = (0.114 − 702) 201 ≈ 14.7%. Alternatively, debtholders get 0.07 ×
351
29.5
150 = 10.5⁡ ⇒ equityholders get 40 − 10.5 = 29.5, so 𝑟𝑠𝜏 = ≈ 14.7%. More
201
complicated: use total payouts, payouts to debtholders and the tax rate to back out
EBIT=55.2, which gives unlevered dividends as (1 − 0.34) × 55.2 = 36.43 and
36.43
unlevered cost of equity as 𝑟𝑠𝑢 = = 0.1214. Then use the formula 𝑟𝑠𝜏 = 𝑟𝑠𝑢 +
300
𝐵 150
(𝑟𝑠𝑢 − 𝑟𝑏 ) (1 − 𝜏) = 0.1214 + (0.1214 − 0.07) (1 − 0.34) ≈ 14.7%.
𝑆𝑙 201

e) Max & Min, Ltd. is currently an all-equity firm with a market value of 900 million.
The firm’s management is considering substituting debt for some of the equity to
increase firm value, and understands that the optimal debt level is determined by the
offsetting effects of the debt tax shield and bankruptcy costs. The tax rate is 25% and
the present value of expected bankruptcy costs increases in debt B at an estimated rate
of 0.0003B2. The firm’s optimal debt/equity ratio is approximately 78%. (3 p.)

Answer:
TRUE. 𝑉𝑙 = 900 + 0.25 × 𝐵 − 0.0003 × 𝐵 2 . 𝑉𝑙′ = 0.25 − 0.0006𝐵 = 0 ⇒ 𝐵 ∗ =
416.67, so 𝑉𝑙∗ = 900 + 0.25 × 416.67 − 0.0003 × 416.672 = 952.08. 𝑆 ∗ = 𝑉𝑙∗ −
𝐵∗ 416.67
𝐵 ∗ = 535.41⁡ ⇒ = 535.41 ≈ 78%.
𝑆∗

f) Suppose Alpha-Beta AG has a share price of 20 and 110 million shares outstanding. It
is considering a payout of 200 million in the form of a cash dividend. The firm’s
shareholders face a dividend-income tax rate of 20%. There are no other frictions. If it
goes ahead with the payout, Alpha-Beta’s ex-dividend stock price will be 18.54. (3 p.)

Answer:
FALSE. Initial market cap is 20 × 110⁡𝑚𝑛 = 2200⁡𝑚𝑛. If there are no other frictions
than the dividend income tax, the payout reduces market cap to 2000 mn
2000⁡𝑚𝑛
(irrespective of rate of taxation) ⇒⁡ex-dividend PPS = 110⁡𝑚𝑛 = 18.18⁡(or DPS =
200⁡𝑚𝑛
= 1.82⁡ ⇒ ex-dividend PPS = 20 − 1.82 = 18.18). Alternatively, an
110⁡𝑚𝑛
200⁡𝑚𝑛
after-tax payout of 200 mn will cost the firm = 250 mn ⇒⁡ex-dividend market
1−0.2
1950
cap = 1950 mn ⇒ PPS = = 17.73 (or a reduction in PPS by DPS=2.27).
110
Question 4. (11 p.)

a) Give two examples, with brief explanations, of debt contracting features designed to
mitigate risk-shifting. (4 p.)

Answer:
Different answers possible, e.g.:
- Shorter maturity (reduces risk-shifting by forcing borrower to renew debt more often)
- Restrictive covenants (reduces risk-shifting by preventing, e.g., increased leverage via
new debt issuance or payouts to shareholders, investments into new lines of business,
sale of strategic assets, etc.)
- Option-like provisions (callability, putability, or convertibility; reduces risk-shifting by
giving the firm or the lender an option on the debt or equity of the firm).

b) Give two examples, with brief explanations, of situations in which it may be rational
for firms maximizing shareholders’ wealth to pass up positive-NPV investment
projects. (4 p.)

Answer:
Different answers possible, e.g.:
- With information asymmetries between the firm(‘s management) and investors, the
firm may be undervalued in debt and equity markets if the firm’s private information
is favorable, implying that new claims must be issued at a discount; if an investment
requires raising new financing, the loss (via dilution) to existing claimants of this
discount may outweigh the NPV of the investment (pecking-order).
- If the firm is highly leveraged, the present value of shareholders’ residual claim on the
investment’s future payoffs may be smaller than the value of alternative uses of the
funds required for the investment outlay, e.g. a dividend payment, even if NPV>0
(debt overhang, agency costs of debt).
- Etc.

c) Give a brief explanation to the information revelation theory of IPO underpricing. (3

p.)

Answer:
- There are information asymmetries between informed investors and the underwriter
of the IPO. Investors have an incentive to understate their demand during the book-
building stage to put downward pressure on the IPO price
- To counteract this incentive, the underwriter rewards (punishes) aggressive
(conservative) bids by higher (lower) allocations in the IPO
- For the threat of a lower allocation to be an effective deterrent against understating
demand, and for higher allocation to incentivize info revelation, the IPO must be
underpriced, otherwise investors don’t care what allocation they get.
Question 5. (6 p.)

Give a one-sentence explanation of the following concepts (1 p. each):

a) Fisher separation;
b) Agency costs of free cash flow;
c) Maturity-matching principle;
d) Free-rider and coordination problems (for firms with a large number of small,
dispersed investors);
e) Vertical merger;
f) Delegated monitoring.
Answers:
a) The optimal level of real investment is independent of subjective preferences for the
time allocation of consumption, is the same for everyone, and only depends on the
equilibrium interest rate (implies the NPV rule).
b) Costs to shareholders of leaving the control of cashflow in excess of that needed to
fund NPV>0 investments to the discretion of the firm’s management, due to their
increased opportunities to use it for personal benefit rather than in the shareholders’
best interest.
c) A rule of thumb for debt maturity choice, suggesting that the maturity of the sources
of funds should be matched to the maturity of the uses of funds (finance long-term
projects with long-term debt, short-term projects with short-term debt), to avoid
mismatches resulting in refinancing risk or underinvestment.
d) Collectively, investors benefit from monitoring of the firm, but each investor
individually has small incentives and opportunities to effectively perform the
monitoring/has the incentive to rely on monitoring being done by someone else (free-
riding), and due to their large number, concerted action between investors is more
difficult (coordination problems).
e) A merger between firms at different stages of production (up-/downstream) within
the same industry.
f) In firms with a large number of investors, to leave the responsibility for monitoring in
the hands of one or a few representative agents, e.g. the board of directors, a large
controlling shareholder (for equity), or a main relationship bank (for debt).
Question 6. (8 p.)
One of the main conflicts of interest in corporate finance is the one between insiders
(management) and outside investors (non-controlling shareholders). This conflict can be
mitigated by different governance mechanisms, which vary widely in importance and
effectiveness depending on firm- and country-specific factors. Suggest and briefly explain at
least two potential problems/limitations with each of the following governance mechanisms:

a) Legal investor protection; (4 p.)

Answer:
Different answers possible. Problems include:
- Shareholders’ residual control rights are vague and legally enforceable only in very
clear/extreme cases (e.g. fraud)
- Courts don’t make business judgments (e.g. it’s hard to litigate management for
making poor investment decisions)
- Even when control rights could potentially be legally enforced, taking a case to court
may be prohibitively expensive, particularly to small shareholders
- The strength of investor protection varies substantially across different countries, as
does the effectiveness of legal institutions generally (e.g. integrity and capacity of the
court system)
- Etc.

b) Incentive alignment via performance-based pay to management. (4 p.)

Answer:
Different answers possible. Problems include:
- Performance-based pay in the form of equity/options can be undone or insured (e.g.
via short-selling)
- It may create adverse incentives for management, e.g. earnings manipulation,
excessive focus on short-term performance, etc.
- Management is rewarded for “luck” (but typically not punished for “unluck”) due to
the imperfect link between any plausible performance measure and management’s
effort
- Compensation committees are not independent of management (e.g. performance
pay may give members of the same business or social networks the opportunity to
reward each other)
- Etc.
Question 7. (6 p.)
Suppose the all-equity firm Epsilon SA has an initial stock price of 20 per share and 80
million shares outstanding. Epsilon acquires Omega Plc., another all-equity firm which has 10
million shares outstanding trading at 45 per share. A mix of 20% cash and 80% newly issued
equity is used to pay for the acquisition. The synergies of the deal are estimated to have a net
present value of 50 million. The post-merger value of the combined firm is 2 billion.

a) What is the likely announcement effect on Omega’s (the target firm’s) stock price
when the acquisition plans are made public (assume that the market expects the deal to
go through). (3 p.)

Answer:
Epsilon’s initial market cap: 20 × 80⁡𝑚𝑛 = 1600⁡𝑚𝑛
Omega’s initial market cap: 45 × 10⁡𝑚𝑛 = 450⁡𝑚𝑛
Including the synergies, the post-merger value of the firm is then 1600⁡𝑚𝑛 + 450⁡𝑚𝑛 +
50⁡𝑚𝑛 − 𝑋 = 2000⁡𝑚𝑛 ⇒ 𝑋 = 100⁡𝑚𝑛, where X is the amount of cash that has gone out of
the firm. We know that the cash is 20% of the acquisition price ⇒ 𝑡𝑜𝑡𝑎𝑙⁡𝑎𝑐𝑞. 𝑝𝑟𝑖𝑐𝑒 =
100⁡𝑚𝑛
= 500⁡𝑚𝑛. When the acquisition is announced, the market value of each share in
0.2
500⁡𝑚𝑛
Omega will increase to , since this is what Epsilon are offering, i.e. an increase by
10⁡𝑚𝑛⁡𝑠ℎ𝑎𝑟𝑒𝑠
5
50 − 45 = 5, or 45 = 11% (which equals the bid premium).

b) How many shares does Epsilon have to issue to cover the equity part of the payment?
(3 p.)

Answer:

Omega’s shareholders get 400 mn in new equity, which is 400/2000 or 1/5 of the combined
value of the firm, so Epsilon’s initial 80 mn shares make up 4/5 ⇒ the total number of shares
80⁡𝑚𝑛
in the combined firm should be 0.8 = 100⁡𝑚𝑛⁡ ⇒⁡Epsilon should issue 20 mn shares. (The
2000⁡𝑚𝑛
post-acquisition PPS will be 100⁡𝑚𝑛⁡𝑠ℎ𝑎𝑟𝑒𝑠 = 20, i.e. unchanged, since Omega’s shareholders
gained the synergies via the bid premium.)