FN2191 Commentary 2019

Examiners’ commentaries 2019

FN2191 Principles of corporate finance
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2018–19. 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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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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Important note

references
section.
Comments on specific questions – Zone A
Candidates should answer FOUR of the following SIX questions. All questions carry equal marks.
Question 1
(a) Explain how the Fisher separation theory shows that, under certain conditions,
shareholders can delegate to managers the task of choosing which physical
investment projects to undertake. What specific conditions must hold for this
to be true?
(8 marks)
(b) PJP, an industrial manufacturer, is considering a new capital investment
project to make and produce and sell a new type of electrical generator.
The first stage of the project requires an investment of $8,000 now for the initial
design and market research. There is a 40% probability that this phase will be
successful. If it is not successful (probability 60%), the project will be
abandoned with zero salvage value.
If the first stage is successful, a further investment of $300,000 will be required
one year from now to make and test prototype generators. If this second stage is
not successful (probability 55%), the prototypes could be sold for $40,000. If it
is successful (probability 45%), PJP would go ahead and produce the generator.
Further machinery for full production would cost $600,000 two years from now.
The net cash flows from production and sales of the generator will be either
$250,000 or $200,000 every year into perpetuity, depending on whether the
demand is strong (probability 50%) or weak (probability 50%). Assume these
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cash flows occur at the year ends with the first of them occurring three years
from now. PJP’s cost of capital is 10%. Assume investors are risk-neutral.
Construct a decision tree and determine the expected Net Present Value of the
project. Should the project be undertaken?
(12 marks)
(c) Assume that PJP can pay another firm to carry out the first two stages, and
report their findings to PJP two years from now. What is the maximum
amount PJP should pay for this?
(5 marks)
Reading for this question
Subject guide, Chapters 1 and 2.
Approaching the question
(a) Assume the firm has a set of physical investment opportunities and also the opportunity of
financial investment in the capital market. The firm’s set of physical investment
opportunities (projects) can be considered in rank order according to their return. The
optimal strategy is to invest in all projects with a higher return than that of financial
investment. Therefore, all firms would choose the same strategy if given the same set of
opportunities. The firm’s borrowing or lending in the capital market will be determined by
consumption preference. Hence shareholders can allow managers to make physical
investment decisions and control financial investment policy according to their own
preferences. The investment and financing decisions are separated.
The analysis relies on the assumption that capital markets are perfect, there are no
transaction costs and there is unrestricted borrowing and lending at the same rate of
interest. If these conditions do not hold the theory breaks down.
(b) There are four possible paths through the decision tree. A good approach is to calculate the
NPV and joint probability for each of these to derive the overall expected NPV.
Cash flows in $:
The expected NPV = $135,636. The project should be undertaken.

(c) The key to this part is that PJP will go ahead with production in two years’ time only if the
findings for the previous stages are favourable.
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Cash flows in $:
The joint probability that stage 1 is successful and stage 2 is successful is 0.40 × 0.45 = 0.18.
The most PJP should pay the other firm is 0.18 × ($1,363,636) = $245,455.
Question 2
(a) i. Explain the key findings (stylised facts) of John Lintner’s empirical study of
firms’ dividend policies. To what extent do these findings suggest dividend
payments signal information to the market?
(9 marks)
ii. A firm with annual earnings per share of £5 and a target payout ratio of 50%
has just made a dividend payment of £2.50. Assume that next year’s
earnings per share will increase to £7 and this will remain constant in the
future. Using Lintner’s partial adjustment model, determine the dividend
that will be paid in two years’ time, assuming a smoothing parameter of 0.7.
(4 marks)
(b) You own 100 shares in the firm Alfa. The current share price is £10 and the
earnings per share is £0.70. Assume there are no capital market imperfections
and that Alfa’s annual earnings will remain constant in future. Alfa pays out all
of its earnings each year as dividends. You prefer to invest your money in the
firm, so you reinvest each year’s dividend in the firm by buying more of its
shares. Your investment horizon is 10 years.
i. What is the value of your investment after 10 years? What would the value
of your investment have been, if Alfa’s policy was a zero dividend payout
over the same period?
(4 marks)
Assume now that there are personal taxes but no other market imperfections.
The tax rate on both dividends and capital gains is 30%.
ii. Assume again that Alfa pays out all its earnings as dividends. You reinvest
all your dividends back in the firm but decide to sell your shares at your 10
year investment horizon, immediately after the last dividend was paid. What
is the value of your wealth?
(3 marks)
iii. What would be your answer in (ii), assuming now that Alfa’s policy was a
zero dividend payout over the 10 years? Is it different? Why/why not?
(5 marks)
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Subject guide, Chapter 7.
(a) i. There are four stylised facts:

• managers seem to have a target dividend payout level
• the payout level is determined as a percentage of sustainable earnings per share
• managers are more concerned with changes in dividends rather than the actual level
of dividends
• managers prefer not to make dividend changes which might need to be reversed.
Lintner’s findings show that firms try to smooth their dividend changes over time. This is
consistent with the concept that managers are better informed than outsiders about the
firm’s performance and prospects and that dividends convey information to the market,
in a similar way to the signalling role of debt in the theory of Ross (1977). Event studies
show that dividend cuts can lead to share price drops which managers wish to avoid.
ii. Lintner’s partial adjustment model:
∆Dt = λ(αEP St − Dt−1 ) for 0 < α < 1, 0 < λ < 1.
Applying the model gives:
Year 0 1 2
Initial dividend, £ 2.50
Dividend change, £ 0.70 0.21
New dividend, £ 3.20 3.41
(b) i. Return on the investment = 0.70/10 = 7%.

After 10 years the initial investment of £1,000 will have grown to:
£1,000 × (1.07)10 = £1,967.13.
It is the same for both strategies because there are no taxes. Retentions and dividend
reinvestments are valued equally.
ii. Return on the investment = 0.70 × (1 − 0.30)/10 = 0.049%.

£1,000 × (1.049)10 = £1,613.45.
Capital gains tax = 0.30 × (£1,613.45 − £1,000) = £184.04.

After-tax value of the investment = £1,613.45 − £184.04 = £1,429.42.
(Note that in practice these results would be slightly lower, reflecting the indivisibility of
the shares when reinvesting dividend income.)
iii. At the 10-year horizon the investment value is £1,967.13 as in part i.

The results for parts ii. and iii. are different although the tax rates are the same for dividend
and capital gains income. The difference reflects two factors: the timing difference of the tax
payments and the tax on reinvested income.
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Question 3
(a) Using a no-arbitrage argument derive an expression for the k-period forward
price in domestic currency of one unit of foreign currency. Denote that Fk is the
k-period forward price, S the current spot price of the foreign currency, r is the
one-period risk free domestic interest rate and rf is the one-period foreign
interest rate.
(8 marks)
(b) Suppose you observe that today’s spot exchange rate between sterling and the
US dollar is £1 = $1.32, while the one-year forward rate is £1 = $1.38.
One-year interest rates are 4% for the US dollar and 2% for sterling.
i. What should the forward rate be, assuming interest rate parity?
(3 marks)
ii. Assume you can borrow today £1 million or the equivalent in US dollars.
Calculate the arbitrage profit you could make, showing clearly the steps in
the strategy.
(6 marks)
(c) Explain how a UK firm can hedge a US dollar receipt expected in one year’s
time using forward exchange contracts and currency futures. What are the
advantages and disadvantages of each type of hedge?
(8 marks)
(a) An investor holding £S has two possible investment strategies. The first is to deposit the
funds at the sterling interest rate to yield £S(1 + r)k at maturity.
The second strategy is to exchange sterling for the foreign currency at the current spot rate,
where one unit of the foreign currency costs £S, and deposit the foreign currency at the
foreign interest rate. At maturity the value of the foreign deposit will be (1 + rf )k .
Exchanging this back into the domestic currency yields £Fk (1 + rf )k .
Since the interest rates are known and fixed and the spot and forward rates are both known
from the beginning, both strategies are riskless and should, therefore, have the same payoff.
Equating the two payoffs gives:
S(1 + r)k = Fk (1 + rf )k .
Rearranging gives the no-arbitrage condition:

k
1+r
Fk = S .
1 + rf
(b) i. Under interest rate parity:

k
1+r
Fk = S .
1 + rf
Plugging in the numbers gives the forward rate £1 = $1.3459.
ii. The actual forward rate is higher than you would expect. To exploit this:
Borrow $1.32m now, exchange into £ at the spot rate to give £1m. After one year
including the interest you have £1.02m. Exchange this into $ at the forward rate $1.38
to give $1.4076m. Pay off the $ borrowing plus interest which is $1.3728m. The arbitrage
profit is $0.0348m.
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(c) Forward exchange contracts enable the firm to lock in an exchange rate today at which they
will sell dollars for sterling in one year’s time. The firm can enter into a forward contract to
sell US $ in one year’s time at today’s forward price. This eliminates uncertainty and the
risk that the future spot rate may be unfavourable. Disadvantages: they also eliminate the
upside potential of a favourable exchange rate movement; they are binding contracts so not
suitable for uncertain transactions; not all firms can access the forward market.
The firm could use currency futures to hedge the risk of an unfavourable exchange rate
movement. Unlike forwards they are tradeable, so more suitable for uncertain transactions.
To hedge the receipt a sterling futures position would be set up which is closed out by a
later opposite transaction. Gains on the futures price will offset adverse movements on the
spot price and vice versa. They are more accessible for small firms than forwards.
Disadvantage: it is difficult to create a perfect hedge due to the standardised nature of the
contracts and basis risk.
Question 4
An entrepreneur has a choice of two mutually exclusive investment projects, Project

A and Project B. Each lasts for one time period and the firm has no other projects.
Project A will result in a cash flow of £27 million in the good state and £10 million
in the bad state. Each outcome is equally likely. Project B will result in a cash flow
of £34 million in the good state and zero in the bad state. Each outcome is equally
likely. Assume the entrepreneur is able to choose which project to undertake after
the finance has been raised.
Each project requires an initial investment of £6 million. Assume risk-neutrality

and a discount rate of zero.
Assume for parts (a) to (c) that the investment is financed by debt.
(a) If Project A is chosen, what is the expected value of the firm and the payoffs to
the debtholders and the entrepreneur?
(3 marks)
(b) If Project B is chosen, what is the expected value of the firm and the payoffs to
the debtholders and the entrepreneur? Which is the better project? Which one
will the entrepreneur choose?
(4 marks)
(c) Assume the debtholders are fully aware of the firm’s possible investment
choices. They decide to use a bond covenant to stipulate that the face value of
the debt will be £9.2 million if the entrepreneur decides to take on the riskier
project. Which project does the entrepreneur choose now? Is this different
from your answer in part (b)? Why/why not?
(5 marks)
(d) Suppose the entrepreneur chooses instead to finance the project with outside
equity. Which project will be chosen? What fraction of the project’s payoff will
the outside equityholders ask for? What is the payoff to the entrepreneur and
the expected value of the firm?
(5 marks)
(e) Explain the risk-shifting (asset substitution) agency problem identified by
Jensen and Meckling (1976), with reference to your results in parts (a) to (d).
Is the solution to use as much outside equity as possible? Explain.
(8 marks)
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(a) The expected value of the firm = 0.5 × £27m + 0.5 × £10m = £18.5m.
Payoff to debt = £6m in both good and bad state, expected payoff £6m.
Payoff to equity = £21m in the good state and £4m in the bad state, expected payoff
£12.5m.
(b) The expected value of the firm = 0.5 × £34m + 0.5 × £0 = £17m.
Payoff to debt = £6m in good state and 0 in bad state, expected payoff £3m.
Payoff to equity = £28m in good state and 0 in bad state, expected payoff £14m.
Project A is better as it has a higher NPV and lower risk, but the entrepreneur will prefer
Project B which has a higher equity payoff.
(c) The entrepreneur’s payoff from project B is now 0.5 × (£34m − £9.2m) + 0.5 × £0 = £12.4m.
This is lower than his payoff from Project A so his preference switches to Project A. The
debtholders have aligned the entrepreneur’s incentives with theirs, ensuring that the less
risky project is taken.
(d) Project A will be chosen as it has the higher NPV. The outside equityholders will ask for a
fraction (α) of the payoff which is equal to their initial investment. £6m/£18.5m = 32.43%.
The payoff to the entrepreneur = £18.5m × (1 − α) = £12.5m and the value of the firm is
£18.5m.
(e) Equityholders will choose the riskier project even though the project decreases the overall
value of the firm. This is because it is more valuable to them due to the option-like nature
of their payoff, enabling them to expropriate value from debtholders. Debt finance may be
raised with the expectation that the lower risk, higher NPV project will be undertaken, but
once funds are obtained managers may substitute the risker project. Covenants may be used
by debtholders to protect against this hazard. Financing with equity or lower levels of debt
removes or reduces the incentive to risk-shift.
External equity carries its own agency cost in reducing the incentive for managerial effort,
since the rewards must be shared with outsiders. An optimal capital structure arises from
the trade-off between the agency costs of debt and of outside equity.
Question 5
The firm XYZ makes a public announcement that it will raise equity finance
through a rights issue of new shares to existing shareholders to finance a new
project with a net present value of £9.8 million and an investment cost of £25.2
million. There will be 15 million rights issue shares, priced at £1.68 each.
Assume that before making public the information about the new project or its
financing, the firm had 30 million shares with a market value of £1.95 per share.
The market is semi-strong form efficient and there are no issue costs.
(a) What is the value of a share in XYZ after the rights issue?
(5 marks)
(b) What is the value of a right to obtain one of the rights issue shares? Why?
(3 marks)
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(c) You are an investor who owns 1% of the shares of XYZ. You are offered 1% of
the rights issue shares.
i. Assume you buy all of the rights issue shares offered to you. What is the
change in your wealth after the rights issue, compared to the value of your
shareholding before the public announcement was made?
(5 marks)
ii. What will be the change in your wealth, assuming you choose to buy half of
the rights issue shares offered to you and sell the rights to buy the other
half ? Is this different to your answer in (i)? Why/why not?
(4 marks)
iii. What will be the change in your wealth if you choose not to buy any rights
issue shares or sell any of your rights?
(2 marks)
(d) Explain how a rights issue can be considered in terms of a call option. Why are
rights issue shares normally priced at a discount to the current market price of
the firm’s existing shares?
(6 marks)
(a) The firm’s value before the announcement = £1.95 × 30m = £58.5m.
The rights issue will raise £1.68 × 15m = £25.2m and the new project NPV = £9.8m.
The NPV of the new project is now public knowledge and the market will price this into its
valuation of the firm. The post-announcement value = £(58.5m + 25.2m + 9.8m) = £93.5m.
The new number of shares = 30m + 15m = 45m. Hence the new share price = £93.5m/45m
= £2.0778, which can be rounded to £2.08.
(b) The value of a right to obtain one of the rights issue shares is the difference between the
theoretical new price and the rights issue price: £2.08 − £1.68 = £0.40.
The reason is that an investor would be willing to pay £0.40 for the right to buy a share at
£1.68, expecting that it will have a market value of £2.08.
(c) i. The investor with a 1% shareholding has 0.3m shares before the rights issue. The value
of their investment is £1.95 × 0.3m = £0.585m. They will be offered 1% (0.15m) of the
rights issue shares for which they will pay £1.68 × 0.15m = £0.252m.
After the announcement and the rights issue, they have 0.45m shares with a new value of
£2.08 each. The total value of their investment is £2.08 × 0.45m = £0.936m.
Subtracting the payment of £0.252m gives net wealth of £0.684m. Compared to the
£0.585m value of their original shareholding this is an increase of £0.099m.
(Note this increase represents a net change of 1% of the value of the new project funded
by the rights issue, subject to rounding. This is in proportion to the investor’s
shareholding in the firm. The rights issue in itself had a neutral effect on the investor’s
wealth.)
ii. The investor buys 0.075m of the rights issue shares at a cost of £0.126m. After the
announcement and the rights issue, they have 0.375m shares so the total value of their
investment is £2.08 × 0.375m = £0.780m. The investor sells the rights to the other
0.075m shares they are offered for £0.40 × 0.075m = £0.03m. Their net wealth is
£(0.780m − 0.126m + 0.03m) = £0.684m, an increase of £0.099m.
The result is the same as in part i. This is because the value of a right is equal to the
difference between the (theoretical) ex-rights price and the rights issue price. As long as
the shareholder either exercises or sells the rights their wealth will be unaffected, except
for their share of the additional value of the new project.
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iii. If the investor does not buy any rights issue shares or sell any rights the value of the
investment will be £2.08 × 0.3m = £0.624m.
(d) The rights issue can be viewed as an option (right) which gives you the right to buy (akin to
a call option) shares of the company at a discounted price. The option is only worth
exercising when the issue price (exercise price) is below the market price. The value of the
option is the true value of the share minus the exercise price, like the payoff of an
in-the-money call option.
If the exercise price is greater than the true value of the share, investors will allow the
option to lapse and the rights issue will fail. For this reason, the rights issue shares are
priced at a discount which ensures the rights will have a value greater than zero throughout
the time that the rights issue shares can be bought. Shareholders must take up or sell the
rights (or a combination of both) to avoid losing money (as shown by the results from part
(c)). The discount does not mean the shareholders are getting a ‘bargain’.
Question 6
Dean plc is considering a takeover of Grange plc. Both companies are entirely
equity financed. Information about Dean and Grange is shown below. Both
companies have just paid a dividend and the next dividend payments are expected
one year from now.
Dean Grange
Dividends per share (most recent) £0.750 £0.380
Number of shares 10 million 3 million
Share price £23 £10
The dividends per share of Grange have been growing at a rate of 4% per year for
the past few years. Following the takeover, it is believed that Grange’s dividend per
share will grow at a rate of 5.5% per year.
(a) Use the Dividend Growth model to estimate Grange’s cost of equity (the
required rate of return of Grange’s shareholders).
(3 marks)
(b) Assume that Grange’s cost of equity does not change as a result of the takeover.
What is the value of Grange’s share after acquisition? What is the synergy gain
of the acquisition?
(4 marks)
(c) What is the premium paid by Dean if it pays £12.50 in cash for each Grange
share? What is the gain for Dean’s shareholders? What proportion of the
synergy gain does this represent?
(4 marks)
(d) What is the premium paid by Dean if it offers four of its own shares for every
nine shares of Grange? What is the gain for Dean’s shareholders? Should Dean
acquire Grange using cash or a share offer?
(6 marks)
(e) Discuss the advantages and disadvantages of each acquisition method to both
Dean and Grange.
(8 marks)
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(a) P0 = D1 (ke − g). Putting in the numbers for P0 , D1 and g and rearranging gives ke = 7.95%.
(b) Again using the Dividend Growth Model, the value of Grange’s share can be derived with
the revised growth rate.
The share value increases to £16.35 per share and the total value of equity increases to
£49,049,755. The value improvement (synergy) is the difference between this and the
original value of £30m, i.e. £19,049,755.
(c) The premium paid by Dean is the amount of the synergy gain given to Grange’s
shareholders.
£12.50 − £10 = £2.50 per share.
In total, £2.50 × 3m = £7.5m.
The gain to Dean’s shareholders is £19,049,755 − £7.5m = £11,549,755.
The proportion of the synergy gain = £11,549,755/£19,049,755 = 60.6%.
(d) The number of new shares = 3m × 4/9 = 1,333,333m so the new total number of shares =
11,333,333. The value of the new company = £230m + £49,049,755 = £279,049,755. Hence
the new share value = £279,049,755/11,333,333 = £24.62 per share.
Dean is offering £24.62 × 1,333,333 = £32,826,658 for Grange. The gain for the shareholders
of Dean = £279,049,755 − £32,826,658 − £230m = £16,223,097.
The premium = £24.62 × 1,333,333 − £30m = £2,829,383.
Dean should make a share exchange offer to acquire Grange, rather than a cash offer
(assuming either would be acceptable to Grange). The share offer results in a higher gain
for Dean’s shareholders.
(e) Some advantages and disadvantages of each acquisition method are:
Cash offer
For Dean:
Advantages: Dean will have complete control of the combined company.
Disadvantages: Potential liquidity issues.
For Grange:
Advantages: Certainty of the amount of benefit they will receive from the acquisition.
Disadvantages: Possible capital gains tax implications.
Share offer
For Dean:
Advantages: No cash outflow.
Disadvantages: Dilution of ownership.
For Grange:
Advantages: A form of continuing investment in the firm they chose to invest in.
Disadvantages: Uncertain return as the anticipated synergy gains may not occur.
Other valid points might be made here.
12

Important note

references
section.
Comments on specific questions – Zone B
Candidates should answer FOUR of the following SIX questions. All questions carry equal marks.
Question 1
An entrepreneur has a choice of two mutually exclusive investment projects, Project

P and Project Q. Each lasts for one time period and the firm has no other projects.
Project P will result in a cash flow of £50 million in the good state (probability
30%) and £23 million (probability 70%) in the bad state. Project Q will result in a
cash flow of £55 million in the good state and zero in the bad state. Each outcome
is equally likely. Assume the entrepreneur is able to choose which project to
undertake after the finance has been raised.
Each project requires an initial investment of £10 million. Assume risk-neutrality

and a discount rate of zero.
Assume for parts (a) to (c) that the investment is financed by debt.
(a) If Project P is chosen, what is the expected value of the firm and the payoffs to
the debtholders and the entrepreneur?
(3 marks)
(b) If Project Q is chosen, what is the expected value of the firm and the payoffs to
the debtholders and the entrepreneur? Which is the better project? Which one
will the entrepreneur choose?
(4 marks)
(c) Assume the debtholders are fully aware of the firm’s possible investment
choices. They decide to use a bond covenant to stipulate that the face value of
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the debt will be £13 million if the entrepreneur decides to take on the riskier
project. Which project does the entrepreneur choose now? Is this different
from your answer in part (b)? Why/why not?
(5 marks)
(d) Suppose the entrepreneur chooses instead to finance the project with outside
equity. Which project will be chosen? What fraction of the project’s payoff will
the outside equityholders ask for? What is the payoff to the entrepreneur and
the expected value of the firm?
(5 marks)
(e) Explain the risk-shifting (asset substitution) agency problem identified by
Jensen and Meckling (1976), with reference to your results in parts (a) to (d).
Is the solution to use as much outside equity as possible? Explain.
(8 marks)
(a) The expected value of the firm = 0.3 × £50m + 0.7 × £23m = £31.1m.
Payoff to debt = £10m in both good and bad state, expected payoff £10m.
Payoff to equity = £40m in the good state and £13m in the bad state, expected payoff
£21.1m.
(b) The expected value of the firm = 0.5 × £55m + 0.5 × £0 = £27.5m.
Payoff to debt = £10m in good state and 0 in bad state, expected payoff £5m.
Payoff to equity = £45m in good state and 0 in bad state, expected payoff £22.5m.
Project P is better as it has a higher NPV and lower risk, but the entrepreneur will prefer
Project Q which has a higher equity payoff.
(c) The entrepreneur’s payoff from project Q is now 0.5 × (£55m − £13m) + 0.5 × £0 = £21m.
This is lower than his payoff from Project P so his preference switches to Project P. The
debtholders have aligned the entrepreneur’s incentives with theirs, ensuring that the less
risky project is taken.
(d) Project P will be chosen as it has the higher NPV. The outside equityholders will ask for a
fraction (α) of the payoff which is equal to their initial investment. £10m/£31.1m =
32.15%. The payoff to the entrepreneur = £31.1m × (1 − α) = £21.1m and the value of the
firm is £31.1m.
(e) Equityholders will choose the riskier project even though the project decreases the overall
value of the firm. This is because it is more valuable to them due to the option-like nature
of their payoff, enabling them to expropriate value from debtholders. Debt finance may be
raised with the expectation that the lower risk, higher NPV project will be undertaken, but
once funds are obtained managers may substitute the risker project. Covenants may be used
by debtholders to protect against this hazard. Financing with equity or lower levels of debt
removes or reduces the incentive to risk-shift.
External equity carries its own agency cost in reducing the incentive for managerial effort,
since the rewards must be shared with outsiders. An optimal capital structure arises from
the trade-off between the agency costs of debt and of outside equity.
14
Question 2
(a) Using a no-arbitrage argument derive an expression for the k-period forward
price in domestic currency of one unit of foreign currency. Denote that Fk is the
k-period forward price, S the current spot price of the foreign currency, r is the
one-period risk free domestic interest rate and rf is the one-period foreign
interest rate.
(8 marks)
(b) Suppose you observe that today’s spot exchange rate between sterling and the
US dollar is £1 = $1.28, while the one-year forward rate is £1 = $1.23.
One-year interest rates are 6% for the US dollar and 2% for sterling.
i. What should the forward rate be, assuming interest rate parity?
(3 marks)
ii. Assume you can borrow today £1 million or the equivalent in US dollars.
Calculate the arbitrage profit you could make, showing clearly the steps in
the strategy.
(6 marks)
(c) Explain how firms can make use of interest rate swaps to manage risk. Describe
the steps involved in the swap process.
(8 marks)
(a) An investor holding £S has two possible investment strategies. The first is to deposit the
funds at the sterling interest rate to yield £S(1 + r)k at maturity.
The second strategy is to exchange sterling for the foreign currency at the current spot rate,
where one unit of the foreign currency costs £S, and deposit the foreign currency at the
foreign interest rate. At maturity the value of the foreign deposit will be (1 + rf )k .
Exchanging this back into the domestic currency yields £Fk (1 + rf )k .
Since the interest rates are known and fixed and the spot and forward rates are both known
from the beginning, both strategies are riskless and should, therefore, have the same payoff.
Equating the two payoffs gives:
S(1 + r)k = Fk (1 + rf )k .
Rearranging gives the no-arbitrage condition:

k
1+r
Fk = S .
1 + rf
(b) i. Under interest rate parity:

k
1+r
Fk = S .
1 + rf
Plugging in the numbers gives the forward rate £1 = $1.3302.
ii. The actual forward rate is much lower than you would expect. To exploit this:
Borrow £1m now, exchange into $ at the spot rate to give $1.28m. After one year
including the interest you have $1.3568m. Exchange this into £ at the forward rate $1.23
to give £1.1031m. Pay off the £ borrowing plus interest which is £1.02m. The arbitrage
profit is £0.0831m.
15
(c) A swap is an exchange of one set of cash flows (for example, cash flows on a floating rate
loan) for another of equivalent market value (for example, cash flows on a fixed rate loan)
between two parties.
The swap can be regarded as a sequence of forward contracts. It can be used to hedge a
mismatch between assets and liabilities. For example, firm A may receive a floating interest
rate (LIBOR, say), but pay a fixed interest rate. It can hedge against a drop in the floating
rate by entering into a swap contract with firm B, which receives the fixed interest rate and
pays a variable rate. Firm A agrees to pay the floating rate to firm B and firm B agrees to
pay a fixed interest rate (the swap rate) to firm A. In this way both remove the uncertainty
associated with the future LIBOR rate.
Question 3
(a) Explain how the Fisher separation theory can, under certain conditions, justify
the net present value rule for evaluating capital investment projects. Explain
with the aid of a diagram how this rule breaks down if a key assumption of the
theory does not hold.
(8 marks)
(b) JSV, a manufacturer of laboratory equipment, is considering a new capital
investment project to make and produce and sell a new type of microscope.
The first stage of the project requires an investment of $9,000 now for the initial
design and market research. There is a 35% probability that this phase will be
successful. If it is not successful (probability 65%), the project will be
abandoned with zero salvage value.
If the first stage is successful, a further investment of $320,000 will be required
one year from now to make and test prototype microscopes. If this second stage
is not successful (probability 40%), the prototypes could be sold for $50,000. If
it is successful (probability 60%), JSV would go ahead and produce the
microscope.
Further machinery for full production would cost $450,000 two years from now.
The net cash flows from production and sales of the microscope will be either
$200,000 or $180,000 every year into perpetuity, depending on whether the
demand is strong (probability 50%) or weak (probability 50%). Assume
investors are risk-neutral. JSV’s cost of capital is 10%.
Construct a decision tree and determine the expected Net Present Value of the
project. Should the project be undertaken?
(12 marks)
(c) Assume that JSV can pay another firm to carry out the first two stages, and
report their findings to JSV two years from now. What is the maximum amount
JSV should pay for this?
(5 marks)
(a) Assume the firm has a set of physical investment opportunities and also the opportunity of
financial investment in the capital market. The optimal strategy is to invest in all projects
with a higher return than that of financial investment, so optimal physical investment
should maximise the horizontal intercept with the capital market line.
16
Assume that at t = 0 the firm has income m and invests I0 in physical investment. At t = 1
its income from physical investment will be Π(I0 ). The horizontal intercept will be at
m − I0 + Π(I0 )/(1 + r). Optimal physical investment is the policy which maximises
Π(I0 )/(1 + r) − I0 which is the NPV rule.
The Fisher analysis breaks down if borrowing and lending rates are not equal since there
will be two points where the capital market lines are tangential to the production
opportunities frontier, implying that agents with different preferences will choose differing
physical investment decisions. A diagram along the lines of Figure 1.3 should be presented
to illustrate these points.
(b) There are four possible paths through the decision tree. A good approach is to calculate the
NPV and joint probability for each of these to derive the overall expected NPV.
Cash flows in $:
The expected NPV = $65,628. The project should be undertaken.

(c) The key to this part is that JSV will go ahead with production in two years’ time only if the
findings for the previous stages are favourable.
Cash flows in $:
The joint probability that stage 1 is successful and stage 2 is successful is 0.35 × 0.40 = 0.14.
The most JSV should pay the other firm is 0.14 × ($1,198,347) = $167,769.
Question 4
Stone plc is considering a takeover of Moss plc. Both companies are entirely equity
financed. Information about Stone and Moss is shown below. Both companies have
17
just paid a dividend and the next dividend payments are expected one year from
now.
Stone Moss
Dividends per share (most recent) £0.41 £0.21
Number of shares 10 million 3 million
Share price £12 £6
The dividends per share of Moss have been growing at a rate of 4% per year for the
past few years. Following the takeover, it is believed that Moss’s dividend per share
will grow at a rate of 6% per year.
(a) Use the Dividend Growth model to estimate Moss’s cost of equity (the required
rate of return of Moss’s shareholders).
(3 marks)
(b) Assume that Moss’s cost of equity does not change as a result of the takeover.
What is the value of Moss’s share after acquisition? What is the synergy gain of
the acquisition?
(4 marks)
(c) What is the premium paid by Stone if it pays £6.90 in cash for each Moss
share? What is the gain for Stone’s shareholders? What proportion of the
synergy gain does this represent?
(4 marks)
(d) What is the premium paid by Stone if it offers two of its own shares for every
five shares of Moss? What is the gain for Stone’s shareholders? Should Stone
acquire Moss using cash or a share offer?
(6 marks)
(e) Discuss the potential economic justifications for financial, strategic and
conglomerate mergers.
(8 marks)
(a) P0 = D1 (ke − g). Putting in the numbers for P0 , D1 and g and rearranging gives ke = 7.64%.
(b) Again using the Dividend Growth Model, the value of Moss’s share can be derived with the
revised growth rate.
The share value increases to £13.57 per share and the total value of equity increases to
£40,719,512. The value improvement (synergy) is the difference between this and the
original value of £18m, i.e. £22,719,512.
(c) The premium paid by Stone is the amount of the synergy gain given to Moss’s shareholders.
£6.90 − £6 = £0.90 per share.
In total, £0.90 × 3m = £2.7m.
The gain to Stone’s shareholders is £22,719,512 − £2.7m = £20,019,512.
The proportion of the synergy gain = £20,019,512/£22,719,512 = 88.1%.
(d) The number of new shares = 3m × 2/5 = 1.2m so the new total number of shares =
11,200,000. The value of the new company = £120m + £40,719,512 = £160,719,512. Hence
the new share value = £160,719,512/11,200,000 = £14.35 per share.
18
Stone is offering £14.35 × 1.2m = £17,219,948 for Moss. The gain for the shareholders of
Stone = £160,719,512 − £17,219,948 − £120m = £23,499,564, which is greater than their
gain with the cash offer.
However, the current market value of Moss is £18m and so the premium offered at this rate
of share exchange is negative (£780,052). As the offer is unlikely to be accepted by the
shareholders of Moss, Stone should consider a different rate of share exchange to acquire
Moss (or a cash offer).
(e) The answer should consider the potential economic benefits (synergies) of each type of
merger. Synergy arises when the value of the combined firm is greater than the sum of the
values of the two separate companies.
A number of synergy-creating factors might be identified and discussed here. Examples
include economies of scale, utilisation of unused tax allowances, alliances of cash-rich firms
with growth opportunity firms, reduction of overlapping administrative functions, achieving
critical mass to enable activities such as research and development, elimination of inefficient
management etc.
Question 5
(a) i. Explain the key findings (stylised facts) of John Lintner’s empirical study of
firms’ dividend policies. To what extent do these findings suggest dividend
payments signal information to the market?
(9 marks)
ii. A firm with annual earnings per share of £10 and a target payout ratio of
40% has just made a dividend payment of £4.00. Assume that next year’s
earnings per share will increase to £12 and this will remain constant in the
future. Using Lintner’s partial adjustment model, determine the dividend
that will be paid in two years’ time, assuming a smoothing parameter of 0.6.
(4 marks)
(b) You own 100 shares in the firm Gamma. The current share price is £10 and the
earnings per share is £0.60. Assume there are no capital market imperfections
and that Gamma’s annual earnings will remain constant in future. Gamma pays
out all of its earnings each year as dividends. You prefer to invest your money
in the firm, so you reinvest each year’s dividend in the firm by buying more of
its shares. Your investment horizon is 10 years.
i. What is the value of your investment after 10 years? What would the value
of your investment have been, if Gamma’s policy was a zero dividend payout
over the same period?
(4 marks)
Assume now that there are personal taxes but no other market imperfections.
The tax rate on both dividends and capital gains is 25%.
ii. Assume again that Gamma pays out all its earnings as dividends. You
reinvest all your dividends back in the firm but decide to sell your shares at
your 10 year investment horizon, immediately after the last dividend was
paid. What is the value of your wealth?
(3 marks)
iii. What would be your answer in (ii), assuming now that Gamma’s policy was a
zero dividend payout over the 10 years? Is it different? Why/why not?
(5 marks)
19
(a) i. There are four stylised facts:

• managers seem to have a target dividend payout level
• the payout level is determined as a percentage of sustainable earnings per share
• managers are more concerned with changes in dividends rather than the actual level
of dividends
• managers prefer not to make dividend changes which might need to be reversed.
Lintner’s findings show that firms try to smooth their dividend changes over time. This is
consistent with the concept that managers are better informed than outsiders about the
firm’s performance and prospects and that dividends convey information to the market,
in a similar way to the signalling role of debt in the theory of Ross (1977). Event studies
show that dividend cuts can lead to share price drops which managers wish to avoid.
ii. Lintner’s partial adjustment model:
∆Dt = λ(αEP St − Dt−1 ) for 0 < α < 1, 0 < λ < 1.
Applying the model gives:

Year 0 1 2
Initial dividend, £ 4.00
Dividend change, £ 0.48 0.192
New dividend, £ 4.48 4.672
(b) i. Return on the investment = 0.60/10 = 6%.

£1,000 × (1.06)10 = £1,790.85.
It is the same for both strategies because there are no taxes. Retentions and dividend
reinvestments are valued equally.
ii. Return on the investment = 0.60 × (1 − 0.25)/10 = 0.045%.
£1,000 × (1.045)10 = £1,552.97.

(Note that in practice these results would be slightly lower, reflecting the indivisibility of
the shares when reinvesting dividend income.)
iii. At the 10-year horizon the investment value is £1,790.85 as in part i.
The results for parts ii. and iii. are different although the tax rates are the same for dividend
and capital gains income. The difference reflects two factors: the timing difference of the tax
payments and the tax on reinvested income.
Question 6
The firm Zavi makes a public announcement that it will raise equity finance through
a rights issue of new shares to existing shareholders to finance a new project with a
20
net present value of £11 million and an investment cost of £18 million. There will
be 8 million rights issue shares, priced at £2.25 each.
Assume that before making public the information about the new project or its
financing, the firm had 20 million shares with a market value of £2.75 per share.
The market is semi-strong form efficient and there are no issue costs.
(a) What is the value of a share in Zavi after the rights issue?
(5 marks)
(b) What is the value of a right to obtain one of the rights issue shares? Why?
(3 marks)
(c) You are an investor who owns 2% of the shares of Zavi. You are offered 2% of
the rights issue shares.
i. Assume you buy all of the rights issue shares offered to you. What is the
change in your wealth after the rights issue, compared to the value of your
shareholding before the public announcement was made?
(5 marks)
ii. What will be the change in your wealth, assuming you choose to buy half of
the rights issue shares offered to you and sell the rights to buy the other
half ? Is this different to your answer in (i)? Why/why not?
(4 marks)
iii. What will be the change in your wealth if you choose not to buy any rights
issue shares or sell any of your rights? (2 marks)
(d) Explain how a rights issue can be considered in terms of a call option. Why are
rights issue shares normally priced at a discount to the current market price of
the firm’s existing shares?
(6 marks)
(a) The firm’s value before the announcement = £2.75 × 20m = £55m.
The rights issue will raise £2.25 × 8m = £18m and the new project NPV = £11m.
The NPV of the new project is now public knowledge and the market will price this into its
valuation of the firm. The post-announcement value = £(55m + 18m + 11m) = £84m.
The new number of shares = 20m + 8m = 28m. Hence the new share price = £84m/28m =
£3.00.
(b) The value of a right to obtain one of the rights issue shares is the difference between the
theoretical new price and the rights issue price: £3.00 − £2.25 = £0.75.
The reason is that an investor would be willing to pay £0.75 for the right to buy a share at
£2.25, expecting that it will have a market value of £3.00.
(c) i. The investor with a 2% shareholding has 0.4m shares before the rights issue. The value
of their investment is £2.75 × 0.4m = £1.1m. They will be offered 2% (0.16m) of the
rights issue shares for which they will pay £2.25 × 0.16m = £0.36m.
After the announcement and the rights issue, they have 0.56m shares with a new value of
£3.00 each. The total value of their investment is £3.00 × 0.56m = £1.68m. Subtracting
the payment of £0.36m gives net wealth of £1.32m. Compared to the £1.1m value of
their original shareholding this is an increase of £0.22m.
(Note this increase represents a net change of 2% of the value of the new project funded
by the rights issue, subject to rounding. This is in proportion to the investor’s
shareholding in the firm. The rights issue in itself had a neutral effect on the investor’s
wealth.)
21
ii. The investor buys 0.08m of the rights issue shares at a cost of £0.18m. After the
announcement and the rights issue, they have 0.48m shares so the total value of their
investment is £3.00 × 0.48m = £1.44m. The investor sells the rights to the other 0.08m
shares they are offered for £0.75 × 0.08m = £0.06m. Their net wealth is
£(1.44m − 0.18m + 0.06m) = £1.32m, an increase of £0.22m.
The result is the same as in part i. This is because the value of a right is equal to the
difference between the (theoretical) ex-rights price and the rights issue price. As long as
the shareholder either exercises or sells the rights their wealth will be unaffected, except
for their share of the additional value of the new project.
iii. If the investor does not buy any rights issue shares or sell any rights the value of the
investment will be £3.00 × 0.4m = £1.2m.
(d) The rights issue can be viewed as an option (right) which gives you the right to buy (akin to
a call option) shares of the company at a discounted price. The option is only worth
exercising when the issue price (exercise price) is below the market price. The value of the
option is the true value of the share minus the exercise price, like the payoff of an
in-the-money call option.
If the exercise price is greater than the true value of the share, investors will allow the
option to lapse and the rights issue will fail. For this reason, the rights issue shares are
priced at a discount which ensures the rights will have a value greater than zero throughout
the time that the rights issue shares can be bought. Shareholders must take up or sell the
rights (or a combination of both) to avoid losing money (as shown by the results from part
(c)). The discount does not mean the shareholders are getting a ‘bargain’.
22

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Examiners’ commentaries 2019

Examiners’ commentaries 2019

Information about the subject guide and the Essential reading

What are the examiners looking for?

Examination revision strategy

Examiners’ commentaries 2019

Information about the subject guide and the Essential reading

Comments on specific questions – Zone A

Reading for this question

Subject guide, Chapters 1 and 2.

Approaching the question

The expected NPV = $135,636. The project should be undertaken.

Reading for this question

Subject guide, Chapter 7.

Approaching the question

(a) i. There are four stylised facts:

ii. Lintner’s partial adjustment model:

∆Dt = λ(αEP St − Dt−1 ) for 0 < α < 1, 0 < λ < 1.

Applying the model gives:

(b) i. Return on the investment = 0.70/10 = 7%.

£1,000 × (1.07)10 = £1,967.13.

ii. Return on the investment = 0.70 × (1 − 0.30)/10 = 0.049%.

£1,000 × (1.049)10 = £1,613.45.

Capital gains tax = 0.30 × (£1,613.45 − £1,000) = £184.04.

iii. At the 10-year horizon the investment value is £1,967.13 as in part i.

Reading for this question

Subject guide, Chapter 9.

Approaching the question

Rearranging gives the no-arbitrage condition:

(b) i. Under interest rate parity:

An entrepreneur has a choice of two mutually exclusive investment projects, Project

Each project requires an initial investment of £6 million. Assume risk-neutrality

Reading for this question

Subject guide, Chapter 5.

Approaching the question

Reading for this question

Subject guide, Chapter 6.

Approaching the question

Reading for this question

Subject guide, Chapters 1 and 8.

Approaching the question

Examiners’ commentaries 2019

Information about the subject guide and the Essential reading

Comments on specific questions – Zone B

An entrepreneur has a choice of two mutually exclusive investment projects, Project

Each project requires an initial investment of £10 million. Assume risk-neutrality

Reading for this question

Subject guide, Chapter 5.

Approaching the question

Reading for this question

Subject guide, Chapter 9.

Approaching the question

Rearranging gives the no-arbitrage condition:

(b) i. Under interest rate parity:

Reading for this question

Subject guide, Chapters 1 and 2.

Approaching the question

The expected NPV = $65,628. The project should be undertaken.