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ECO00008M

MSc Degree Examinations 2020-1

Economics

Corporate Finance

Please answer any three of the following four questions. Each question is worth 33 marks.

Question 1

You are considering establishing a biotech company, HBS Inc. According to your estimates of the expected net cash flows HBS will generate, this investment will have a positive NPV at discount rates less than 10,35% and a negative NPV at discount rates greater than 10,35%. The target debt-equity ratio for HBS is 0.2 and you expect to keep it constant over its life (which is assumed to be infinite). You identify a company with similar business. This company has a debt-equity ratio 0.48 which is expected to remain constant for ever. If the comparison firm’s debt-equity ratio is 0.48, its debt is riskless and its equity beta is 1.85. The risk-free interest rate is 3%. The expected return on the market portfolio is 9%. The corporate tax rate is 40%. (Word Limit: 300 words for each of the four parts (a, b, c, d) below).

a) Suppose that if your company’s debt-equity ratio is 0.25 debt is riskless. Would you establish HBS given that you could keep the debt-equity ratio constant at 0.25? (10 marks)

b) Would you establish HBS if it were all-equity financed? Is your decision different from that in Part (a)? Explain briefly your answer. (8 marks)

c) Suppose now that the same comparison firm instead of trying to keep a constant debt-equity ratio of 0.48 it has outstanding riskless debt with market value £192 million which is expected to remain constant for ever. Its market capitalisation (market value of its equity) is £400 million. For this level of leverage, debt is essentially riskless. What are the effects of this change? Would this change affect your decision about establishing HBS? Explain briefly your answer. (8 marks)

d) Suppose now that HBS is all-equity financed but the corporate tax rate is zero. Would you establish HBS in this case? Explain your answer. (7 marks)

Question 2

a) It has been argued that the issue of debt may induce managers to take excessive risk. Explain the source of this problem. Can this problem be solved or mitigated? (16 marks) (Word Limit: 600 words)

b) Explain  how  personal  taxes  can  create  dividend  clienteles.  What  are  the implications of the clientele effect? (17 marks) (Word Limit: 600 words)

Question 3

a) What is the debt overhang problem? What is the driving force of this problem? Can you suggest some solutions to this problem? (16 marks) (Word Limit: 600 words)

b) Explain the free-rider problem in the market for corporate control. Can you suggest how we may overcome this problem? (17 marks) (Word Limit: 600 words)

Question 4

Consider an entrepreneur who has a project that requires an investment of 97.5 at date 0. At date 2, the project either succeeds and generates a cash flow of 210 or fails and  yields  60.  The  success  probability  depends  on  the  effort  exerted  by  the entrepreneur. At date 1, the entrepreneur chooses the effort level he will exert, e . The effort level is a continuous variable that takes values in the interval [0, 1]. The success probability is the same as the effort level chosen (p(e) = e) and the failure probability is 1 − e . Also, the choice of the effort level implies a utility cost for the entrepreneur given by c(e) = 75e2 . All agents are risk neutral and there is no discounting. The effort level chosen is not observable by outside financiers and so it cannot be specified in a contract. Capital markets are perfectly competitive.

a) Suppose that the entrepreneur has enough funds to undertake the project without borrowing. What effort level will he choose? Will he invest? (5 marks) (Word Limit: 200 words)

b) Suppose now the entrepreneur has no funds available and raises the required amount by issuing debt. What is the face value of debt issued? Is debt riskless? What is the effort level chosen in equilibrium? Will the entrepreneur undertake the project? (8 marks) (Word Limit: 200 words)

c) Suppose the entrepreneur raises the required amount by issuing equity. What is the effort level chosen in equilibrium? Will the project be undertaken?  Is your answer different from that in Part (b)? Explain why. (8 marks) (Word Limit: 300 words)

d) Suppose that the entrepreneur is not restricted to debt and equity. What claim is he going to issue to maximise his net expected payoff (given limited liability)? Explain your answer. (12 marks) (Word Limit: 400 words)