ECN372 Corporate Finance 2 PDF

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Main Examination Period 2017 ECN372

Corporate Finance 2

Duration: 2 hours

YOU ARE NOT PERMITTED TO READ THE CONTENTS OF THIS QUESTION PAPER UNTIL INSTRUCTED TO DO SO BY AN INVIGILATOR

Answer TWO questions is Section A and ALL questions in Section B; Section A carries 40 marks and Section B carries 60 marks If you answer more questions than specified, only the first answers (up to the specified number) will be marked. Cross out any answers that you do not wish to be marked Calculators are permitted in this examination. Please state on your answer book the name and type of machine used. Complete all rough workings in the answer book and cross through any work that is not to be assessed. Possession of unauthorised material at any time when under examination conditions is an assessment offence and can lead to expulsion from QMUL. Check now to ensure you do not have any notes, mobile phones, smartwatches or unauthorised electronic devices on your person. If you do, raise your hand and give them to an invigilator immediately. It is also an offence to have any writing of any kind on your person, including on your body. If you are found to have hidden unauthorised material elsewhere, including toilets and cloakrooms it will be treated as being found in your possession. Unauthorised material found on your mobile phone or other electronic device will be considered the same as being in possession of paper notes. A mobile phone that causes a disruption in the exam is also an assessment offence. EXAM PAPERS MUST NOT BE REMOVED FROM THE EXAM ROOM Examiner: Dr Radoslawa Nikolowa

© Queen Mary, University of London, 2017

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ECN372 (2017)

Section A (Answer TWO Questions) Question 1 a) Discuss the main steps of the Adjusted Present Value (APV) method for valuing a project. [14 marks] b) Explain the main advantages of the APV method relative to the Weighted Average Cost of Capital (WACC) method. [6 marks] Question 2 a) Discuss the following statement: “Corporate governance relates to the ways in which the suppliers of finance to corporations assure themselves of getting a return on their investment”. [12 marks] b) Briefly explain how the use of debt financing could help mitigate the conflict of interests between the firm’s management and the firm’s investors. [8 marks] Question 3 a) A company is run by a manager acting in the best interest of the company’s shareholders. The company has high levels of existing debt and financial distress is a possibility. Discuss the implications that the highly levered capital structure may have on the firm’s decision to undertake a positive net present value project financed by equity-holders. [12 marks] b) Discuss two ways in which the problem highlighted in (a) could be solved. [8 marks]

ECN372 (2017)

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Section B (Answer ALL Questions) Question 4 Assume that you are in a Modigliani and Miller economy without taxes. For an initial investment of $750 this year, a project will generate cash flows of either $1300 (boom) or $800 (recession). The two events are equally likely. Assume the risk free rate is 5%. a) Assume initially the project is all equity funded and the expected rate of return on equity is 20%. Find the net present value (NPV) of the project. Find the value of equity. [4 marks] b) Assume now that the project is partly funded by borrowing $450 at the risk free rate of 5%. Find the payoffs to debt and equity in each state (boom and recession). Find the market value of equity. [6 marks] c) Find the rate of return on equity in each state as well as the expected rate of return for the levered and the unlevered company. Compare your findings for the levered and the unlevered company and discuss. [13 marks] d) Very briefly discuss the following statement: “The cost of debt is lower than the cost of equity, therefore the weighted average cost of capital of the levered firm should be lower than the weighted average cost of capital of the unlevered company.” [7 marks]

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ECN372 (2017)

Question 5 An entrepreneur has an investment opportunity that costs $400 today. The project yields a cash flow equal to either $750 (success) or $300 (failure) one year from now. A project can be of two types, good or bad. A good project succeeds with probability 0.7, while a bad project succeeds with probability 0.4. The capital market assigns a probability of 0.4 to the project being good. The entrepreneur has no internal funds. Assume that the entrepreneur knows that his project is good. All agents are risk neutral and the discount rate is zero. a) Find the expected payoff for the entrepreneur if the project is financed with equity. [6 marks] b) How would the entrepreneur’s expected payoff change if the probability assigned by the market to the project being good increases. Answer the question without doing any calculations, focus on the intuition. [5 marks] c) Find the expected payoff for the entrepreneur if the project is financed with debt. [6 marks] d) Based on your answers to (a) and (c), how is the entrepreneur going to finance the project? Discuss your answer. [5 marks] Now assume that a bank has access to a certification technology and can establish whether a firm is good or bad. The cost of the technology is C and if the entrepreneur decides to use the bank that holds this technology, the bank will need to be rewarded for the additional cost. e) For what values of the cost C will the entrepreneur choose to use the bank with the certification technology? Discuss your result. [8 marks] End of Paper...