Questions BCF PDF

Preview

Summary

Sample questions for exam...

Description

BCF 2018/2019 Sample questions 1) Which of the following statements is False? a. The tradeoff theory weighs the costs of debt that result from shielding cash flows from taxes against the benefits from effects of financial distress associated with leverage b. Leverage has costs as well as benefits(2 benefits: tax shield and monitor benefit: it mitigates agency problems between managers and shareholders & 2 costs: bankruptcy costs and risk shifting) c. According to the tradeoff theory, the total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs d. Firms have an incentive to increase leverage to exploit the tax benefits of debt. But with too much debt, they are more likely to risk default and incur financial distress costs 2) Explain trade-offs between stock-option plan and restrictive stock plans when designing compensation contracts to bank CEOs. Stock option plans is a way to compensate and attract employees. The plans give employees the right to buy a specific number of the company’s shares at a fixed price for a specific period of time. Risk-taking incentives may aggravate if managers and CEOs receive straight stock options on equity. Stock option plan give incentive to take higher risk, returns are considerably high and there are few risk losses at stake. There is a premium paid for the option and that is the maximum loss. There is high vega risk which means that probably the stock price is much higher than the strike price. Restrictive stock plan gives more incentive to managers to be conservative, CEOs have a lot at stake since they are directly connected to the stock value. Managers are owners of shares for five years but do not have rights on them. This logic gives an incentive to managers to work high and to increase the value of the share. High delta risk. From the contract theory, contract design will increase the delta risk, which is the change in CEOs wealth with respect to the change in bank’s stock price; and vega risk, the change in CEO’s wealth with respect to changes in bank’s stock return volatility.

3) Explain why governance of banks is different from governance of non-financial firms. Governance of banks is different from governance of non-financial firms for a number of reasons. First of all banks have an unique position in financial intermediation and the payment system and their failure can create negative externalities and systemic risk especially if they are large banks, the externalities would be macroeconomic. Then, banks’

agency problems are intensified by the presence of government guarantees and deposit insurances, which distort bankers’ incentives and encourage risk-taking. Finally, depositors, which are the main funding source of banks, do not have good incentives to monitor the managers of such institutions and this happens because of information asymmetries in opaque financial institutions and coordination costs. All these reasons explain why banks and financial institutions are the most heavily regulated businesses and why their governance is different, governance which must be designed so as to align the interests of managers with those of both shareholders and debtholders(bondholders and depositors). 4) Modern theory of financial intermediation argues banks and financial intermediaries exist because they reduce transaction costs. Present the most important type of transaction costs banks and others reduce and explain how their activities can contribute to economic efficiency. The most important type of transaction costs bank and others reduce is the the information cost. Indeed, cost of information is the main barrier which small investors encounter. Banks and FI’s develop expertise through which they can reduce such cost and help investors making profits. This happens because they apply a piece of information to big investments or they use the same information for many different services and by doing so creating economies of scale/scope.

5) What are the main effects of non-performing loans on a bank business activity and performance? Non-performing loans can be thought at as bad assets that a bank carries on its balance sheet. NPLs have a negative effect on bank’s performance. First of all the bank’s profitability starts to suffer as the income from bad assets goes under normal levels. At this point the bank must restrain its loan policies and increase loan provisions, while the funding costs rise because counterparties seek to cover the risks of lending to weakened banks. Write down and write offs deplete the bank’s capital buffers. NPLs crowd out new lending and banks have reduced capacity to extend new credit. Altogether, the bank will experience lo profitability and low growth. 6) Explain and discuss the main differences between a bank-based financial system and a capital market-based financial system. Bank-based financial systems rely on relationship-based financing as opposed to marketbased systems which rely on arm’s length financing. In a relationship-based system the financier gets its return through some form of power or retaining some kind of monopoly over the firm he finances. Furthermore, the relationship is conducted through implicit contracts, hence it is said to be opaque. The financier has a close tie with the borrowing firm and there are continuous contacts to ensure a steady flow of business. This kind of system performs better with smaller firms, when investor legal protection is weaker, when there’s little transparency and when innovation is incremental rather than revolutionary. On the other hand there’s the market-based system in which the financiers

have little power and there’s more competition. The firm will be able to access a wider circle of potential lenders because there will be more widespread financial information about it. Thus, the system will be more transparent and explicit contracts will be used but they are difficult to write and they require enforcement by the courts. Loans will be contracted for a specific period, and interest rates will be competitive. This form of financing delivers better in markets with large formally organized firms, when there’s better legal enforcement and transparency, and when innovation tends to be more revolutionary. A Relationship-based system does not pay much attention to market signals and prices are not valuable for investment decisions, hence, relationships can distort the efficient allocation of funds. On the contrary, in market-based economies there is a “virtuous circle” at work: in the process of relying on prices for guidance, the arm’s length transactions that predominate also have the beneficial effect of making prices more informative. Thus, the more transactions that come into the market, the more likely it is that decisions made on the basis of price are likely to be the right one.

7) In which way the Management Opportunism Theory of firm capital structure is inconsistent both with Trade-off and Pecking order theories? Management Opportunism theory has is based on the market timing hypothesis. In corporate finance “equity market timing” refers to the practice of issuing shares at high prices and repurchasing them at low prices. The intention is to exploit temporary fluctuations in the cost of equity relative to the cost of other forms of financing. Firms that conduct SEOs typically have high share valuations that increase considerably before the SEO. The theory is in contrast with trade-off theory because the latter predicts that firms will lever up after a share price increase rather than conduct a SEO, as raising equity amplifies rather than offsetting the deleveraging that occurred exogenously. Management Opportunism Theory is in contrast also with the Pecking order theory, which predicts that managers issue securities with least information asymmetry, whereas the market timing theory suggests that managers sell securities that are most mispriced. It means that SEOs typically follow share price run-ups, which imply increased future cash flows that could be used to support additional debt

8) Why are pyramids common in many countries but not in Anglo-American countries such as the US or UK?

Corporate governance and legal protection of investors vary enormously across countries, for a number of reason like culture, development, Concentrated ownership naturally arises as a religion, legal system, politics etc. solution to countries with weak investor protection. managerial agency conflicts in weak investor protection and inadequate laws Thus, the main cause of pyramid structures is . Pyramid structures are associated with expropriation of minority shareholders by the big ones. Such a scenario generates an environment where “tunneling” (illegal business practice in which a majority shareholder or high level company insider directs company assets or future business to themselves for personal gain) by dominant shareholders. An explanation as why Anglo-American countries present less pyramids than other countries such as Italy, Sweden , Korea and many other is because these former economies ( US and UK) are the most developed in the world with the highest shareholder protection rules and as such they are able to avoid pyramid structures in corporate governance.

Explain the agency costs Agency theory of corporate finance deals with the analysis of conflicts between providers of capital and agents or delegates who are the users of capital. When asset ownership is separated with management control, agency theory predicts that agency costs may arise and they may have significant effects on firm performance and value. The choice of capital structure may help mitigate these agency costs. Under agency costs hypothesis, high leverage reduces the agency costs of outside equity and increases firm value by constraining managers to act more in the interest of shareholders. Agency costs of equity: agency costs arise as soon as an entrepreneur sells a fraction A of her firm to outside investors. The entrepreneur enjoys private benefits of control(perquisites), but bears only (1-A) of the cost of “perks”. For example a manager who owns 10% of a firm may choose to buy a VanGogh to hang in his office with the funds of the company: this means that 90% of the price is paid by shareholders! Thus, separation between ownership and control of a firm gives rise to agency costs of outside equity. Deb decreases agency costs of free cash flow by decreasing cash available at the discretion of managers....