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Sample Exam 2020 Solutions[1]

Rotterdam School of Management
Erasmus University
– Corporate Finance
Online test (non-proctored)
General information
Date test:
Course coordinator:
Time test:
Test reviewed by
Type test:
Number of questions:
Number of pages:
open book
x questions
x pages (incl. cover sheet)
 You are allowed to use a calculator.
 You are allowed to use a programmable calculator.
 You are allowed to use notes.
 You are allowed to use books.
 You are allowed to use a dictionary.
 You are allowed/ not allowed to use the question mark option on the MC answer sheet.
Integrity Statement:
Please read the following paragraph carefully. Furthermore, you are expected to adhere to the
disciplinary rules for written examinations (please consult ‘Rules of conduct for online testing,
Examination Board RSM – EUR).
Your test will be scanned by plagiarism detection software.
By taking this remote exam, we expect that you will adhere to the ethical standard of behaviour
expected of you. This means that we trust you to answer the questions and perform the assignments in
this exam to the best of your own ability, without seeking or accepting the help of any source that is
not explicitly allowed by the conditions of this exam.
Please be aware that if you do not comply with these terms and conditions and/or there is a suspicion
of fraud, sanctions may be imposed by the Examination Board which could even extend to permanent
termination of your student registration (Rules and Guidelines 2019-2020, Article 3.4).
Please copy the following text in your exam if you agree:
“I will make this exam to the best of my own ability, without seeking or accepting the help of others or
use resources that are not explicitly allowed.”
No part of this test may be reproduced, stored in a retrieval system or transmitted in any form or any means, without
permission of the author or, when appropriate, of the Erasmus University Rotterdam.
Good Luck!
Please read the Integrity Statement above in detail and take it very seriously.
Please note that there will be different versions of the exam and we will also run
plagiarism checks.
The exam will consist of shorter questions (that may require a calculation or a short
answer about theory) and longer questions. The long(er) questions could include
calculations, questions about theory, and questions about an article not discussed in
class of which you should be able to interpret the main results based on the material
covered in class. [Please have a look at papers / slides to see examples of tables and
figures. I won’t show you any table/figure of an assigned paper though given that the
exam is open book.]
The questions below will show you the type of questions you can expect in the final
exam. I assume that they won’t come at a surprise to you as the format is close to the
assignments and workshop questions.
The exam will be representative of the chapters in the book, our discussions,
assignments, workshops, cases, and additional material that was assigned or discussed.
Please note that the exam will be quite long given that it is open book. It will contain
several questions that are relatively close to questions you have seen before (but do not
expect to just get old questions with different numbers). Moreover, it will also contain
some questions that are new and very challenging, requiring from you to apply learnt
theories and concepts to new settings.
My advice for the exam is as follows: Start with the questions that you can answer more
easily (and collect those points). If you are stuck, move on! You can go back to more
difficult questions later if time permits.
Question Type 1: Construction of payoff diagrams
Metzka Bean has the following capital structure:
Senior debt 100,000 EUR
Junior debt 100,000 EUR
10 shares of Convertible preferred (total 100,000 EUR)
If not converted: 1.5x liquidation preference, junior to all debt but
senior to common equity
Convertible into Common equity; 1 share of convertible preferred
converts into 1 new share of common equity
90 shares of Common equity (Old / original common equity holders)
Please provide the payoffs to the different claimants for the following
values of the firm.
Junior debt if the value of the firm is 50,000? [
Convertible preferred if the value of the firm is 0.5M? [
Old common equity holders if the value of the firm is 2.0M? [
Please see slides of Q&A session
Question Type 2: Shorter questions
a) Comment on the following statement: “Because of the negative effect of
debt on the price/ earnings ratio, firm are pushed toward equity.”
No. All that should matter to management is firm value, which is not causally affected
by the firm’s P/E ratio. See discussions in textbook for more detail (you should
explain those in the exam - a reference to the textbook is not sufficient).
b) Explain three forces that can make equity cheaper than debt for corporate
Reduced likelihood of financial distress with associated deadweight costs,
Less personal income taxes
Less bond holder expropriation.
See discussions in textbook for more detail (you should explain those in the exam - a
reference to the textbook is not sufficient).
Question Type 3: Longer questions
A firm has expected free cash flow for the coming year of $15 million. There are no
taxes. The risk-free rate is 4%, the firm’s unlevered (asset) beta is 1 and the market
risk premium is 6%. Its free cash flows are expected to grow forever at 5%. [You can
use the CAPM to calculate the expected return: r = r_f + beta * market risk premium.]
a) A firm has excess cash of $100 million and zero debt and considers using
this to fund an additional investment project which will either have a
payoff in one year of $200 million with probability 0.75 or $50 million
with probability 0.25. What is the NPV of the investment? What is the
total present value of the firm if it undertakes the investment? Assume the
cost of capital of the new project is the same as that of assets in place.
Answer: If the cost of capital of the new project is the same as that of the asset in
place, the expected payoff of the new project is 0.75*200 + 0.25*50 = 162.5 with a
present value of 162.5/1.1 = 147.7 and an NPV of 47.7. (The cost of capital is
0.04+0.06 = 0.1). The assets in place are worth 15/(0.1-0.05) = 300. So the firm is
worth 347.7.
b) The firm undertakes the investment in part (a) and also issues debt
(perpetuity) with a face value of $400 million and uses the proceeds to pay
a dividend to its shareholders maturing at the same date as the project
payoff is realized. If the beta of the debt is 0.2, what is the maximum
dividend it can pay? Explain. (Assume for this and later parts that its
assets in place can be sold for their present value.)
Answer: Cost of debt is 0.04+0.2*0.06 = 0.052. In the good state, the firm has a total
value in one year of 300 + 200 = 500 so the debt will be repaid in full. In the bad state
the firm’s realizable value is 300+50 so the debt will default. The expected payoff on
the debt is therefore 0.75*400 + 0.25*350 = 312.5. The present value of this expected
payoff is 312.5/1.052 = $297.05 million, so this will be the proceeds of the risky debt
issue and the maximum dividend the firm can pay out.
YTM is defined by 297.05 = 400/(1+YTM) so YTM = 34.66% - a huge spread.
c) Continuing from part (b), what is the cost of equity of the levered firm?
What is the value of its equity? Again state any assumptions you need to
Answer: Working backwards – this a M-M world with risky debt, because total firm
payoffs are unaffected by the debt and there is no asymmetric information. Therefore
E = Value of unlevered firm – Value of debt = 347.7 – 297.05 = 50.65. Thus Re = 0.1
+ (0.1 – 0.052)*(297.05/50.65) = 0.1 + 5.87*0.048 = 38.15%.
d) Continuing from parts (b) and (c), assume the firm can instead use $50
million from proceeds of its debt to invest in a second project, with a
payoff of 60 in the state in which the first investment pays off $200 million
and a payoff of $50 million in the state in which the first investment pays
off $50 million. (Again assume the cost of capital of the additional project
is the same as that of assets in place.) What is the NPV of this second
project? Will the shareholders pursue it, or instead choose to include the
$50 million in the dividend? Explain.
Answer: The expected payoff of the project is: (0.75*60+0.25*50) = 57.5. At the
unlevered cost of capital this project has moderately positive NPV of 2.27 so is worth
undertaking. If firm pays full dividend, shareholders get an additional $50 on top of a
dividend they receive in any eventuality of $247.05 for sure plus $100 = 500-400 in
the good state or zero = max(0,350-400)=0 in the bad state next period. If they
undertake the second investment they forego the additional $50 plus 100 + 60 in the
good state versus max(0, 350+50-400)=0 in the bad state. Thus they compare
PV(0.75*100=75) + 50 = 75/1.1946 + 50 = 112.78 (full dividend) versus
PV(0.75*(100+60)=120). If the second investment is pursued, the debt becomes riskfree and so the cost of equity will fall, but obviously not back to 10% (the firm is still
leveraged so equity beta is above 1) so it is sufficient to show that 120/1.1 = 109 to
see that the second investment will not be pursued – the shareholders will pay out the
full dividend of $297.05 million instead. This is an example of debt overhang – the
bulk of the benefit of the additional investment accrues to the creditors by making
them better off in the bad state where the firm otherwise defaults. Shareholders do not
benefit sufficiently to choose to invest.
Question Type 4: Interpretation of Figure/Table
The table shows announcement returns of different types of deals to bidding
shareholders. All-stock deal means that the bidder uses its stocks to pay for the target,
while an all-cash deals means that the target shareholders are paid with cash only.
Discuss differences of all-stock and all-cash deals. What theories might explain
those differences? Explain the main arguments.
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CARs to stock bidders are smaller
o Public targets -2.2% vs. -0.3%  1.9% smaller
o Private targets 0.1% vs 0.26%  0.16% smaller
Potential explanations: asymmetric information
[Potential reasons for smaller returns in absolute numbers of private targets: their
In a world of market imperfections, markets may only be semi-strong efficient, and
insiders (CEOs) may possess more information about the firm than the public
o For instance, they may know whether the current stock price of the firm is
o If the firm is overvalued, firms have incentives to use stock “as a currency”
to pay for the stock of the targets
o Markets will interpret this (at least partially) as negative information about
the firm and the stock price will fall
o This is directly linked to the discussion of general equity issues and the
pecking order theory