End Term Acf

8/8/2019 End Term Acf

1/42

RETURN THIS ENTIRE BOOKLET

ADVANCED

CORPORATE

FINANCE

PGP

2002-04

End-Term Weight

46%

Total Duration

2 Hours 30 minutes

NAME

ROLL NO.

RESTRICTED OPEN BOOK-YOU MAY USE:

1.Principles of Corporate Finance Brealey & Myers

+ACF Issued Articles Session 9 onwards

Answer questions 1-5 in the spaces provided. Answer 6 and 7 in the separate answer booklet

provided.

THIS BOOKLET HAS 12 PAGES

QUESTION MAX

MARKS

MARKS

OBTAINED

1 16

2 20

3 10

4 08

5 12

6 14

7 20

TOTAL 100

Page 1


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1. PERCs

A firm currently has 100 million shares outstanding trading at Rs. 10. The firm plans to issue 10 million

PERCS at this price. Each PERC has to be converted to one equity share at the end of 3 years. However,the value of share issued per PERC should not exceed Rs. X. Each PERC will carry an annual dividend of

Rs. 1.00 at the end of each year. The ordinary share of this firm is expected to pay an annual dividend ofRs.0.50 per share. The rate commensurate with the risk of the dividend stream is 10% per annum. The

standard deviation of stock prices is 30% and the risk-free rate is 8%. Ramaswamy sweated for six hours

and tells you that X is Rs. 13.00. Is he reasonably correct?

HintHe sweated because he was wearing a suit in a Kolkatta summer with a power-cut, he took 6 hours

because of being Ramaswamy. Therefore, do this problem briskly.


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Page 3

2. Still at Question Number 2, the Revenge of the Two-Year Project-In which we use WACC

(ADR), FTE and APV in that orderA new firm proposes to invest in a two-year project requiring an initial investment of 1000 in time `0'. The

project generates annual cash flows of 700 in Year 1 and 715.44 in Year 2. This is the appropriate cashflow to use for capital investment decisions; when WACC [weighted average cost of capital] is used for

discounting. The initial investment is financed, in part, by debt carrying a risk-free interest rate of 10% per

annum. The debt level will be 50% of the market value of the firm. Debt will be repaid/raised in Year 1 so

as to preserve the debt-equity ratio. The balance is financed by equity. The appropriate return on all-equity

financed assets is 20%. The corporate tax rate is 30%. There are no personal taxes. Fill up the following

table. Assume Miles-Ezzel assumptions are valid.

ITEM ANSWER CALCULATION

1. WACC

2. Cost of equity

Year 0 Year 1 Year 2

3. Firm value using

WACC XXXXXXX

4. Debt value XXXXXXX

5. Cash flow to equity XXXXXXX

6. Equity value at Year

0 using FTE

Your answer in [6]

should be 50% of your

answer in [3] for Year 0

USING APV

7. Tax-shield

XXXXXXX

8. PV of tax shield:Year 0

9. Base case PV:

Year 0


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10. PV of firm = [8]+[9]

Your answer in [10]

should be the same as

your answer in [3]

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3. VirusWare, called itself a growing firm. This was strictly true in an algebraic sense. Faced with

increasing customer resistance to its anti-virus products, it decide to give up on software and get back to its

original activity, leasing. This was made easy by the fact that as of 1st April 2003, the firm was left with

zero debt and no assets (not even unutilized tax shield) except a cash balance of Rs10 lakhs. The market

value of the equity was Rs10 lakhs. The new firm to be renamed Leaseavatar is expected to deploy Rs 100lakhs as leased assets. A new business opportunity became available in the telecom sector. This followed

from the TRAI ruling that a WLL user had the same rights as a landline user, and could move his phoneanywhere provided it was not further from the base-point than a landline with a cord of 3 metres. The

Government of India therefore announced that a subsidy would be provided to lessors in this business.

Leaseavatar would raise debt at 10% to meet its financing requirements. Leaseavatar has a tax rate of 40%.

Assets leased out are expected to have a life of one year. Lessees are expected to have a of 1, able to

borrow at 10% and in the zero tax bracket (ZTB). For several years Leaseavatar was a member of the ZTB

club and had assiduously built relationships with other ZTB firms. The lease rental (expressed as annual

rental in paise for Rs 1 worth of assets leased) would be so set that the lessees would just break even. Whatsubsidy per rupee of asset leased should Leaseavatar seek from GOI? Ignore any other operating cost.

USE FOUR DECIMAL PLACES

LESSEE PERSPECTIVE

V0 = 1- H

t (Pt [1-T] + bt T)/(1+r[1-T])t

H: Period of leaseT: Corporate tax rate

r: Borrowing rate

V0: Value of lease at t=0 **Pt :Lease payment in t **

bt :depreciation in t **

**per dollar of asset leasedLESSOR PERSPECTIVE

V0 = -1+ H

t (Pt [1-T] + bt T)/(1+r[1- T])t

: Debt per dollar of assets leased

Calculation

Answer

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4. Euphoria Ltd strongly believes it is undervalued by 25%, and is of the firm opinion that a share

repurchase offer set at a price reflecting this will result in share prices going up; the market may not fully

recognize a 25% undervaluation, but a price correction will indeed take place that will provide an return of

20% to shareholders. Euphoria is currently traded at Rs80 (this is convenient for those whose calculator

batteries have given up life). It is expected the market price after the announcement will settle at Rs95.What fraction of shares would have been repurchased?

Calculation

Answer

5. Ramaswamy was extremely pleased when his firm finally issued stock options to employees. His firm

had no debt (Ramaswamy handled negotiations with banks and financial institutions), paid no dividends.The share price was currently Rs10 with a volatility of 20%. These stock options could be exercised after

one year at Rs11. Each stock option was eligible to be converted into one share, and one stock options

would be issued for every 100 shares. The risk-free rate was 5%. Ramaswamy could either take 500 stock

options today or the companys whitish grey sweat-shirt worth Rs375 today. Which should he take? You

need to show computations. BUT YOU CAN MAKE SIMPLIFYING ASSUMPTIONS IF YOU BELIEVE

THAT THESE WILL NOT ALTER THE DECISION. Ignore any utilty/disutility from the sweat shirt;

assume that there is an active sweat shirt market that will provide a price of Rs375.

Calculation

Answer


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Page 9

ANSWER QUESTIONS 6 AND 7 ON THE SEPARATE SHEETS PROVIDED

6.1At least some executive compensation plans look like carrots to start with until realization dawns and

the beneficiary realizes that these are sticks. One of the consequences of an EVA (economic-value added)based performance regime is that an executive can be rewarded by a Leveraged Stock Option (LSO). This

works roughly as follows:

Suppose you are employed by a firm whose current stock price is Rs10, is all equity-financed with a cost ofcapital of 10%, and pays no dividend. An initial exercise price is set at, say, a 10% discount, that is Rs9.

You are, therefore, required to purchase the LSO for Rs1. Five years down the road the exercise price is set

at the initial price adjusted upward for the cost of capital. With annual compounding the exercise price is

around Rs16. Essentially, as a manager you have paid Rs1 today for an option to buy the share at roughly

Rs16, five years from now. I know you are itching to value this LSO, dont bother. Instead write briefly

on the LSO as an incentive. Also how does the LSO differ from an LBO in which managers pick up 10% of

equity with 90% debt-financing.

EVA (I am sure you know this) is crudely annual operating surplus less a capital charge

(equal to cost of capital*total funds). Thus a firm that exactly earns a return equal to its cost of capital has a

zero EVA.

RESTRICT YOUR ANSWER TO ABOUT 300 WORDS

6.2 You are the Chairman of a high-tech firm with seemingly endless growth opportunities. In the AGMwhere everybody is smiling (the food is great, revenues have been excellent, profits have been excellent) a

shareholder makes the following statement: Mr Chairman, the samosas are excellent, your operations are

good, but I think your financial management is poor. Why do you have Rs400 crores of idle investments in

government securities/short-term bank deposits and simultaneously pay higher interest on Rs250 crores of

long-term loans? Why dont you refund the loans and pay us the balance as dividend?

RESTRICT YOUR ANSWER TO ABOUT 300 WORDS. RULES OF THE GAME. YOU CANNOT USEPHRASES LIKE ADVERSE SELECTION/INFORMATION ASYMMETRY /CAPM

/GLOBALIZATION/ SYNERGY.

7. A banker according to a poet is like everybody else except that he is richer. Christopher James and Peggy

Wier have possibly a different view point. Empirical evidence on commercial bank loan announcements

(as well as other financial events) is in Page 11/12. Table 3 contains descriptive statistics of various types

of borrowing arrangements, and Table 4 the impact on common stock prices of the announcement of

various types of borrowing arrangements. Table 5 provides stock price reactions to the stated purpose of the

borrowing. Commercial borrowing is very important, accounting for close to half the total new borrowing.

Tables 1 and 2 have not been provided.

Write a note on the implications of these tables for managers.

RESTRICT YOUR ANSWER TO ABOUT 800 WORDS

Page 10


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RETURN THIS ENTIRE BOOKLET

ADVANCED

CORPORATE

FINANCE

PGP

2003-05

End-Term Weight

46%

Duration

2 Hours 30 minutes

NAME

ROLL NO.


1.Principles of Corporate Finance Brealey & Myers

+ACF Issued Articles

Answer questions 1-6 in the spaces provided. Answer 7 and 8 in the separate answer booklet

provided.

THIS BOOKLET HAS 14 PAGES

QUESTION MAX

MARKS

MARKS

OBTAINED

1 12

2 12

3 8

4 12

5 9

6 13

7 17

8 17

TOTAL 100

Page 1


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2. Warrants

FirmA has 10 million warrants outstanding. Currently the firm has 100 million shares outstanding trading

at Rs. 10. Each warrant is convertible to one share two years from today at an exercise price of Rs. 12.Shares and warrants are the only financial claims that the firm has. Equity (I mean equity not share) has a

volatility of 31.24%. The current value of equity is estimatedto be Rs.1017.54 million. The share pays nodividends.The risk-free rate is 10%, and the standard deviation of shares is 30%.

a) What is the value of a warrant based on the valuation of a call, using Black-Scholes?

b) Is this value consistent with the estimated value of equity?

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3. Fill the payoff-at-maturity table below for a SWORD; show calculations. Assume the following:

Va = 1000 (PV Assets-in-place) N=100 (existing shares) M=10 (New shares issued)

E = 80 (Warrant exercise price) PO=100 (Purchase option price) R=120 (PV Royalty payments)

Vg = 250 (Growth option)

SWORD-WARRANTNOT EXERCISED SWORD-WARRANTEXERCISED

1. Parent stock price

2. Wealth: Old

Shareholders

3. Wealth:

New/SWORD Holders

4. Total Wealth

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4. A firm currently has ten million common shares outstanding, trading at Rs. 10. The firm plans to issue

one million PERCS at Rs. 10 each. Each PERC will be converted to one equity share at the end of 2 years

with a cap set at Rs. 15. The ordinary share of the firm is expected to pay an annual dividend of Rs. 1.00

per share. The rate commensurate with the risk of the dividend stream is 8% per annum. The volatility of

equity is 30%. The risk-free rate is 6%. Find the annual dividend in rupees to two-decimal places that eachPERC will pay at the end of the first and second year. An approximation is expected. But do not take the

word approximation too seriously.

Answer

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5a FirmA has a market value per share of Rs.100 and a book value per share of Rs. 2. FirmB has a market

value per share of Rs. 10,000 and a book value per share of Rs.10,000. Which firm is likely to have a

higher leverage ratio.

[Leverage ratio is defined as Book value of Debt/(Book value of Debt+Market value of Equity)].

EXPLAIN

5b FirmC had earnings per share of Rs.10 (excluding extraordinary items) in the year recently concluded.

Next year if the number of shares outstanding is the same and earnings per share is Rs. 5 (excludingextraordinary items), what can you conclude about the quality of the firm. EXPLAIN

5c FirmD has debt with an average maturity of one year. Its leverage ratio is 0.1[as defined in 5a]. It is not

in a regulated industry. Would you expect FirmD debt to have a low proportion of higher priority fixed

claims and a high proportion of junior fixed claims. EXPLAIN.

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6. A new firm proposes to invest in a two-year project requiring an initial investment of 1000 in time `0'.

The project generates annual cash flows of 700 in Year 1 and 715.44 in Year 2. This is the appropriate

cash flow to use for capital investment decisions; when WACC [weighted average cost of capital] is used

for discounting. The initial investment is financed, in part, by debt carrying a risk-free interest rate of 10%

per annum. The debt level will be 50% of the market value of the firm. Debt will be repaid/raised in Year 1so as to preserve the debt-equity ratio. The balance is financed by equity. The appropriate return on all-

equity financed assets is 20%. The corporate tax rate is 30%. There are no personal taxes. Fill up thefollowing table. Assume Miles-Ezzel assumptions are valid.


1. WACC

2. Cost of equity


3. Firm value using

WACC XXXXXXX




0 using FTE

Your answer in [6]



USING APV

7. Tax-shield

XXXXXXX

8. PV of tax shield:

Year 0

9. Base case PV:

Year 0

10. PV of firm = [8]+[9]

Your answer in [10]


your answer in [3]

Page 13


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PLEASE ANSWER 7 AND 8 SEPARATELY IN THE ANSWER SHEETS PROVIDED. Two pages

should be the limit for each.

These answers will be assigned letter-grades as follows: 17=A, 14=B+, 11=B-, 8=C, 4=D, 0=U

7 Write an essay on how a firm should choose the appropriate mix of debt and equity.

8. ZIIT is in the IT training business. Fixed assets are kept low through a strategy of renting rather thanbuying. ZIIT views itself as a high growth company, in the last three years revenue growth has been 40%

on an annual basis. Shares are currently traded at Rs. 98. Next year earnings are projected at Rs. 15 per

share. The beta is 1.3. The market rate of return is 13% and the risk-free rate is 6%. The CEO believes that

ZIIT is not appreciated on Dalal Street, you know these guys simply do not know anything about this

business-we are the fastest growing trainer in China, and they cannot make up their mind about our share

prices, last year our shares had a volatility of 65%. ZIIT needs to raise an amount roughly equal to 30% ofthe market value of current equity . This will be used to pay for lease deposits for office space in China,

hardware, software, training of trainers, and business promotion. Currently ZIIT has less than 10% debt in

its capital structure. Decide on what form of security you will issue and the issue process.


16/42

Page 12The End-term examination ends here


17/42

The examination has two parts. This is Part A. Part B will be distributed after 45 minutes. Both parts

should be returned in 2 hours 30 minutes

ADVANCED

CORPORATE

FINANCE

PGP

2004-06

End-Term Weight

46%

Total Duration

2 Hours 30 minutes

NAME

ROLL NO.


1.Principles of Corporate Finance Berkley & Myers

+ACF Issued Articles Session 9 onwards

Part A has 8 PAGES

QUESTION MAX

MARKS

MARKS

OBTAINED

A1 10

A2 10

A3 15

A4 15

Total Part A 50

Total Part B 50

TOTAL 100

Page 1


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A1

The manager of a firm works in the interest of old (existing shareholders). The firm is considering investing

in a new project with an initial investment of 100 in assets that can provide payoffs as shown below. The

existing shareholder and any new stakeholders know all the information given below. However, states

Good and Bad can occur with a 50%probability each. Only the manager knows which state will occur.Others know that he knows. FILL THE BLANK CELLS IN THE TABLES BELOW

PART A:THE FIRM RAISES RISK-FREE DEBT OF 100 TO UNDERTAKE THE INVESTMENT

Do nothing Issue debt and invest

Good Bad Good Bad

Liquid assets 50 50 50 50

Assets in place 200 80 300 180

NPV of new investment 0 0 20 12

Value of firm 250 130 370 242

Payoff to old shareholders

Do nothing Issue debt and invest

Good news

Bad news

With risk-free debt will the firm accept all positive NPV projects?

PART B: THE FIRM RAISES NEW EQUITY OF 100 TO UNDERTAKE THE INVESTMENT

Do nothing Issue equity and invest

Good Bad Good Bad




Value of firm 250 130 370 242

Payoff to old shareholders

Calculate the payoff **assuming that new shareholders use expected values and do not infer from the act ofequity issue


Good news

Bad news**

Recompute the payoff ** above assuming that new shareholders infer from the act of equity issue.


Good news

Bad news

What is the implication for new equity issue?

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A2 Ramaswamy is contemplating joining a software company, with only equity in its capital structure, as

CEO. The firm has 1 million equity shares outstanding each with a market price S of Rs 10. The shares

have a volatility S of 50% and a beta of 2. The risk-free rate is 6% and the expected return on the market

is 13%. Ramaswamy was offered a choice, either a consolidated straight salary of Rs 5 lakhs for the nextthree years paid immediately OR an immediate title to 300,000 warrants (each with an option to acquire

one share of the firm) with a maturity of 3 years (these are European warrants) and an exercise price equal

to current stock price*(1+cost of equity

) 3

. With the warrant issue, the value of the firm per share, P, is Rs10.65 and appropriate standard deviation of the firm , P , is 53.84%. The firm does not expect to pay any

dividend in the next three years. Which compensation structure should Ramaswamy choose?

Show that the value of the firm per share is consistent with your warrant value

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A3 DECS

A firm currently has ten million common shares outstanding, trading at Rs. 16. The firm plans to issue one

million DECS at Rs. 16 each. Each DEC will be mandatorily converted to one equity share at the end of 2

years. The exchange rate would be one share if the maturity price of the share was less than or equal to Rs.

16. For a maturity price between Rs. 16 and Rs. 24 the exchange rate was so set that the exchange valuewould be Rs. 16. Beyond Rs. 24, the exchange rate was set at 2/3 of a common share per DEC. Each DEC

will carry an annual dividend of Rs. 3 at the end of the first and second year. The ordinary share of the firmis expected to pay an annual dividend of Rs 2 in the next two years. The rate commensurate with the risk of

the dividend stream is 10% per annum. The risk-free rate is 8%, and the volatility of the firms common

stocks is 40%.

Is the DECS correctly priced?

ITEM VALUE

PV convertible dividend

PV common dividend

Stock Price

Call (X1)

5a*Call (X2)

Value of DECS

Is it correctly priced?

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A4 A new firm proposes to invest in a two-year project requiring an initial investment of 1000 in time `0'.

The project generates annual cash flows of 824.30 in Year 1 and 712.14 in Year 2. This is the appropriate


for discounting. The initial investment is financed, in part, by debt carrying a risk-free interest rate of 10%

per annum. The debt level will be 40% of the market value of the firm. Debt will be repaid/raised in Year 1so as to preserve the debt-equity ratio. The balance is financed by equity. The appropriate return on all-

equity financed assets is 20%. The corporate tax rate is 30%. There are no personal taxes. Fill up thefollowing table. Assume Miles-Ezzel assumptions are valid.


1. WACC

2. Cost of equity


3. Firm value using

WACC XXXXXXX




0 using FTE

Your answer in [6]



USING APV

7. Tax-shield

XXXXXXX


Year 0

9. Base case PV:

Year 0

10. PV of firm = [8]+[9]

Your answer in [10]


your answer in [3]

Page 8


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The examination has two parts. This is Part B. Both parts should be returned in 2 hours 30 minutes

ADVANCED

CORPORATE

FINANCE

PGP

2004-06

End-Term Weight

46%

Total Duration

2 Hours 30 minutes

NAME

ROLL NO.

RESTRICTED OPEN BOOK

Part B has 4 PAGES plus ADDITIONAL sheets for writing

QUESTION MAX

MARKS

MARKS

OBTAINED

B1 15

B2 15

B3 20

Part B 50

B1 Share buyback [based on McNally]

The focus of this question is on share buybacks where some shareholders agree not to tender. This may

include insiders. The assumption is that the act of share buyback leads to a revision of the expected future

cash flow of the firm and an increase in valuation. This revision can be credibly signaled by announcing the

buyback. Non-tendering shareholders effectively transfer wealth to tendering shareholders in that they

would be better-off if the information could be revealed in another fashion. However, if share buyback isthe optimal credible signal, than in a way non-tendering shareholders effectively gain through share

repurchase.

A firm with N0=100 shares outstanding has five shareholders, each owning 20 shares. Four of these are

outsiders and one is an insider who exercises effective control (by force of character rather than majority-

see McNally). The insider thus owns a fraction =20%. Currently the firm owns 500 cash and the market

expects future after tax cash flows to be a level 25 annually. The appropriate discount rate is 5%.

What is the current market price per share PO?

The firm offers to buyback a fraction =20% of its shares at a Tender Price PTE of 15. However, theinsider will not participate in the buyback. Each outsider agrees to offer 5 shares under the buyback. As a

result of the buyback announcement, the market revises the level perpetual cash flow to 38 annually. Hint:

In computing the value of the firm after the buyback ensure you have taken care of the amount paid

towards repurchase.

What is the market value per share after the buyback PE?

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The full-information price is defined as the price that would have prevailed prior to repurchase if the new

information about the firms future earnings had been known.

Compute the full-information price per share PFI.

Now compute the Full-Information Premium: fullprm=(PT - PFI)/PO

Compute the returns to the non-tendering shareholder. This is the return based on initial and final wealth of

the non-tendering shareholder at market price.

Compute the returns to the tendering shareholders. This is the return based on initial and final wealth of thetendering shareholders at market price.

Compute the wealth transfer from non-tendering to tendering shareholders. This is the wealth based on

initial wealth of non-tendering share holders if full information was reflected in the initial market price and

final wealth of the non-tendering shareholders at market price.

Check that wealth transfer from non-tendering to tendering shareholders is

Initial Firm Value*fullprm* /(1- )

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B2 A firm intends to use a SWORD to finance development of a new molecule. The outcome will be

known a year from today.

Va = 1000 (PV Assets-in-place) N=100 (existing shares) M=10 (New shares issued)

PO=200 (Purchase option price) R=300 (PV Royalty payments)

Vg = EITHER 0 OR 400 (Growth option)

E= EITHER 50 OR 100 (Warrant exercise price)

Compute wealth of new shareholders from Va and Vg

Traditional Capital

Budgeting

SWORD-WARRANT

NOT EXERCISED

SWORD-WARRANT

EXERCISED

Vg = 0, E=50

Wealth NEW

Shareholders

Vg = 0, E=100

Wealth NEW

Shareholders

Vg = 400, E=50

Wealth NEW

Shareholders

Vg = 400, E=100

Wealth NEW

Shareholders

Write a brief note on which warrant price (50 OR 100) you would recommend.

WRITE IN THE ADDITIONAL SHEETS PROVIDED

B3 You have just joined a not-to-well known Indian conglomerate with global operations. In your position

as assistant to the assistant to the assistant to the CFO you discover that this conglomerate is much larger

than you imagined and is in dozens of businesses: cement, steel, power and water utilities, software, bio-

tech etc. Typically each business is incorporated in a separate legal entity-many of these are listed. Allbusinesses have one common financing principle, enunciated by the late founder, THE DEBT-EQUITY

RATIO SHALL BE ONE. In the last decade this has been perceived to be dysfunctional. You have been

asked to prepare a memo on how debt levels should be chosen for each business. Now just write this memo.

WRITE IN THE ADDITIONAL SHEETS PROVIDED

Page 4

THE VERY END


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ADVANCED

CORPORATE

FINANCE

PGP

2005-2007

End-term

Part A

Weight

46%

Total Duration

2 hours and 30 minutes

SUBMIT PARTA BY 10.30

NAME

ROLL NO.

Part Issue Time Submission Time Marks

A 9.00 10.30 40

B 10.00 11.30 60

No clarifications will be provided.

Restricted open-book. Bring Brealey and Myers, all material issued by the PGP Office for ACF as

advised in my e-mail.

This part has 4 pages. Answer in the separate answer sheet provided.

TRY AND FIT YOUR ANSWER FOR EACH QUESTION ON TWO SIDES

A1: YOU HAVE TO ANSWER THIS: Farepak [see attached news item]

What are the corporate governance issues that emerge from the attached news item on Farepak? What are

the mechanisms/processes that can address these issues?

A2: ANSWERANY ONE OF THE FOLLOWING (A2.1 or A2.2):

EITHER

A2.1 You are advising the CEO of a conglomerate in a range of businesses from boring old-fashioned

power generation to exotic technologies. Each business is set up as a separate listed company. While many

of these are widely held, in a few cases ownership is held by a few large investors. The CEO is convinced

that a couple of the conglomerate firms are seriously undervalued by the market. Write a note on payoutpolicy (covering dividend/share buyback) that the CEO should advise various companies of the

conglomerate to follow.

OR

A2.2 When would you use optional convertibles, and when would you use mandatory convertibles?

Page 1


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ADVANCED

CORPORATE

FINANCE

PGP

2005-2007

End-term

Part B

Weight

46%

Total Duration

2 hour and 30 minutes

SUBMIT PART B BY 11.30

NAME

ROLL NO.

Restricted open-book. Bring Brealey and Myers, all material issued by the PGP Office for ACF as

advised in my e-mail.

The end-term examination has 14 pages.

Answer in the spaces provided. No extra sheets will be provided.

No clarifications will be provided. State and justify any assumption you feel

absolutely necessary.

Max

Marks

Marks

ObtainedB1 12

B2 10

B3 10

B4 4

B5 12

B6 4

B7 8

Part A 40

Total 100

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B1 SWORD

A biotech firm wishes to issue a SWORD, as follows:

Existing shares N=100

Potential new shares (if warrant exercised) M=10Value of assets-in-place Va=1000

Value of growth options Vg=500

The issuer is wondering to indicate a call value (Purchase Option PO value) of 350 OR 100; and a warrant

exercise price E of 200 OR100. Discuss this choice. First fill up share the share price of the parent firm.

No-Warrant Yes-Warrant No-Warrant Yes-Warrant

PO=350 PO=100

Share Price of

Parent

E=200

Share Price ofParent

E=100

Discussion

Page 3


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B2 The Dutch retailer AHOLD is just recovering from creative accounting. Its share is trading at 8,

well below its past prices, and in the view of management, is significantly undervalued. An investment

banker has advised AHOLD to issue PERCS, designed as follows.

Each PERC will be issued at 8, and will be compulsorily converted into a common share of AHOLD in 2years, with the value of the common share per PERCS not to exceed 10. During this period the PERC

holder will be paid annual dividends of 0.97. One PERC will be issued for every 10 common sharesoutstanding. The underlying share has a volatility of 40%, the risk-free rate is 4%. You may assume that

this risk-free rate is appropriate for discounting any dividend stream. AHOLD is expected to pay dividend

on common shares, of 0.50 a year.

Is the PERC correctly priced?

CALCULATION

ANSWER

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B3 SWORD ONCE MORE?

Value the warrant (at issue time) issued by ALZA/BES in Exhibit 1 of the SWORD article. You may

assume that the dilution of parent represented by warrant is the dilution factor used in the Maug article, the

volatility of the parent stock is 50%, and the risk-free rate is 5%. Also assume that the parent has nosecurities other than common stock and warrants, and that the stock is not expected to pay dividends.

In your valuation, work with a volatility of the firm of 51.34%. How good is this value?

CALCULATION

ANSWER

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B4 A firm takes an asset worth Rs.1 on lease for two years. Lease rentals are payable at the end of each

year. The life of the asset for taxation purposes is 2 years. Straight line depreciation at 50% can be claimed

if the asset is owned. With these the value of the lease, to the lessee, is given by:

V0 = 1- H

t=1 (Pt [1-T] + bt T)/(1+r[1-T])t

H: Period of lease

T: Corporate tax rater: Borrowing rate

V0: Value of lease at t=0 **

Pt :Lease payment in t **

bt :depreciation in t **

**per dollar of asset leased

The break-even lease payment is 0.5762 for =1 and T=0, as shown below

With Discount rate = r[1-T]=10%

Present Value Year1 Year1

Lease Payment (after-tax) 1.0 0.5762 0.5762

Depreciation tax shield 0.0 0 0

V0 1-1.0-0.0=0

1. Show that the break-even lease payment is 0.5756 for =1 and T=50%

Discount rate r[1-T]=


Lease Payment (after-tax)

Depreciation tax shield

V0

2. Show that the break-even lease payment is 0.5909 for =0.8 and T=50%

Discount rate r[1-T]=


Lease Payment (after-tax)

Depreciation tax shield

V0

Page 9


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B5 The Pesky Two-Year Cash Flow

A new firm proposes to invest in a two-year project requiring an initial investment of 1000 in time `0'. The

project generates annual cash flows of 645.49 in Years 1 and Year 2, respectively. This is the appropriate


for discounting. The initial investment is financed, in part, by debt carrying a risk-free interest rate of 5%per annum. The debt level will be 50% of the market value of the firm. Debt will be repaid/raised in Year 1

so as to preserve the debt-equity ratio. The balance is financed by equity. The appropriate return on all-equity financed assets is 20%. The corporate tax rate is 40%. There are no personal taxes. Fill up the

following table. Assume that the Miles-Ezzel assumptions are valid.


1. WACC

2. Cost of equity


3. Firm value using

WACC XXXXXXX




0 using FTE

Your answer in [6]



USING APV

7. Tax-shield

XXXXXXX


Year 0

9. Base case PV:

Year 0

10. PV of firm = [8]+[9]

Your answer in [10]


your answer in [3]

Page 11


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B6 A firm expects zero cash flow this year. The firm has equity holders and a single lender. Debt

obligations are as follows:

This Year [Immediate] Next Year

Debt holder 250 1400

a. If the firm does not raise new capital it will default immediately. If the firm liquidates immediately a

value of 1300 will be realized. Immediate and future claims of the debt holder will be first settled, beforesatisfying equity holder claims.Calculate the payoffs on liquidation

This Year [Immediate]

Payoffs

Debt holder

Equity

b. Suppose a venture capitalist agrees to lend 250 immediately against a promised payment of 400 next

year. The venture capitalist is willing to accept a lower priority than the current lender. The VC will be paid

only after satisfying the claim of the existing lender. Equity holders will be paid after satisfying the claim

of the VC. The next year cash flow will be EITHER 2200 (State: Good) OR 400 (State: Bad). The twostates are equi-probable. This cash flow includes operating and terminal values.

Calculate the payoffs as follows

This Year Next Year

State: Good

Next Year

State: Bad

Debt holder

Venture capitalist

Equity

What has the infusion of VC capital done to the original debt holder and equity holders respectively? Youmay assume a zero discount rate.

Page 13


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B7 A stock is expected to sell at Rs 120 next year if no dividend is paid. However, markets expect a

dividend of Rs 10 next year, and the stock is trading at Rs 100 today. There is no tax on dividends at

personal level but firms have to pay a 10% tax on dividends at corporate level. Investors pay no capital

gains tax. What is the expected after-tax rate of return that investors will earn?

CALCULATION

ANSWER

The Government suddenly announces that a capital gains tax of 20% will be reintroduced for

ivestors. The tax on dividends at firm level will be abolished, but investors will have to pay

tax at the personal level, at 30%. What will the price of the stock now be?CALCULATION

ANSWER

Page 14

The Very End of ACF


34/42

DISTRIBUTE PARTA AT START

COLLECT PART A AT 10.45

ADVANCED

CORPORATE

FINANCE

PGP

2006-2008

Term VI

End-term

Part A

Weight

46%

Total Duration

2 hours 30 minutes

PART A 1 hour 45 minutes

NAME

ROLL NO.

Restricted open-book. Bring Brealey and Myers, all material issued by the PGP Office for

Part A has 12 pages.Answer in the spaces provided. No extra sheets will be provided.



MaxMarks

MarksObtained

A1 12

A2 16

A3 16

A4 16

A5 16

A6 12

Part B 50

Total 138

Page 1


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A1 The manager of an all-equity financed firm works in the interest of old (existing shareholders) who are

passive. Discount rates are zero. The firm is considering investing in a new project with an initial

investment of 100 in assets that provide payoffs in Year 1 as shown below, financed by new equity of 100.

At time 0 old shareholders and new stakeholders know all the information given below. However, states

Good and Bad can occur in Year 1 with a 50% probability each. Only the manager knows at time 0 whichstate will occur. New shareholders know that he knows.

Do nothing Issue equity and investGood Bad Good Bad




Value of firm 150 50 300 200

STEP 1: Calculate the expected value of the firm

The expected value of the firm if it does nothing is 0.5*(150+50)=100

YOUR MOVE: The expected value of the firm if it issues equity and invests is

STEP 2: Calculate tentative (assuming that new shareholders use expected values and do not infer from the act of equity issue) payoffs

to old shareholders

MY MOVE: If the firm does nothing the payoff to old shareholders is 150 with good news and 50 with bad

news

YOUR MOVE: If the firm issues and invests the payoff to old shareholders is in the table below.

HINT: New shareholders will be satisfied with a claim of 100/[Expected value o f the firm]

TENTATIVE PAYOFFS TO OLD SHAREHOLDERS

Do nothing Issue equity and

invest

Calculation

Good news 150

Bad news 50

STEP 3: Compute the equilibrium payoffs above assuming that new shareholders infer from the act of equity issue.

EQUILIBRIUM PAYOFFS TO OLD SHAREHOLDERS

Do nothing Issue equity and

invest

Calculation

Good news

Bad news

Page 3


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A2 An investment banker is wondering how to price the IPO of FirmZ. The banker can credibly

communicate to the world that the price of a FirmZ share is either Rs. U with a probability p or Rs. D with

a probability 1-p. If underpriced, uninformed investors will get f% of the allocation. If overpriced,

uninformed investors will be allocated all the shares.

Step 1:Formulate an issue price X that will ensure that uninformed investors break-even.

Formulation

Step 2 Solve for X with following inputs: U Rs 1200, D Rs 800, p 40% and , f 30%

Calculation

Answer

Step 3 Calculate the expected underpricing

Calculation

Page 5


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A3 A new firm proposes to invest in a two-year project requiring an initial investment of 1000 in time `0'.

The project generates annual cash flows of 704.07 in Years 1 and Year 2, respectively. This is the

appropriate cash flow to use for capital investment decisions; when WACC [weighted average cost of

capital] is used for discounting. The initial investment is financed, in part, by debt carrying a risk-free

interest rate of 5% per annum. The debt level will be 40% of the market value of the firm. Debt will berepaid/raised in Year 1 so as to preserve the debt-equity ratio. The balance is financed by equity. The

appropriate return on all-equity financed assets is 12%. The corporate tax rate is 30%. There are nopersonal taxes. Fill up the following table. Assume that the Miles-Ezzel assumptions are valid.


1. WACC

2. Cost of levered equity


3. Firm value using

WACC XXXXXXX

USING Flow-to-Equity




0 using FTE

USING APV

7. Tax-shield

XXXXXXX


Year 0

9. Base case PV:Year 0

10. Firm value using

APV

Page 7


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A4 A firm has issued a zero-coupon convertible bond. The firm has a value of 12,000 and a volatility rate

of 30%. The common stock pays no dividends and there are 400 shares outstanding. The firms convertible

bond has a face value of 4.000, has five years to maturity and may be exchanged into 40 shares of stock.

The risk-free interest rate is 4%.

A4.1 Compute the value of the convertible bond and the share price

Calculation

Answer

A4.2 Compute the expected rate of return and volatility rate of the convertible bond and stock

Calculation

Answer

Page 9


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A5 A firm currently has ten million common shares outstanding, trading at Rs. 14. The firm plans to issue

one million DECS at Rs. 14 each. Each DEC will be mandatorily converted to one equity share at the end

of 2 years. The exchange rate would be one share if the maturity price of the share was less than or equal

to Rs. 14. For a maturity price between Rs. 14 and Rs. 21 the exchange rate was so set that the exchange

value would be Rs. 14. Beyond Rs. 21, the exchange rate was set at 2/3 of a common share per DEC. EachDEC will carry an annual dividend of Rs.1.24 at the end of the first and second year. The ordinary share of

the firm is expected to pay an annual dividend of Rs 1.00 in the next two years. The rate commensuratewith the risk of the dividend stream is 5% per annum. The risk-free rate is 4%, and the volatility of the

firms common stocks is 40%.

Is the DECS correctly priced?

ITEM VALUE

PV convertible dividend

PV common dividend

Stock Price

Call (X1)

a*Call (X2)

Value of DECS

Is it correctly priced?

Page 11


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A6 An investor has purchased a share of an unlisted company for PC. If she sells the share just before it

goes ex-dividend she will get price PB. Capital gains tax tg is payable. If she sells immediately when the

share goes ex-dividend she gets PA and the firm will pay an amount DDT as dividend distribution tax to the

government (as a percentage of the dividend) and a dividend DIV to the shareholder (per share basis).

Step 1 Formulate the relationship between PB and PA as a function of other variables.

Formulation

Step 2 If PC is Rs. 100, and PB is Rs 200, the capital gains tax rate is 20%, the dividend distribution tax

rate is 12%, and the dividend is Rs 20; calculate PA.

Calculation

Answer

Page 12 End of Part A


41/42

DISTRIBUTE PART B AT 10.00 A.M. ALONGWITH ANSWER BOOKLET

COLLECT ANSWER BOOKLET AT 11.30 A.M.

STUDENTS CAN TAKE AWAY THIS QUESTION BOOKLET AT EXAM END

ADVANCED

CORPORATE

FINANCE

PGP

2006-2008

Term VI

End-term

Part B

Weight

46%

Total Duration

2 hours 30 minutes

Restricted open-book. Bring Brealey and Myers, all material issued by the PGP Office for ACF.

Part B has 7 NUMBERED pages.

Answer in the separate answer booklet provided.



It will help if your answers are well-written (no telegraphic/SMS language etc), stick

to the word limit, and reflect conceptual understanding of corporate finance)

B1 You have just been assigned to the convertible bond desk of your employer-an investment banker Your

organizations advice in the past was based initially on fashion (advising clients to issue innovativeproducts), then herding (advising clients to issue what other firms were issuing) and then anti-herding

(advising clients to issue what no one else was issuing then). Empirical evidence is strong that all these

strategies were bad for clients.

You are now expected to produce a well-written two-page (maximum) checklist on client characteristicsappropriate for issue of optional convertible and mandatory convertibles. [25 marks]

B2 The attached exhibits are from two India-centric studies:

a) A study by Franklin Allen, Rajesh Chakrabarti, Sankar De, Jun Qian and Meijun Qian [tables

5, 6 and 7]

b) A study by Ajay Pandey [tables 3, and 4; Figures 1-3]

What do these exhibits tell you about capital structure, financing and dividend policies of Indiancompanies. Limit your answer to 2 pages. [25 marks]

a) In tables 5, 6 and 7 focus on large enterprises [M is Manufacturing, and S is Services].

b) In table 3 and figures 1-3; adjusted log returns are defined in page 2.

Page 1


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Page 2

Documents

End Term Acf