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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.
RESTRICTED OPEN BOOK-YOU MAY USE:
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.
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
10. PV of firm = [8]+[9]
Your answer in [10]
should be the same as
your answer in [3]
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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.
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Page 12The End-term examination ends here
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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.
RESTRICTED OPEN BOOK-YOU MAY USE:
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
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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
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
Calculate the payoff **assuming that new shareholders use expected values and do not infer from the act ofequity issue
Do nothing Issue equity and invest
Good news
Bad news**
Recompute the payoff ** above assuming that new shareholders infer from the act of equity issue.
Do nothing Issue equity and invest
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
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 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.
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
10. PV of firm = [8]+[9]
Your answer in [10]
should be the same as
your answer in [3]
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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?
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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
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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]=
Present Value Year1 Year1
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]=
Present Value Year1 Year1
Lease Payment (after-tax)
Depreciation tax shield
V0
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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
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 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.
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
10. PV of firm = [8]+[9]
Your answer in [10]
should be the same as
your answer in [3]
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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.
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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
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The Very End of ACF
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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.
No clarifications will be provided. State and justify any assumption you feel
absolutely necessary.
MaxMarks
MarksObtained
A1 12
A2 16
A3 16
A4 16
A5 16
A6 12
Part B 50
Total 138
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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
Liquid assets 0 0 0 0
Assets in place 150 50 280 190
NPV of new investment 0 0 20 10
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
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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
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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.
ITEM ANSWER CALCULATION
1. WACC
2. Cost of levered equity
Year 0 Year 1 Year 2
3. Firm value using
WACC XXXXXXX
USING Flow-to-Equity
4. Debt value XXXXXXX
5. Cash flow to equity XXXXXXX
6. Equity value at Year
0 using FTE
USING APV
7. Tax-shield
XXXXXXX
8. PV of tax shield:
Year 0
9. Base case PV:Year 0
10. Firm value using
APV
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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
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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?
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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
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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.
No clarifications will be provided. State and justify any assumption you feel
absolutely necessary.
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.
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