Overall

Question 1

static tradeoff theory

Answer 1

The static tradeoff theory is one of the main capital
structure theories and poses that firms have a target
debt ratio based on the advantages and disadvantages of debt. One advantage of debt is the tax treatment of interest, whereas a disadvantage is the cost of financial distress. The static tradeoff theory could also include agency costs.

Question 2

market timing theory

Answer 2

The market timing theory poses that firms issue financial securities when managers believe that these are overvalued, and repurchase securities when managers believe these are undervalued. A firm’s capital structure could be the result of managers’ historical attempts to time the market

Question 3

What is the main risk that merger arbitrageurs face?

Answer 3

The main risk for merger arbitrageurs is that the merger does not finalize and that the stock price of the target firm drops

Question 4

What signal can convertible call delay provide on the future value of the firm? Please explain

Answer 4

The firm expects high stock prices in the future. More specifically, managers believe that the conversion option will be in-the-money at maturity (i.e. that the firm’s stock price will exceed the conversion price), so there is no need to call

Question 5

How can stock options play a role in providing retention incentives?

Answer 5

Through their vesting periods: The rewards can only be collected after a specified period, and one cannot sell the options

Question 6

How could a market crash affect the role that stock

options play in providing retention incentives?

Answer 6

After a market crash, granted options are not very useful for retention. When the stock price falls far below the exercise price, the options become almost valueless and the executive would be better off by going to a new firm and receiving new options there, as the new options would have the current stock price as the
exercise price.

Question 7

Assume that an executive only gets compensated in the form of a bonus based on annual earnings. Which incentives are created when the executive hits the bonus cap long before the end of the year?

Answer 7

The created incentives are to postpone earnings and to withhold effort, as this year’s bonus is already at its maximum.

Question 8

It is often argued that the presence of large investors might improve corporate governance by reducing the agency problem. Please discuss the relevant agency problem and the link between the agency problem and large investors.

Answer 8

▪ The relevant agency problem here is that managers might have different incentives than shareholders. Although shareholders own
the firm, the managers make most of the decisions. Examples of relevant agency problems include overinvestment, expropriation, and staying too long at the firm.
▪ Having large shareholders could increase the monitoring of the managers. Large shareholders have the incentives to monitor (“to
be informed”) and the power to make demands

Question 9

According to the static tradeoff theory, should profitable firms have higher or lower leverage, all else equal?

Answer 9

The static tradeoff theory predicts that profitable firms have higher leverage, all else equal
▪ 1) Profitable firms pay higher taxes and thus could use the tax shields provided by debt financing
▪ 2) Profitable firms have a lower probability of financial distress and can thus take on more debt financing
▪ 3) Profitable firms are more likely to have high free cash flows and are thus more likely to face overinvestment by managers: the interest payments related to debt financing reduce free cash flows and discipline the manager

Question 10

Assume we are in the Myers-Majluf (1984) world. Explain carefully how the manager’s decision to invest (i.e. issue equity) depends on the slack, assets-in-place, and investment opportunities of the
firm.

Answer 10

Myers and Majluf (1984) show that old shareholders
only favor an equity issue if the increment to firm value (which is based on the equity issue and the investment opportunity) obtained by them exceeds the share of existing assets and slack going to new shareholders
▪ Issue if (E / (P + E)) * (s + a) ≤ (P / (P + E)) * (E + b)

Question 11

Why is slack valuable for current shareholders in the Myers-Majluf world?

Answer 11

Slack is valuable because no external financing is
required with ample slack available, and information
asymmetry becomes irrelevant. With ample slack, all
positive investment opportunities will be taken on

Question 12

What does the empirical evidence on the average stock price performance in the years following an equity issue show?

Answer 12

Underperformance of equity issuers compared to firms that do not issue equity

Question 13

What are the main benefits that Apple will derive from this bond issue? Do you think the huge cash balance for a company like Apple is problematic? Discuss briefly.

Answer 13

The debt issue brings substantial tax advantages.
▪ The additional benefit is that interest payments could reduce overinvestment problems, which could be a problem of having large cash reserves.
▪ Note that for Apple, which might have many investment opportunities, it could be valuable to have cash reserves (for example to finance acquisitions).

Question 14

In a world with no information asymmetry, no costs of a failed call, and no dividends, what would optimal call policy be from the shareholders’ perspective?

Answer 14

▪ Under some assumptions, it is in the best interest of the convertible bondholder to never convert before maturity
▪ The assumptions include no information asymmetry and no dividends
▪ By waiting you leave your options open
▪ In that case, the firm should call as soon as the
conversion value first exceeds the call price
▪ This is because the firm should represent the
shareholders
▪ Calling takes away the option of the convertible
bondholders to wait

The firm should call as soon as the conversion value
first exceeds the call price

Question 15

Discuss four main weaknesses of the design and use of typical executive stock options.

Answer 15

▪ Valuation: Options cost more to the firm than they are worth for the executive
▪ Dividends: Stock options create incentives to not pay dividends
▪ Market crashes and retention: When markets crash and options become far out-of-the-money, there is no retention incentive
▪ Relative performance: The option is not relative to the performance of other firms: when the overall market goes up, the value of the option is likely to go up (and vice versa), beyond the control of the manager

Question 16

Discuss whether it is optimal for a U.S. firm to have a

large board, based on empirical evidence.

Answer 16

Empirical studies typically find a negative relation
between board size and firm value.
▪ Large boards could have more free-riding problems
▪ Large boards could have more coordination problems (slower decision-making)
▪ A large board means paying more directors

Question 17

How can a controlling family use a pyramidal control
structure to benefit itself at the expense of other
shareholders?

Answer 17

Pyramid structures
▪ A way for an investor to control a corporation without owning high percentages of equity
▪ The investor first creates a company in which he has a controlling interest
Tunneling
▪ A conflict of interest that arises when a shareholder who
has a controlling interest in multiple firms moves profits
(and hence dividends) away from companies in which he
or she has few cash flow rights towards firms in which he
or she has more cash flow rights (“up the pyramid”)

Question 18

Briefly explain merger arbitrage when the acquirer pays in stock, and explain why merger arbitrage is typically a profitable strategy.

Answer 18

▪ In a stock offer: Arbitrageurs buy shares of the target, while shorting stock of the acquirer
▪ The profits come from the stock price of the target not increasing enough to fully represent the bid (even after the announcement of the bid you can typically still buy a share of the target at a lower
price than what the acquirer is offering).
▪ Shorting the acquirer’s stock has the purpose of hedging against movements in the stock price of the bidder. For example, if the stock price of the bidder falls, then the bid of the acquirer is worth less than before (which is bad news if you bought shares of the target), but this decrease can be offset by the profits you make on your short position in the bidder (a short position leads to a profit when the stock price falls).

Question 19

the pecking order theory

Answer 19

In the pecking order theory, there is no well-defined optimal debt ratio. Changes in debt ratios are driven by the need for external funds, not by any attempt to reach an optimal capital structure.The attraction of interest tax shields and the threat of financial distress are assumed second-order. Highly profitable firms with limited investment opportunities work down to low debt ratios (!)

Question 20

What determines financing decisions?

Answer 20

1) Debt financing

2) Equity financing

Question 21

Agency costs

Answer 21

1) Asset substitution (risk shifting)
2) Over-investment (empire building) - conflict between shareholder and management

Solutions. Higher interest rate payments reduce free cash flow.

Question 22

Static tradeoff theory predictions:

Answer 22

Firms size (up) -> more debt financing
Fixed assets (up) -> more debt financing
Growth opportunities (up) -> LESS debt financing
Profitability (up) -> more debt financing

Question 23

Information asymmetry

Answer 23

some people (managers) know more than others (shareholders)

Question 24

Debt policy factors

Answer 24

1) Financial flexibility
2) Credit rating
3) Earning and CF volatility
4) Insufficient internal funds
5) Level of interest rate risk
6) Interest tax savings

Question 25

Convertible security

Answer 25

is an investment that can be changed from its initial form into another form

Question 26

Why issue convertibles?

Answer 26

1) most theories build on familiar concepts like information asymmetry, agency costs and the cost of bankruptcy
2) Compared to debt, convertible security can be preferable when there is a potential asset substitution or high uncertainty about risk -> can be issues at lower interest rate than debt due to option to convert.
3) Issues convertibles to get equity through the backdoor.

Question 27

More equity like convertibles, if:

Answer 27

1) low conversion rate - people more likely to convert

2) long maturity - higher chance of getting in the money

Question 28

Convertibles straight debt

Answer 28

1) Firms paying high taxes are expected to issues straight debt convertibles
2) Firms with high FCF are expected to issue straight debt convertibles

Question 29

Convertibles preffered stock

Answer 29

Firms with high profitability of financial distress are expected to issues preffered stock convertible

Question 30

Call feature

Answer 30

it is the firms decision to call (also known as redeem)

Question 31

Optimal call policy

Answer 31

Firm should call as soon as the conversion value first exceeds the call price:

1) firms should represent the shareholder
2) calling takes away the option of convertible bond holder to wait (downside protection)

Question 32

Reasons for call delay

Answer 32

1) Dividend versus coupon -> if firm pays dividends it should not call
2) Costs of a failed call -> bond holders have 30 days to decide
3) Signalling private information -> signalling that managers believe that the value will not fall (call in order to lose downside protection)

Question 33

Convertibles arbitrage hedge

Answer 33

Buy convertibles securities and short the common stock of the issuing firm (delta)

Question 34

Wall crossing

Answer 34

refers to the process of giving investors advance or inside information about a publicly traded company. Investors are wall-crossed and bound to confidentiality so that no trading occurs in an uninformed market.

Question 35

Announcement effect

Answer 35

1) debt no effect
2) equity negative effect
3) convertibles not as negative as equity.

Question 36

Illegal trading before announcement:

Answer 36

Buyer number matters:

1) If there is 1 buyer no short selling is observed
2) If there is 2-10 buyers some short illegal short selling can be observed
3) If there is more than 10 buyers significant amount of short selling can be observed.

Question 37

Reasons for takeover

Answer 37

1) Diversification
2) Managed inefficiently
3) Overinvestment
4) Undervalued target
5) Tax benefits (not allowed reason)
6) Synergies
7) Higher EPS (not useful reason)

Question 38

Synergy

Answer 38

is takeovers in the situation where the value of combined entity exceeds those of the previously separate components.

Question 39

Types of takeovers

Answer 39

Horizontal - takeover of a target company operating in the same line of business as the acquiring company;
Vertical - takeover of a target company that is either a supplier or customer of goods produced by the acquiring company
Conglomerate - takeover of a target company in an unrelated type of business.

Question 40

Why could Abnormal returns be negative for acquire?

Answer 40

1) Not a good merger
2) Shift from bondholder to shareholder that destroys value
3) Could be priced already into price
4) Could overpay for target
5) Experts believe it will not go through.

Question 41

Goals of executive compensation

Answer 41

1) motivate executives to take actions that creates long term shareholder value
2) Attract the right executive at the lowest cost
3) Retain the right executive at the lowest cost

Question 42

How to compensate executive?

Answer 42

1) Base salary
2) Bonusses
3) Stock options
4) Long-term incentive plans