Paper 1

Question 1

M&M no tax

Answer 1

M&M1 no tax- value of firm is independent to the debt it has.

M&M2 no tax- firms cost of equity capital is a positive linear function of the firms capital structure

Question 2

M&M with tax

Answer 2

M&M1 with tax- the more debt a firm acquires, the more value it has. Happens due to interest from debt is tax deductible. Firms WACC decreases as firm relies heavily on debt financing.

M&M2 with tax- firms cost of equity rises as the firm relies heavily on debt financing.

Question 3

IPO underpricing and Reasons

Answer 3

Underwriters value the IPO less than its market value. Gives opportunity cost for shareholders and benefits shareholders

Reasons:
-stop ‘winners curse’
-‘insurance for underwriters’
-reward investors truthfully willing to pay

Question 4

3 types of underwriters

Answer 4

Firm commitment underwriting- underwriters buy all shares and take responsibility for unsold shares

Best efforts underwriting- underwriters sell shares, but can return unsold shares

Dutch auction underwriting- auction shares and sell to the highest bidder

Question 5

Underwriters (periods)

Answer 5

After market- period after issue is sold to public. During period we don’t sell securities for less than offering price (1month)

Green shoe provision- option to buy additional shares at offering price (1month)

Lock-up agreement- how long insiders wait after an IPO before selling equity (6months)

Quiet period- before IPO, limit communications with public

Question 6

Static theory and graphs. Pecking order theory

Answer 6

Static theory- firm borrow to the point where the tax benefit from an extra £1 is equal to the cost that comes from increased probability of financial distress.

1st graph- gain from tax shield is offset by financial distress
2nd graph- WACC initially falls due to the tax advantage of debt. Rises again after *D/E due to financial distress cost.

Pecking order theory- same def as static theory
Hierarchy or financing:
-Internal
-Debt
-Equity

Question 7

Security Market Line (SML)

Answer 7

Positively sloped straight line, showing relationship between expected return and beta.

Question 8

Capital asset pricing model (CAPM)

Answer 8

Shows expected return on asset depends on 3 things;
-Pure TVM
-Reward for bearing systematic risk
-Amount of systematic risk

Question 9

Operating leverage

Answer 9

How much a firm relies on fixed cost.
The higher the DOL the more danger it’s in of forecasting risk.