Past paper questions

Question 1

Should we discount the value of debt tax shields at the cost of debt rD or the return on assets rA. What governs this choice?

[2018, 5m]

Answer 1

• This depends on the RISKINESS of the debt tax shields.
• If the debt tax shield is fixed in dollar term (and has a similar risk profile to the FIRM’S DEBT), then rD is appropriate.
• If the value of debt tax shields varies with the value of the firm (for example, because the firm increases the debt tax shield when it is doing well), then rA is appropriate because the debt tax shield has similar risk to the OVERALL FIRM.

Question 2

Can it be in debt holders’ interest to waive protective covenants? Why or why not?

[2017, 5m]

Answer 2

Yes.
- eg. when debt overhang prevents a positive NPV investment
- In this case, waiving a covenant that the firm cannot issue additional senior debt can benefit existing debt holders.

Question 3

In the presence of corporate and personal taxes, is it possible that the TAX SHIELD OF DEBT is negative? Explain.

[2017, 5m]

Answer 3

Yes, when (1-tc)(1-te)>(1-td),

where tc is the corporate tax rate,
te the tax rate on equity payouts, and
td the tax rate on payouts to debt holders.

However, when consider only corporate taxes, debt tax shield is always 0 or +ve

Question 4

“Shareholders can never gain from negative NPV investments.”
Comment on this statement.

[2017, 5m]

Answer 4

• False statement.
• Shareholders may have an incentive to take risky negative NPV projects (RISK SHIFTING / EXCESSIVE RISK TAKING).

Question 5

The effective tax rate that McDreamy will face is only 15% rather than the 35% that you had originally forecasted.
Without
doing any further calculations, briefly describe the effect of this change on (i) McDreamy’s WACC and (ii) its expected value compared to part (d).

[2023, 5m]

Answer 5

WACC will increase, but the project’s expected value will also increase!

1. WACC increases because the value of the interest tax shields on the debt declines,
   - effectively increasing the after-tax cost of debt.
2. The value of the project also increases because it is paying less in taxes, which increases the after-tax cash flows to investors.
   - This effect dominates the increase in the WACC: it is always better to pay lower taxes than to shelter a fraction of the higher taxes through a debt tax shield.

Question 6

1. 4 main variables you would consider changing if you want to perform a sensitivity analysis for NPV valuation
2. How would you implement this?

[2020, 5m]

Answer 6

Main variables
- sales growth
- operating margins
- discount rate
- long-term growth rate

Analysis is implemented by creating alternative scenarios varying (some or all) the variables above and then estimating a new valuation.
- these variables are often correlated (e.g., a negative scenario often involves lower sales
growth and lower margins), so we need to consider all variables moving together.

Question 7

Examples of
1. Direct costs
2. Indirect costs of bankruptcy/financial distress

[2020]

Answer 7

Direct costs
- accountant and lawyers’ fees
- costs of the bankruptcy procedures

Indirect costs
- impact on customers/suppliers if they expect the
company to be in distress {and employees leaving}
e.g. airlines that customers / suppliers become afraid won’t be flying in a year
- debt overhang problem (i.e. underinvestment)
- over-investment (gambling for resurrection) {take excessive risks}
- fire sale of assets

Question 8

Consider a start-up that plans to start a supermarket chain that sells organic food in areas with
low-income residents. The idea is to improve residents’ health by providing healthier choices, while still making a profit.
What is the best way to assess the terminal value of this project after 5 years?

[2020, 5m]

Answer 8

1. There are plenty of publicly traded supermarket chains. Once your supermarkets have acquired a
   similar scale, i.e., when your growth projection period is over, apply the current comparables to the
   last financial statement estimates. {exit multiple method}
2. Another alternative is to use a perpetuity-based estimate.
   - This requires the last forecasting period’s cash flows, the terminal discount rate, and the long-run growth rate.

Question 9

The WACC and the APV methods use the same free cash flows to estimate the value of a
company, with the only difference being the discount rates used by each method to discount these cash-flows.
True or false? Explain.

[2020, 5m]

Answer 9

False.
- While both methods use the same free-cash flows with different discount rates (e.g., the Ra in
the case of APV versus the weighted-average cost of capital for the WACC method),
- the APV estimate the present value of tax-shields (PVTS) separately.
- The WACC method incorporates the PVTS directly
through the discount rate.

Question 10

When using the CAPM to estimate the expected rate of return for a project expressed in US
dollars, we should use the 3-month Treasury bill yield as the proxy for risk-free rate.
True or false?

[2020, 5m]

Answer 10

False.
- We should use a maturity that best matches the duration of the project’s cash-flows. It’s not
necessarily true that the 3m yield is the one to use (the CAPM is agnostic about this).
- In corporate valuations, analysts typically use the 10y Treasury bond.

Question 11

In a Modigliani and Miller’s perfect capital markets world explain what happens to the cost of equity when a firm issues risk free debt.

[2016, 5m]

Answer 11

• Cost of equity INCREASES because the risk of equity increases.
• This is true even with risk free debt!
• Equity holders’ cash flows will be more risky because debt holders will get the safest part of cash flows.

Question 12

Explain how debt can reduce the agency costs of managerial discretion.

[2016, 5m]

Answer 12

• Debt DISCIPLINES managers by forcing the company to pay out FREE CASH as INTEREST
• Therefore, debt incentivises managers to work hard to create value…
• …b/c if these interest payments are not met, the co. defaults and can be liquidated
• If the firm gets liquidated, managers lose their job.

*This is not the case with dividends as the co. does not commit to make dividend payments.

Question 13

Is multiples valuation the appropriate method to value conglomerates?
Explain why, or why not.

[2016, 5m]

Answer 13

Multiples valuation is NOT appropriate to value conglomerates.
- Finding similar diversified firms is difficult because most likely they will not have a similar industry portfolio.
- On the other hand, using a portfolio of stand alone firms (single-industry) is also not appropriate because those are going to be smaller, younger firms and with less M&A activity (book values can be very different)