Short question Theory

Question 1

proxy contest

Answer 1

Proxy contest is an attempt by a dissident group of shareholders to gain representation on a firms board of dirctors.

Question 2

leveraged buyout (

Answer 2

A leveraged buyput is the purchase of a company by a small group of investors, financed largely by debt, Often the assets of the company are used as colletaeral to allow cpmpanies to make large aqcuisitions without having to commit a lot of capital

Question 3

Define Joint Venture

Answer 3

A joint venture is a combination of subsets of assets contributed by two or more business entitities for a specific bsuness purpose and a limited duration.

Question 4

Define Direct bankruptcy costs

Answer 4

Direct bankruptcy costs are incurred in bankruptcy or reorginaization such as legal adimintrative afire sale sale costs

Question 5

Hubris

Answer 5

Hubris refers to the excessive self-confidence (pride, arrogance) of managers causing them to overbid and overpay for a takeover target

Question 6

Golden Parachute

Answer 6

Golden parachutes are separation provisions of an employment contract that provide for payments to managers under a change-of-control clause. Usually a lump sum payment is involved if the manager loses his\her job.

Question 7

Convertible Bond

Answer 7

A convertible bond is a bond (debt contract) that may be converted into another security (typically equity) at the holder’s option.

Question 8

Sunk Costs

Answer 8

A sunk cost is a cost that has been incurred and cannot be reversed.

Question 9

Equity carve out:

Answer 9

A transaction in which a parent firm offers some (typically up to 20%) of ,a subsidiary’s common stock to the general public to bring in a ääsn infusion without loss of control

Question 10

A pure stock offer

Answer 10

If the shares of the acquiring firm are overvalued, then the aquierer should try to buy thorugh

Question 11

Spinoff

Answer 11

A transaction in which a company distributes on a pro.rata basis all of the shares it owns in a subsidiary to its own shareholders hereby creating a new public company with (initially) the same proportional equity ownership as the ;parent company

Question 12

Vertical merger

Answer 12

In vertical mergers, by directly merging with suppliers, a company can decrease reliance and increase profitability. An example of a vertical merger is a car manufacturer purchasing a tire company. Such a vertical merger would reduce the cost of tires for the automaker and potentially expand business to supply tires to competing automakers.

Question 13

Devistiture

Answer 13

The partial or full disposal of an investment or asset through sale, exchange, closure or bankruptcy. Divestiture can be done slowly and systematically over a long period of time, or in large lots over a short time period.

Question 14

Poison Pil

Answer 14

A strategy used by corporations to discourage hostile takeovers. With a poison pill, the target company attempts to make its stock less attractive to the acquirer. There are two types of poison pills:

1. A “flip-in” allows existing shareholders (except the acquirer) to buy more shares at a discount.
2. A “flip-over” allows stockholders to buy the acquirer’s shares at a discounted price after the merger

Question 15

Poison put

Answer 15

A bond that allows bondholders to redeem before maturity at a high price should certain, named events take place. These events commonly include restructuring, a leveraged buyout, an attempted hostile takeover, or paying dividends in excess of a certain amount or percentage. Poison-put bonds can act as an anti-takeover measure; they help management discourage takeovers by raising their expense. On the other hand, when the company is going through a difficult time, poison-put bonds can limit management’s restructuring options for the same reason

Question 16

Briefly explain the trade off theory of capital structure (60 words)

Answer 16

According to the trade-off theory of capital structure, companies optimally trade off the tax shield advantage of debt against the expected bankruptcy costs. The interest repayments on debt are tax deductible. This benefit of debt has to be traded off against the increase in expected bankruptcy costs that result from taking on higher debt levels. Highly levered companies are more likely to go bankrupt.

Question 17

Does it matter for the total firm value whether the firm keeps the debt level constant or whether it keeps the leverage ratio constant Explain your answer?

Answer 17

The WACC formular assumes that debt is rebalnced to maintain a constant debt ratio. Rebalancing ties the level of future intrest tax shields to the future value of the company. This makes the tax shield risky. Fixed debt levels however are not necessarily better for stockholders (just because you assume a lower Wacc). Note that, when the debt is rebalanced next years interest tax shields are fixed and, thus, discounted a lower rate. The following years interest is not known with certainty for one year and, hence, is discounted for one year at the higher risky rate and for one year at the lower rate. This is much more realistic sine it recognizes the uncertainty of future evetns

Question 18

Many empirical studies have tested the validity of the trade-off theory of capital-structure’ Whai is the empirical evidence in fiavour (pro) and against (contra) the trade-off theory of capitalstructure

Answer 18

Following proxies are empirically associated with low debt ratios
• Tax-loss carry forwards
• Volatility of earnings/market value (business risk)
• Expenditure on marketing, R&D (intangibles)
• MBV (growth opportunities)
Contra:
profitable firms within industry have lower gearing
Above results can be consistent with other theories

Question 19

What are conglomerate mergers

Answer 19

A merger between firms that are involved in totally unrelated business activities. There are two types of conglomerate mergers: pure and mixed. Pure conglomerate mergers involve firms with nothing in common, while mixed conglomerate mergers involve firms that are looking for product extensions or market extensions.

Question 20

During which merger wave were conglomerate mergers popular? What has been the performance of these conglomerate mergers and what is the explanation for their performance

Answer 20

Third wave: This was seen during the conglomerate merger phase of the 1960s.
Performance was rather poor as synergy effect has been overestimated

Question 21

What theoretical justification can you give for conglomerate mergers?

Answer 21

There are many reasons for firms to want to merge, which include increasing market share, synergy and cross selling. Firms also merge to diversify and reduce their risk exposure. However, if a conglomerate becomes too large as a result of acquisitions, the performance of the entire firm can suffer. This was seen during the conglomerate merger phase of the 1960s.

Question 22

What is the “diversification discount, and how can one explain this phenomenon?

Answer 22

It is argued that diversified firms trade at a discount relative to similar single segment firms. Diversification discount is usually assumed to be caused by:
• Internal inefficiency and agency
• Increased info asymmetry
• Inneffienct internal capital markets

Question 23

State and discuss the nature of 3 different takeover defenses

Answer 23

1)Defensive restructuring:
“scorched earth policy”, selling crown jewels
Issue new equity to “friendly” shareholders
2)Poison pills: warrants issued to existing shareholders giving them right to buy firm securities at very low prices in event of tender offer
3)Poison puts: allows bondholders to sell bonds at par to issuer or its successor
4)Golden parachutes (protects management)

Question 24

what is the difference between a cash offer and a stock offer (in the context of takeovers)?

Answer 24

In a stock deal, a portion or the entire amount of the acquisition price is paid in shares of the acquiring company. In a cash deal, the acquisition price is paid in cash. In stock deals, buyers share both the value and the risks of the transaction with the shareholders of the company they acquire in proportion to the percentage of the combined company the acquiring and selling shareholders each will own. In cash transactions, acquiring shareholders take on the entire risk that the expected synergy value embedded in the acquisition premium will not materialize. Sellers can often achieve a higher price for their companies by accepting stock deals

Question 25

Firms A and B are each considering an unanticipated new investment opportuninty that will maginally increase the value of the firm and will also increase the firms level of diversification. Firm A is unlevered, and firm B has a capital structure of 50% debt. Assuming that the sahrehplders contril te firm, will either firmake the investment.?

Answer 25

From the optiom prcing model we know that the greater diversification created by the new investment will lower the rate of return variance of the firms assets. If the firm is not levered the prokect will b e accepted because it increases shareholders weltaht (although marginally), which is identical to the value of the all equity firm. The project has positive NPBV. However, with a levered firm. Shareholders equity may be though of as a call option on the value of the firm. Consequently, the lower variance of return on the assets of the firm will decrease the value of the call. Of the decrease is large enough to offset the small positive NPV of the project, it will be rejected by hareholders of the levered firm.

Question 26

What are the empirical problems involved in testing for the effect of capital structure on the value of the firm?

Answer 26

The main empirical problem is that firms typically change their capital structure as the same time that they change their portfolio of assets by taking on new investment. Cosequently, the effects are indistunishable. Changes in the value of the firm may be attributed to investment policy, financial policy or both. In addition to this fundamental problem, there are problems of measurement error. For example, how can one measure future growth in the form, or expected rates of return, or differences in risk? Finnaly, the empirical work frequently uses cross-section regressions which are liekyl to have highly correlated residuals. This wekanes the power of the statiscal significance test.

Question 27

Supporse that new banking regulation imposes higher capital requirements on banks. How would this affect banks decisions to invest in new porjects?

Answer 27

An increase in capital requirements would reduce the target leverage ratio, which in turn would increase the WACC, since the equations below show the a reduction in the target leverage ratio, will decrease the tax shield saving and hence increase the WACC.:In increase in WACC would in turn raise the hurdle rate for firms procjects, causing more projects to be turned down, and investments to decrease

Question 28

Regulators acrcross the world have started to impose higher capital requirements on banks as a result of the recent banking crisis. How will these new requirements affect future lending?

Answer 28

It it lieky that the cost imposed to all banks by higher captal requirements will be bassed on to borrower. This means that the spread between lending rates and the base rate may be much higher than what used to be the case before the crisis. In addition, other credit terms (such as the amount of collateral required) may become tougher too. As a result credit may become less freely available

Question 29

The WACC formular assumes that debt is rebalances to maintain a constant debt ratio D/B. Rebalancing ties the level of future interest tax shields to the future value of the company. His maes the tax shield risky. Does that mean that fixed debt levels (no rebalancing) are better fore stockholders.?

Answer 29

Fixed debt level, without rebalancing, are not nexessarily better for stockholders. Note that, when the debt is rebalances , next years interest tax shields are fixed and, thus, discounted at a lower rate. The followings years interst is not known with certainy for one year and, hence, is discounted for one year at the higher riky rate and fr one year at the lower rate. This is much morerealistic sind it recognizes the uncertainty of future events.

Question 30

Management Buyout

Answer 30

MBO is a process by which the substantial part of the shares of the company are purchased by the Executives of the company from the promoters
When the promoters are planning to sell a firm, the managerial personnel may buy the same from the promoters

Question 31

Market Portfolio

Answer 31

A theoretical bundle of investments that includes every type of asset available in the world financial market, with each asset weighted in proportion to its total presence in the market. The expected return of a market portfolio is identical to the expected return of the market as a whole.

Question 32

Credit Spread

Answer 32

A credit (or quality) spread is the difference in yields between two issues that are similar in all respects except for credit rating. An example of a credit spread is the difference in yields between long AA rated general obligation municipal bonds and long A rated general obligation (an intermarket spread as well).

Question 33

Credit Spread Risk

Answer 33

Refers to the fact that the default risk premium required in the market for a given rating can increase, even while the yield on treasury securities of similar maturity remains unchanged. An increase in this credit spread increases the required yield and decreases the price of a bond.

Question 34

CMO

Answer 34

CMOs are created from mortgage passthough certificated and referred to as derivitave mortgage back secituties, since they are derived from a simpler MBS structure. A CMO issue has different tranches, , each of which has a different type of claim to the cash flows from the pool of mortgages.

Question 35

Prepayment Risk

Answer 35

Is similar to call risk. Premayts are picipal repayments in excess of those required on amortizing loans, such as resentila mortgages. If rates fall, causing prepayments to increase, an investor must reinvest these prepayments at the new lower rate

Question 36

Covenenat and Example

Answer 36

A promise in an indenture, or any other formal debt agreement, that certain activities will or will not be carried out. Covenants are most often represented in terms of financial ratios which must be maintained for businesses which lend, such as a maximum debt-to-asset ratio or other such ratios