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Question 1

According to Modigliani and Miller, capital structure policy and payout policy are irrelevant.

Answer 1

Both payout and capital structure policy are irrelevant because they are purely financial transactions, they neither create nor destroy value. As long as the firm invests in all positive NPV projects, the firm will maximise value and payouts. Capital structure just determines how the total investment necessary is split among different investors, while payout determines how the total payout is split among different investors.

Question 2

One reason capital structure policy may be relevant is due to taxes. Discuss another alternative reason.

Answer 2

There are multiple reasons why M&M fails in the real world. Among them are risk shifting, debt overhang, insufficient effort, perks and diversion of cashflows, and asymmetries of information.
Ex.: Ross (1977) asymmetry of information - signalling of the firm’s value to the market through debt financing (manager’s decision)

Question 3

One reason payout policy may be relevant is due to taxes. Discuss an alternative reason.

Answer 3

Dividends may be used as a costly signal to inform the market of the firms quality. Only good firms can afford to pay high dividends due to either bankruptcy costs or high taxes. Bad firms would not imitate.

Question 4

Many valuable takeovers may not occur due to the free-rider problem.

Answer 4

The free-rider problem is that when a raider who can raise firm value makes a bid on a firm, the current shareholders know that if they do not sell and the bid is successful they will benefit from the value added. Thus many refuse to sell their shares unless the price is very
high. However, if the price is very high than the raider does not benefit so no raid occurs. Thus efficient, NPV rising raids may not occur.

Question 5

What are the empirical facts regarding the stock returns of the participants in the takeover (bidder and target). Is this consistent with the free-rider problem?

Answer 5

The free rider problem suggests that after a takeover announcement the bidder’s returns are negative and the acquired firm positive; this is consistent with the data. In the data shareholders of target firms gain from takeovers as they receive a high premium on the shares when they are sold/taken over. For bidding firms – results are mixed. Cash offer appears to have no significant impact on the bidder’s return. Share exchange on the other hand seems to suggest a decline in the bidder’s share price and return.

Other studies look at operating performance of mergers, rather than market values. Here the evidence too, is mixed. Some studies find improvements in operating performance (namely, higher return on assets, profit) but others find no improvement.

Question 6

Describe one possible solution to the free-rider problem. (takeover situation)

Answer 6

Grossman and Hart (1980) suggested a dilution mechanism: any mechanism that would allow the raider to take value away from any shareholders who held out and did not sell their shares if the raider was successful in acquiring enough shares to buy a controlling stake in the firm. For example, allowing the raider to force any holdouts to sell shares to him at a low price once he is in control is a dilution mechanism. The reason this works is that old shareholders know that if they hold out and do not sell their shares during the raid, they may suffer after the raid. Thus they choose to sell their shares and the efficient raid occurs. Another potential solution to the free-rider problem is to accumulate shares in secret. It works because prior to the raid becoming public information, the firm price is low as it is an inefficient firm. If the raider can acquire a lot of shares at this time, secretly, he does not need to pay a high price for most shares. After the raid becomes public, the free-rider problem will still occur and he will have to pay a premium for the remaining shares. However, he does not need to buy very many more shares to get to a majority, therefore the raid may still be worth it.

Question 7

Briefly explain the intuition behind the CAPM. According to the CAPM, which characteristic explains whether an asset should have a high or a low return?

Answer 7

The CAPM is an equilibrium model based on certain assumptions about preferences about risk. The intuition is that the average agent holds the market portfolio, therefore any asset with a positive covariance with the market portfolio does poorly when the agent does poorly and is therefore bad insurance. Such assets should have low prices and high returns. Thus, according to the CAPM, the only characteristic that matters for asset pricing is an asset’s covariance with the market, or equivalently its beta. Assets with high beta should have high expected returns.

Question 8

Discuss empirical evidence regarding the CAPM. Are there certain assets for which the CAPM appears wrong?

Answer 8

There are multiple anomalies discussed in the subject guide for which the CAPM does not seem to work. Among these are the small stock premium, the value premium, and momentum.

Question 9

Roll’s critique

Answer 9

The CAPM says that the only thing that matters is covariance with the market portfolio. However, according to Rolls critique, we do not actually observe the true market portfolio. We observe the return on a public equity market such as the S&P500, whereas the true market portfolio may contain private equity, corporate debt, real estate, and labour income. Thus, we cannot really determine that the anomalies disprove the CAPM.

Question 10

Jill Crener, the host of TV show Crazy Cash, gives stock recommendations every day and insists following these recommendations will beat the market.

Answer 10

If Jill’s strategies are indeed profitable than the market is not efficient since everyone has access to them. However, more likely she is just crazy and the recommendations are not profitable.

Question 11

Inintech announces that it has discovered a cure for colon cancer. Its share price rises by 45%.

Answer 11

It appears that the market responds swiftly to an announcement, suggesting that it is consistent with the semi-strong form efficiency. The market is unlikely to be strong form efficient as the privately held information is not already in the price.

Question 12

If a firm’s stock price falls by more than 2% on any given day, the return is typically positive the following day.

Answer 12

This is negative autocorrelation which implies that past returns are not fully incorporated in the stock price. This is a violation of weak form efficiency.

Question 13

The difference between the best performing and worst performing London hedge funds was 86% in 2013.

Answer 13

If managers have superior or private information then this may be a violation of strong form efficiency. However, this may simply be due to luck.

Question 14

Describe the Net Present Value and the Internal Rate of Return decision rules. Compare the two, does one have advantages over another?

Answer 14

The NPV rule is the right rule for discounting cash flows. It takes every possible cash inflow and outflow at future dates and values them as of today by discounting. If the net is positive, the project should be taken.

The IRR computes the discount rate which would make the NPV equal to zero. If the IRR is above the true discount rate, the project should be taken.

For standard projects the two give identical answers. However, for non-standard projects, where there are choices of size or magnitude, or only one project may be taken, the IRR may give misleading answers.
when we must only choose one project out of many, when the borrowing rate is different from the lending rate, when the discount rate is changing through time, when cash flows are often changing from positive to negative.

Question 15

How does volatility affects call option prices?

Answer 15

Volatility increases the value of call options. This is because call option payoffs are convex in the underlying. As the underlying is worth more, the payoff is higher; however, if the underlying is worth less (below the strike) the payoff is still the same – zero. Thus increasing volatility increases the probability of very low and very high payoffs of the underlying. Low and very low payoffs are equally painful as they result in zero; however, high payoffs are not as good as very high payoffs.

Question 16

Explain how volatility affects equity prices when equity is close to default? Does this have any implications for optimal capital structure?

Answer 16

Just as with call options, volatility increases the value of equity when equity is close to default. The intuition is the same; taking on more risk has little cost on the downside and large benefits on the upside. This is referred to as risk shifting or asset substitution, which is one of several potential dist`ress costs. Firms usceptible to risk shifting are better off using equity rather than debt financing.

Question 17

What are some examples of financial signals discussed in the course? What is necessary for a signal to be effective?

Answer 17

We have discussed signalling with dividends and signalling with debt. For a signal to be effective ‘bad’ firms must find it more costly to use the signal than ‘good’ firms. If this is the case, good firms can use the signal and bad firms would not imitate. At the same time, the signal should not be too costly for good firms, otherwise they would rather do nothing and be grouped with bad firms.

Question 18

What did Modigliani and Miller mean when they said financial policy is irrelevant?

Answer 18

Both payout and capital structure policy are irrelevant because they are purely financial transactions, they neither create nor destroy value. As long as the firm invests in all positive NPV projects, the firm will maximise value and payouts. Capital structure just determines how the total investment necessary is split among different investors, while payout determines how the total payout is split among different investors.

Question 19

Is NPV a better appraisal technique than the Internal Rate of Return?

Answer 19

For standard projects the two give identical answers. However, for non-standard projects, where there are choices of size or magnitude, or only one project may be taken, the IRR may give misleading answers whereas the NPV is correct.

Question 20

Discuss three motives for corporate takeovers.

Answer 20

In this question, students should explain the three motives for takeover: Financial, Strategic and Conglomerate. In each case, talk about the inefficiency that was exploited and how the improvement would benefit the shareholders of the acquiring firm. In this case, you are expected to describe the inefficiencies of management, economies of scale and economies of scope as reasons for the acquisition.

Question 21

What empirical evidence do we have in regard to value creation following a takeover for:

i. the bidder firm’s shareholders, and
ii. the acquired firms shareholders.

Answer 21

In the data shareholders of target firms gain from takeovers as they receive a high premium on the shares when they are sold/taken over. For bidding firms – results are mixed. Cash offer appears to have no significant impact on the bidder’s return. Share exchange on the other hand seems to suggest a decline in the bidder’s share price and return.

Question 22

Linter (1958) characterized dividend behaviour. Based on his observations, if a firm’s earnings increase by $0.05/share, the firm’s dividends are likely to increase by less than $0.05, $0.05, or more than $0.05? Explain your answer.

Answer 22

Linter (1958) finds that firms like to keep dividends steady even if earnings are moving around. Thus if a firm’s earnings increase by $0.05/share, the firm is unlikely to increase dividends by $0.05/share. Most likely dividends will stay constant or increase by some amount less than $0.05/share. Here you should highlight the model, explain the equation and talk a little about the motives, like dividend smoothing.

Managers seem to have a target dividend pay-out level. This is determined as a proportion of long-run (sustainable) earnings of the firm. Thus if there is a large temporary shock to earnings today, this does not mean there will be a large change in dividends.

• Managers seem to be more concerned with changes in dividends than the actual level of dividends.
• Managers prefer not to make changes that may be reversed. As a result, dividends are relatively smooth and do not change often.
• Lintern’s numerical model for dividends was dDIV(t) = L * (a * EPS(t)– DIV(t – 1)) thus dividends adjust to earnings changes slowly.

Question 23

Explain the tax clientele theory for the existence of dividends.

Answer 23

The tax clientele theory says that there are many different types of investors. Some of these investors are in low tax brackets and therefore do not pay much (if any) taxes on dividend income. For these investors there is no advantage from capital gains because even though they are taxed at a lower rate than dividends it makes no difference to these investors since their tax rate is already low. On the other hand, issuing dividends carries lower transaction costs than buying back shares. Thus to attract this class of investors some firms will issue dividends. Low tax investors are not just poor people, they include tax exempt entities such as universities and certain pension funds. On the other hand, for most investors dividends are much more costly than capial gains in terms of taxes. These investors prefer to be paid through repurchases and other firms will issue less dividends and do more repurchases to attract this class of investor.

Indeed, empirically it is true that low tax investors have portfolios that are tilted toward dividend paying stocks.

Question 24

Explain the signalling theory of dividends.

Answer 24

Good firms want the markets to know that they are good so that they can have cheaper access to financing. Generally, a signal needs to be less costly for the good type than the bad type in order to discourage the bad type from imitating the signal. Dividends are one such potential signal. Note that dividends are an expensive way to pay investors. Dividends are taxed at the corporate rate inside the firm, rather than at the personal rate outside the firm. Capital gains are also taxed at the corporate rate inside the firm but at the capital gains rate (lower than personal) outside the firm. Interest is not taxed inside the firm and is taxed at the personal rate outside the firm. Thus the good firm, which benefits from investors knowing that it is good because it can raise capital for positive NPV projects, does not mind paying investors in a more expensive way because the benefit outweighs the cost. The bad firm has fewer good projects and is less interested in cheap financing; it would rather just pay its investors as cheaply as possible.

Question 25

Discuss the risk shifting (asset substitution) problem. What kind of capital structure does it favour?

Answer 25

When a firm is close to default, equity holders want to take on more risk than optimal. This is because they are ‘gambling for resurrection’ → the downside is not going to get any worse due to limited liability. On the upside, the bigger the gamble, the bigger the potential payoff. This may only happen if the firm has taken on too much debt; thus this problem favours equity in the capital structure.

On the other hand, increasing the probability of the upside helps equity holders because they receive the residual after all payments to debt, which are fixed. Since it is the CEO’s job to represent equity holders, she will take on too much risk. This means the firm will not be acting optimally (taking the highest NPV projects), and will therefore be valued below maximum.

Potential solutions include financing the firm with equity only so that there is no incentive to risk shift. Another solution is convertible debt so that if equity holders do risk shift and end up in the good state of the world, creditors can convert their debt to equity and dilute equity’s incentives to risk shift.

Question 26

Discuss the debt overhang problem. What kind of capital structure does it favour?

Answer 26

With debt overhang the firm chooses not to invest in positive NPV projects. This occurs when a firm is distressed and likely to default soon. If equity holders choose to take the project instead of paying themselves a dividend, they will be incurring the full cost of the project but receiving only part of the benefit since most of the benefit goes to creditors (equity holders are unlikely to receive anything). Thus equity holders choose to not take a positive NPV project.

Debt overhang is most severe for firms with high expectations of default, and with low (but positive) NPV projects. Note that if the project has a very high NPV, then the equity holders will want to take it because the fraction they receive in expectation is still higher than the cost.
One possible solution is renegotiation. Since the firm is bypassing positive NPV projects, in theory everyone could benefit if they could somehow take the project and split the NPV between equity and debt holders. Negotiation can involve a reduction of interest payments, or a deferral of interest payments.

Another possible solution is issuance of new debt. However, this can only work if the new debt is more senior than existing debt. Thus new creditors know they are likely to be paid back and do not charge too high interest rates. However, this is typically forbidden in the covenants of the existing debt. If the firm files for bankruptcy, then issuing senior debt is allowed.

Question 27

Discuss the agency problem of managers not putting in enough effort or using up firm resources for personal gain. What kind of capital structure does it favour?

Answer 27

When managers are not properly incentivised, they may not work very hard, or may waste the firm’s resources. To prevent them from doing this we can set proper incentives by giving managers compensation which is highly dependent on how well the firm does – in this case the manager wants to work hard and would not want to waste firm resources. Equity is one form of such compensation. Thus we want the equity of the firm to be highly concentrated in the hands of the manager. But to do that, most of the firm’s financing needs must be met by debt (if they are met by outside equity, then the manager cannot hold a large fraction of the equity). Thus this friction favours lots of debt in the capital structure and a small amount of equity that is held by the insiders.

Question 28

Personal taxes result in the Modigliani and Miller 1st proposition being violated. Briefly explain why.

Answer 28

Since different payouts are taxed in different ways, it is optimal for the firm to structure its financing so as to minimise the tax liability. Therefore capital structure is not irrelevant and M&M1 is violated.

In particular, personal taxes on equity payouts are typically lower than on debt payouts. Equity payouts are either capital gains (share repurchases) or dividends; debt payouts are interest. Capital gains are taxed at the capital gains tax rate while interest is taxed at the personal tax rate, which is typically higher than capital gains. Depending on the tax regime, dividends are taxed at the same rate as interest, or lower. Thus, overall, if we just consider personal taxes (and other frictions), equity is cheaper than debt and firms should issue as much equity as possible.

Question 29

Briefly explain the Modigliani and Miller 1st proposition and discuss some of the reasons which may cause it to be violated.

Answer 29

M&M1 says that capital structure is irrelevant if certain conditions hold. This means that it does not matter how the firm finances its investment – the value for the shareholders will be unchanged. This is because financial decisions do not affect value, they only determine how this value is split among the different stakeholders.

Among the reasons that M&M1 can be violated:

• corporate taxes make debt cheaper (implies more debt in the capital structure)
• high amounts of debt leading to debt overhang and underinvestment (implies less debt in the capital structure)
• high amounts of outside equity leading to too little effort by managers (implies more debt in the capital structure)
• asymmetric information leading to only bad firms issuing risky securities and good firms underinvesting in positive NPV projects, this is referred to as pecking order (implies more debt in the capital structure)

• asymmetric information leading to good firms signalling with certain types of securities, for example a firm can signal with debt, because debt is risky and costly (implies more debt in the capital structure), or a firm can signal with dividends because they are costly from a tax perspective (implies less debt in the capital structure).
Debt (as in Ross 1977) is costly because it increases the probability of the firm going bankrupt (for this to work the model also needs either bankruptcy costs, or disutility from bankruptcy for manager). Dividends (as in Bhattacharya 1979) are costly because they are taxed at a higher rate than other types of payouts.

• High amounts of debt leading to risk shifting; that is, managers take on too much risk because upside is unlimited and downside has limited liability (implies less debt in the capital structure)
• Personal taxes make equity cheaper (implies less debt in the capital structure)

Question 30

Explain pecking order theory. According to pecking order theory, how do bad firms tend to finance investment? How do good firms tend to finance investment?

Answer 30

If the market does not know which firms are good and which firms are bad, it will value all firms as average. A good firm that is valued as average does not want to issue equity because its equity is undervalued – it will be giving up too large a fraction of its equity for too little of a cash infusion. On the other hand, bad firms don’t mind since their equity is over valued. If a firm has a new, NPV>0 project which requires financing, if it knows it is a good firm (so that it is undervalued), and if it has no option but to finance it by equity, it may choose to not finance this project at all. This is because the cost of giving away too many shares is higher than the benefit of the project. This problem is more severe if the NPV is small relative to the value of the firm, and if the firm is more undervalued. This problem can even occur with risky debt, because it is priced in a similar way to equity. However, if the firm has cash, it is not worried about outside valuations and will finance all positive NPV projects.

The pecking order theory states that in the presence of asymmetric information, firms will finance investment with the most informationally insensitive securities, such as cash or safe debt, and then move up the pecking order to risky debt and equity if they have no choice.

Question 31

A recent research study found that firms run by CEOs who have family problems (such as a seriously sick child) tend to underperform. You are aware that your cousin, who is married to the CEO of NORNE LLC, is likely to file for divorce. As a result you expect NORNE’s stock price to fall and you short it. Which kind of efficiency must be violated for your expectations to be correct? Explain your reasoning.

Answer 31

Note that a CEO’s family problems are typically private information, therefore this gives us no evidence that either the weak form or the semi-strong form efficiency are violated. However, if you expect to profit from this trade, you must believe that this market is not strong-form efficient in that private information about the CEO’s personal life is not yet incorporated into prices.

Question 32

How does the price of a European put option change if the time to maturity rises? If the price of the underlying rises? If the volatility of the underlying rises? If the exercise price rises? Explain.

Answer 32

If the volatility rises, the put option price rises. This is because with options, the downside is limited (by zero) and the upside can be very high (unlimited for call options). Increased volatility increases the probability of both.

A rise in time to maturity has exactly the same effect as volatility – there is now more time for the underlying to reach very low or very high prices.

If the price rises, the put option price falls. This is because a put entitles you to sell at a particular fixed price. If the actual price is now higher, the option to sell at a fixed (relatively low) price is less valuable.

If the strike price rises, the put option price rises. This is because a put option entitles the owner to sell the underlying for the exercise (strike) price. Selling at a higher price is good.

Question 33

How does the empirical security market line compare to the one predicted by the CAPM?

Answer 33

The empirical line is flatter than the one predicted by theory. Stocks with low betas tend to have higher returns than predicted by CAPM; stocks with high betas tend to have lower returns than predicted by CAPM.

This pattern may be due to mismeasurement of beta. Mismeasurement can be due to Roll’s critique, or for a host of other reasons. If we are mismeasuring beta, then stocks we are calling high beta are likely to have high beta but not quite as high as we are measuring (beta is the sum of the true beta and an error). In which case, their expected return should be lower than we would be predicting. Similar for low beta stocks, their true beta is not as low as we are measuring. The result would be a flatter line.

Another possible explanation is borrowing constraints. If low risk aversion investors are unable to borrow in order to short low beta stocks and long high beta stocks, they will just be forced to hold long positions in high beta stocks. Thus high beta stocks will be overbought and overvalued and have relatively low returns; low beta stocks will be underbought and undervalued, with relatively high returns.

Question 34

Suppose the CAPM does not hold, is this evidence of the violation of market efficiency?

Answer 34

It is not necessarily inconsistent with market efficiency. The CAPM is not necessarily the right model to describe all risk. Any firm with higher loading on the ‘true’ risk in the economy should have higher returns. Multi-factor models attempt to capture the risks in the economy not captured by the CAPM.

Question 35

Discuss evidence on ‘anomalies’ such as size, book-to-market, and return predictability.

Answer 35

Size: small firms tend to have higher returns than large firms.

Book-to-Market: value firms (firms with high Book/Market ratio) tend to have higher returns than Growth firms (low Book/Market ratio).

At longer horizons stock returns are predictable by variables like P/E, say.

Question 36

Corporate taxes result in the Modigliani and Miller 1st proposition being violated. Briefly explain why.

Answer 36

Since different payouts are taxed in different ways, it is optimal for the firm to structure its financing so as to minimise the tax liability. Therefore capital structure is not irrelevant and M&M1 is violated. In particular, at the corporate level any payments to creditors are not taxed, while all other profit (which is eventually paid out to equity) is taxed at the corporate tax rate. Therefore debt is cheaper than equity and if we consider corporate taxes only, firms should issue as much debt as possible.

Question 37

How does the price of a European call option change if the volatility of the underlying rises? If the price of the underlying rises? If the interest rate rises? If the strike price rises? Explain.

Answer 37

If the volatility rises, the call option price rises. This is because with options, the downside is limited (by zero) and the upside is unlimited. Increased volatility increases the probability of both.

If the price rises, the call option price rises. This is because a call entitles the owner to buy at a particular fixed price. If the actual price is now higher, the option to buy at a fixed (relatively low) price is more valuable.

If the risk free rate rises the call option value rises. This is because it decreases the present value of the exercise price.

If the strike price rises, the call option price falls. This is because a call option entitles the owner to buy the underlying for the exercise (strike) price. Buying at a higher price is bad.

Question 38

Suppose you observe that today’s price-to-dividend ratio forecasts future stock returns, is this necessarily a violation of the Efficient Market Hypothesis? Explain. Briefly review evidence on the forecastability of stock returns.

Answer 38

Certain variables (such as P/D) forecasting returns is not necessarily a violation of the efficient market hypothesis (EMH). The EMH states that returns should not be predictable once we have accounted for risk. However, if certain assets are more risky, they should have higher returns. Thus if the P/D ratio is also forecasting risk, then it should forecast future returns. Empirical evidence suggests that stock returns are weakly forecastable at longer horizons. Some of the variables that can forecast stock returns are the price-to-dividend ratio, the default spread, the wealth to consumption ratio, past volatility and the corporate spread.

Question 39

Explain how and why debt may be used as a signal to investors as in Ross (1977).

Answer 39

Generally, a signal needs to be less costly for the good type than the bad type in order to discourage the bad type from imitating the signal. In Ross’s model, having a lot of debt is costly because it increases a firm’s probability of paying bankruptcy costs or a manager’s probability of being fired. However, good firms can stand this increased probability because being good, their probability of bankruptcy is still quite low. Good firms take on a lot of debt to signal that they are good. Bad firms do not imitate this because, for them, the probability of being in trouble, conditional on having lots of debt, is much higher.