Workshop, Past paper questions

Question 1

Would Nymeria’s share- holders be better off (in expectation) if the acquisition was financed using cash from the company accounts instead? Explain.

[2m, 2020]

Answer 1

1. Payment method is irrelevant in an MM world.
2. Since markets are frictionless and all transactions are fair, acquirer shareholders are equally well off (in expectation) under both payment methods.
3. In a cash acquisition, acquirer shareholders would own 100% of a com- bined firm worth 294 - 40 = $254m post-acquisition (in expectation), the same as their expected wealth in a share acquisition.

Question 2

Preferences of overconfident bidder CEOs regarding cash vs. share deals

[2m, 2020]

Answer 2

Moral of the story: Overconfident (OC) CEOs may forego +NPV deals if they incorrectly perceive that they’re giving too much away to target shareholders by issuing what they
believe to be UNDERPRICED SHARES.
» To avoid issuing ‘underpriced’ equity, OC bidder CEOs are likely to prefer exhausting cash before using equity to finance an acquisition.

CEO’s NPV {loss} = actual NPV + synergy estimation - dilution ‘loss’

• That’s because he’s also (relatively more) overconfident about the stand-alone value of his firm, leading him to believe that acquirer shareholders will suffer a dilution ‘loss’ of
  137.16 − 107.5 = $29.66m from the issuance of what he thinks are underpriced shares to target shareholders.
• This perceived loss overwhelms any real and perceived gains from the acquisition:

Question 3

Explain why the call provision attached to Company X’s debt is worthless.

[2m, 2021]

Answer 3

1. The company’s debt, being zero-coupon, will have always have a value ≤ F (prior to maturity,
   the debt will generally trade at a discount to F due to the possibility of default, even in the absence of a time discount).
   Given the call/redemption price is F , the company will never opt to call it back.
2. Equivalently, the company holds a call option on a non-dividend paying underlying (the zero-coupon debt).
   Hence, it is always optimal to wait until maturity to exercise, but since the option’s payoff is always 0 at maturity (the value of the bond will at most = F ), the option is worthless.

Question 4

Explainwhytheintroductionofoutsideequityin(b)changestheentrepreneur’sinvestment
behaviour relative to your answer in (a).

[3m, 2022 paper]

Explain how costs of financial distress affect the entrepreneur’s payoff and his incentive to pursue private benefits.

Answer 4

The range of investment outlays where the entrepreneur chooses the more effi-
cient (i.e. higher NPV) project/technology is smaller in the presence of outside equity.
This is a consequence of the effort problem of outside equity: the introduction of outside equity can induce the entrepreneur to choose the project that produces private benefits because he no longer captures the entire gains from investing in the efficient project.
Under the financing terms demanded by outside investors in (b), when the project cost exceeds 225, the amount of the expected marginal benefit of the efficient project (450 − 350 = 100) that is retained by the entrepreneur is less than the private benefits (50) that would accrue to the entrepreneur from choosing less efficient project.

2. Bankruptcy costs result in debt investors demanding a larger face value, which reduces the cash flow payoff to the entrepreneur, which in turn increases the relative attractive- ness of private benefits. Hence, the range of project costs where the entrepreneur opts for the more valuable project/technology is now smaller than in (d).

Question 5

Comment on: “In times of financial stress, when lenders are impatient and the discount rate is high, credit markets may fail. Some firms may be rationed out of debt markets, i.e. there is no interest rate at which lenders are willing to lend to them.”

[Workshop 3]

Answer 5

Underlying problem: RISK SHIFTING
- High discount rate -> larger EXPECTED cash flow to debt demanded by creditors
- larger FACE VALUE on debt (in good states)
- less CF to equity (in good state)
- more incentive for equity to gamble on the upside / increase risk
- lenders demand even larger F…
- debt markets ‘fail’

Question 6

For a levered firm in an imperfect market, when there is ITS, what is β_ITS if…
1. capital structure (D/E) is constant?
2. debt is permanent?

Answer 6

1. β_ITS = β_U hence β_A = β_U
2. β_ITS = β_D hence β_A =/= β_U

Question 7

Is IPO market timing good or bad for efficient project selection?

[2016 paper]

Answer 7

The option to time IPO to the market’s misvaluation is BAD for EFFICIENT project selection.
- eg. in the Q, the project has a NEGATIVE NPV of 0.1*£100M/1.2-£10M=-£1.7M but is still selected.