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金融代写-F711 C01
时间：2021-11-29
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Name: __________________________________ _______ Student ID#: ___________________
M.FIN. F711 C01 (Wednesday) Mergers, Restructuring and Corporate Control (Fall 2019)
Test 1
Instructions:
a) This test consists of seven (7) questions over four (4) pages; you have 1½ hours to complete it.
b) The maximum score is 25 points; the point distribution details are given alongside the questions.
c) You are allowed to bring in one page (single side) of formulas.
1. The real option approach to capital budgeting will be more useful for the _____________________ (food / petroleum)
industry. Why? (1 point)
2(a). Shareholders prefer a _______________ (higher/lower) leverage ratio than bondholders. Why? (2 points).
(b). Managers prefer a _______________ (higher/lower) leverage ratio than shareholders. Why? (2 points).
3. Firm A uses no debt. Its decision rule for expansion is: invest as soon as output price rises to some critical level PA.
Firm B is similar, except that it is levered; its decision rule is: invest as soon as price rises to PB. If both firms finance the
expansion with equity, then PA is ______________________ (greater than / smaller than / equal to) PB. Why? (2 points)
4. If your company switches to a technology with greater production flexibility, how will it affect the firm’s optimal leverage
ratio? Explain. (4 points)
5. Your company is planning to issue convertible bonds with a face value of $1,000, a conversion price of $25, and a
coupon rate of 5%. (i) What is an agency-theory rationale for issuing convertible debt rather than straight (non-
convertible) debt? (ii) If the conversion price was changed to $40, would it strengthen or weaken the argument of part (i)?
Explain. (iii) If you decided on the $40 conversion price, the coupon rate will likely be ________________________
(larger than / smaller than / equal to) 5%. Why? (3 points)
6. A firm has an investment project that is completely irreversible (i.e., no part of the initial investment can be recovered).
The initial investment is $100; once the project is (instantaneously) implemented, it will produce 1 unit of the output per
year (forever), and the operating cost is zero. The current output price is P per unit, but the price will either increase by
20% or fall by 40% next year (with probability 2/3 and 1/3 respectively); and will remain unchanged thereafter. The
appropriate discount rate is 10%.
(a) What is the critical investment price (i.e., the price at which investment should be made today)? (1 point)
(b) Now suppose the firm has existing debt (one-year maturity) with face value of $40. What will be the critical
investment price? (2 points)
(c) What type of agency problem is illustrated in part (b)? And what does it imply regarding the effect of debt on
investment? (1 point)
7. ManU Corp. has two mutually exclusive $50 million projects, which it plans to finance with debt. Project A will pay off
$90 million if the economy is good, but only $20 million if the economy is poor (both are equally likely). Project B will pay
off $60 million for certain. Investors are risk-neutral and the discount rate is 0.
(a) What is the NPV of each project? (1 point)
(b) Suppose ManU can raise the $50 million by issuing a bond with face value of $50 (because the lender naively believes
the company will take the safe project). Which project will ManU’s shareholders prefer? What is the expected payoff to the
naïve lender? (2 points)
(c) If the lender is sophisticated, what will be the face value of the bond, and which project will the company choose? (2
points)
(d) What is the magnitude (dollar amount) of agency cost to shareholders? (2 points)
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M.FIN. F711 C01 (Wednesday) Test 1 Answers
1. petroleum; because there is more uncertainty in the petroleum industry.
2(a). Higher. Because they benefit from tax shield and they are not as worried (as bondholders) about default risk; they
also benefit from the disciplining effect of high debt level on manager (Jensen’s Free Cash Flow hypothesis).
(b). Lower. Because managers’ human capital is NOT diversified, they want lower default risk.
3. smaller; B will underinvest, since it has debt.
4. With greater production flexibility, firm value will rise, hence optimal leverage ratio higher.
But also greater scope for asset substitution, hence optimal leverage will fall.
Overall effect: not sure, depends on which effect dominates. Thus, optimal leverage ratio might rise or fall.
5. (i) It mitigates the asset substitution problem. (ii) If conversion price is raised, probability of conversion is reduced,
hence convertible holders are less likely to become shareholders; thus, it weakens the argument. (iii) Higher; with higher
conversion price, the conversion option becomes less valuable; the convertible holder will have to be compensated with a
higher coupon rate.
6. (a) NPV of investing now, NPV0 = [(2/3)(1.2P)+(1/3)(.6P)]/0.1 – 100 = 10P–100.
NPV of waiting, NPVw = [(2/3)(12P–100)]/1.1 = (8P–200/3)/1.1
It is optimal to invest now if NPV0 > NPVw, or P > 14.44.
(b) With debt, shareholder payoffs will be different:
NPV0 = 10P–100–40/1.1 = 10P – 150/1.1. NPVw = [(2/3)(12P–100–40)]/1.1
It is optimal to invest now if NPV0 > NPVw, or P > 18.89.
(c) This illustrates under-investment (i.e., delayed investment); the implication is that existing debt has a negative effect on
investment.
7. (a) NPVA = .5(90+20) – 50 = 5 NPVB = 60 – 50 = 10
(b) F = 50. Shareholders payoff: A → .5(40+0) = 20 B → 60 –50 = 10
Shareholders will pick A. Expected payoff to bondholders = .5(50+20) = 35.
(c) Let F = face value. Then, bondholders want .5(F+20) = 50, or F = 80.
With this F, shareholders’ payoff: A → .5(10+0) = 5 B → 60 – 80 = -20. Will pick A.
(d) Because of the agency problem, shareholders payoff is 5 instead of 10. Thus, agency cost = 10 – 5 = 5.
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Name: __________________________________ _______ Student ID#: ___________________
M.FIN. F711 C01 (Wednesday) Mergers, Restructuring and Corporate Control (Fall 2019)
Test 2
Instructions:
a) This test consists of nine (9) questions over five (5) pages; you have 1½ hours to complete it.
b) The maximum score is 35 points; the point distribution details are given alongside the questions.
c) You are allowed to bring in one page (single side) of formulas.
1. Company A makes a tender offer to shareholders of company T (trading at $P0) at a 20% premium. The managers of
company T, who jointly own 51% of the stock, do not tender; as a result, the tender fails. The price of T after the failure
will be: (1 point)
(a) less than P0 (b) P0 (c) between P0 and 1.2 P0 (d) greater than 1.2 P0
Why? (2 points)
2. Why does issuing callable debt send a positive signal? (2 points)
3. You have to choose between two technologies, A (which has higher fixed operating cost and lower variable operating
cost) and B (which has lower fixed operating cost and higher variable operating cost). If you choose technology A, it would
send a ________________________ (positive/negative) signal to the market. Why? (3 points)
4. If you would like to increase your firm’s EPS by means of acquisition(s), you should acquire companies with P-E ratio
_____________ (higher / lower) than your company (everything else remaining the same). Why? (2 points)
5. A well-known defensive (anti-takeover) tactic is to use a Leveraged Recap (issue debt and use the proceeds to buy back
equity). How could this deter potential acquirers? (2 points)
6. In this figure, the average cost is shown as a function of the output rate, and illustrates increasing returns to scale. After
a year, the average cost will change because of the learning curve. In the diagram, draw (approximately) the average cost
curve after a year. (3 points)
2
4
6
8
10
0.8 1.8 2.8
Average
Cost
Output Rate
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7. The stocks of companies B and T are trading at $20 and $15, and the number of outstanding shares 30 and 20, respectively.
Firm B wishes to acquire T, and operating synergies are expected to be worth $145. B’s management believes that T can be
realistically acquired at a premium of 50% if the offer is in cash.
(a) How large should a cash offer be? Will it be acceptable to both sets of shareholders? (2 points)
(b) T is in a different industry, hence there is some uncertainty about the synergy estimate. B’s management would therefore
prefer a stock offer. However, this would send a negative signal, which is expected to be as large as 5% based on past
evidence. On the other hand, a stock offer can be 5% lower than a cash offer because it will be a non-taxable transaction.
Taking these issues into account, what exchange ratio should B offer? (5 points)
8. Exxon had 2431 million shares trading at $72, and Mobil had 780 million shares trading at $75.50. Exxon makes a stock
offer to Mobil’s shareholders, 1.32 shares of Exxon for each share of Mobil. The market response to the announcement (i.e.,
event return) is +3.1% for Exxon and +20.6% for Mobil.
(a) Looking at the event return for Mobil (20.6%), and ignoring signaling effects, what is the market’s estimate of the dollar
value of synergies from the merger? (4 points)
(b) Based on the above synergy estimate (from part (a)), what should Exxon’s event return have been (instead of 3.1%)? (1
point)
(c) Now suppose the market expects a signaling effect of 5% because of the stock offer. What would your answer to part (a)
be? (2 points)
9. Firm B (bidder) has 10 million shares outstanding, trading at $35 a share; firm T (target) has 5 million shares
outstanding, trading at $25 a share. Firm B wishes to acquire T using its own stock. Operating synergies are expected to
be worth $35 million in present-value terms. Firm B has been advised by its investment banker that firm T can be
acquired by making an offer worth $30 per share.
(a) What exchange ratio should firm B offer? (3 points)
(b) If, instead, B offers $12.50 cash per share plus 1 share of B for every 2 shares of T, what is the expected price of firm
B’s stock after completion of the acquisition? What is the expected event return for T’s shareholders? (3 points)
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F711 c01 Fall 2019 (Wednesday section) Test 2 answers
1. d. Because the managers, being insiders, know that 20% is too small a premium (since they reject the offer).
2. Because the firm is willing to pay the option premium (for the option to call) now in return for the option to call later,
which implies that the option is under-valued. This in turn implies that the firm expects default risk to fall more than the
market does.
3. Positive; you choose the high-fixed-cost technology because you expect high business volume or low volatility (both
positive).
4. Lower P-E ratio.
If P-E ratio is lower, it means that for the same price the earnings level of the target company is higher; this boosts the EPS
of the acquiring company. (Note that this does not imply a higher value, just a higher EPS, like in the bootstrapping example
in the courseware, chapter 5).
5. (i) higher leverage makes the company less attractive, and (ii) higher price (because of positive signal of buying back stock)
makes acquisition more expensive.
6. The Average Cost curve after a year will be of the same shape but lower that the current one.
7. (a) B: 20*30 = 600. T: 15*20 = 300. Synergies = 145. Total = 1045.
Offer $22.50 per share, or $450 total. A’s shareholders will find it acceptable. B’s shareholders worth 1045 – 450 = 595.
Therefore, not acceptable to B’s shareholders.
(b) B: .95(600) = 570. Total = 570+300+145= 1015. Offer .95(450) = 427.50.
Offer x shares, then x/(30+x) = 427.50/1015, or x = 21.83. Exchange ratio = 21.83:20 or 1.09 shares of B for one of T.
8. (a) Values: Exxon = 2431*72 = 175 billion, Mobil = 780*75.50 = 58.9 billion. #shares = 2431+1.32*780 = 3460.6
million
Let S = EPV of synergies. Then, post price P = value/#shares = (58.9+175+S)*1000/3460.6.
Must have 1.32*P = 1.206*75.50, or P = 68.98. Substituting into above, we get S = $4.81 billion.
(b) If S = 4.81, Exxon’s event return = 68.98/72 – 1 = –4.19%.
(c) Value = (58.9+175*.95+S), and P = (58.9+175*.95+S)*1000/3460.6. Must have 1.32*P = 1.206*75.50, which gives:
S = $13.56 billion.
9. Values: B = 10*35 = 350, T = 5*25 = 125, Synergies = 35, Total value (post-acquisition) = $510 million.
(a) Want to make offer worth 5*30 = $150 million; say, offer x million shares; then x/(10+x) = 150/510, giving x =
4.1667, or exchange ratio = 4.1667/5 = 0.8333 for 1.
(b) T’s shareholders get (per share) 12.50 in cash plus 0.5 shares of B. Total cash paid out = 5*12.50 = $62.5 million.
Total number of shares (post-acquisition) = 10+2.5 = 12.5 million. Total value (post-acquisition) = 510–62.5 = $447.5
million, and price = 447.5/12.5 = $35.80.
T’s shareholders’ stake is worth = 12.50 + 0.5*35.80 = 30.40, hence event return = 30.40/25–1 = 21.6%.
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Name: __________________________________ _______ Student ID#: ___________________
M.FIN. F711 C01 (Wednesday) Mergers, Restructuring and Corporate Control (Fall 2019)
Test 3
Instructions:
a) This test consists of nine (9) questions over four (4) pages; you have 1½ hours to complete it.
b) The maximum score is 30 points; the point distribution details are given alongside the questions.
c) You are allowed to bring in one page (single side) of formulas.
1. A company needs to raise funds and plans to issue equity. When would it prefer a subsidiary carve-out over a company
IPO? (2 points)
2. DIP (debtor in possession) financing is “super-priority” financing available to firms in Chapter 11 reorganization, where
the DIP lender becomes the most senior lender. DIP financing is expected to lead to a(n) ___________________ (decrease
/ increase) in the risk shifting or asset substitution incentive. Why? (2 points)
3. The yield spread on a corporate bond is greater than zero because of: (3 points)
(i)
(ii)
Which of these is more important for AAA-rated bonds? Why?
4. In an LBO, value is often added by reducing agency problems between managers and shareholders. This improvement
should show up in the cash flow projections under: (1 point)
(a) capital expenditures (b) tax payments (c) operating margin (d) interest payments
5. When a company buys back its stock, it becomes a __________ (more / less) attractive takeover target. Give two reasons.
(2 points)
6. Sometimes shares are repurchased in order to deter a potential acquirer of the firm. The _______________ (FPT/DAR)
method is more effective for this purpose. Why? (2 points)
7. The stocks of companies A and T are trading at $36 and $17.50 respectively. Firm A wishes to acquire T and makes an
offer (to T’s shareholders) of 0.25 shares of A plus $12 cash for every share of T. At this announcement, the price of A falls
to $34 and that of T rises to $20. If there was no margin and you could get the short-sale proceeds immediately, what zero-
investment arbitrage position would you take at announcement and what dollar profit would this generate? (Ignore
transactions costs) (3 points)
8. A firm with a million shares outstanding wants to buy back 25% of its stock, using a Dutch Auction Repurchase (DAR).
The company collects the following information: no shareholder is willing to sell at or below $100, while all shareholders
are willing to sell at $200; also, there is a linear relationship between the number of shareholders willing to sell and the price
at which they are willing to sell.
(a) What is the supply curve? At what price will the company repurchase the stock? (2 points)
(b) What are the expected event returns for the selling and non-selling shareholders? (1 point)
(c) What will be the post-DAR supply curve? (3 points)
9. Company A had 30% debt and 70% equity (in market value terms). It had 1 million shares outstanding (of which the
management held 30%), with the stock trading at $35; it also had perpetual debt with a yield-to-maturity of 12%. It
decides on a leveraged recapitalization by issuing an additional $15 million of (equal-seniority) debt and using the
proceeds to buy back stock. The value of the old debt falls by 20% as a result of the recapitalization. The company’s tax
rate is 40%. The signaling effect is expected to be 2.5%.
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(a) If the management wants to buy back the stock at a fair price, how many shares must it buy back and at what price? (6
points)
(b) What will be the leverage ratio (debt to total firm value) after the recap? (1 point)
(c) If none of the managers participate in the share repurchase program, what will be the management shareholding after
the recap? (2 points)
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F711 c01 Fall 2019 (Wednesday section) Test 3 answers
1. (i) when subsidiary has a higher growth rate, (ii) when subsidiary has a lower cost of equity, (iii) when parent
company’s stock is underpriced.
2. decrease; because shareholders do not need to “go for broke” (take large gambles) now.
3. (i) default risk, (ii) systematic risk.
Systematic risk is more important for high-grade bonds because there is very little default risk.
4. (c).
5. less; (i) price is higher, and (ii) management ownership is higher.
6. DAR; because the highest-reservation-price shareholders will remain.
7. long 1 T, short 0.25 A and borrow $11.50.
CF0 = -20+0.25(34)+11.50 = 0. CF1 = –0.25A+0.25A+12-11.50(1+i) > 0.
Dollar profit = 12 – 11.5(1+i).
8. (a) V(r) = 100 +100r, where r is in millions. Buy back at $125
(b) expected return to both = 25%
(c) V(r) = (100+100r)/.75 – 125(.25/.75) = 133.33+133.33r-41.67.
But buy back 0.25, hence r is replaced with (r+.25), giving: V(r) = 133.33+133.33(r+.25)-41.67 =
125+133.33r.
9. (a) No. of shares = 1 (.3 management and .7 non-management). E = 35, D = 15, V = E+D = 50
Tax shield = 15(0.4) = 6.
Bankruptcy cost: Coupon on old debt = .12*15 = 1.8; old debt value falls from 15 to 12, hence YTM becomes 1.8/12 = .15.
This is also the YTM of the new debt, since equal seniority. Therefore, YTM increases from 12% to 15% because of default
risk, hence additional interest = 3% of 15 = 0.45. This is the extra cost because of higher default risk, hence this is the
bankruptcy cost per year. The present value of this perpetual stream is 0.45/0.15 = $3 million.
Post-LR values: D = 15 – 3 + 15= 27. V= 50 + 6 – 3 + (2.5% of 35) = 53.875. E = V – D = 26.875.
Say, buy back N shares @P; then, NP = 15, and (1–N)P = 26.875; gives P = $41.875 and N = 0.3582 million shares.
(b) Leverage = 27/(53.874) = 50.12%.
(c) Management owns 0.3/(1–0.3582) = 46.74%.
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Name: __________________________________ _______ Student ID#: ___________________
Business F721. Mergers, Restructuring and Corporate Control (Fall 2019)
Test 1
Instructions:
a) This test consists of nine (9) questions over four (4) pages; you have 1½ hours to complete it.
b) The maximum score is 25 points; the point distribution details are given alongside the questions.
c) You are allowed to bring in one page (single side) of formulas.
1. A one-year project requires an initial investment of $C0 and returns $C1 at the end of the year. Show that the IRR of the
project is the same as the return on investment. (2 points)
2(a). Shareholders prefer a _______________ (higher/lower) leverage ratio than bondholders. Why? (2 points).
(b). Managers prefer a _______________ (higher/lower) leverage ratio than shareholders. Why? (2 points).
3. When a company increases its leverage ratio, its cost of debt _________________________ (rises/falls/stays the same).
Why? (2 points)
4. Bondholder-stockholder agency problems will have a __________________ (positive / negative) on the optimal
leverage ratio. Why? (2 points)
5. A dividend restriction reduces the _____________________ (underinvestment / risk shifting) agency problem of debt.
Explain. (2 points)
6. According to the Pecking Order Hypothesis, firms prefer debt to equity in financing their investments. How can
signaling explain this preference for debt? (1 point)
7. Signaling effects will have a __________________ (positive / negative) on the optimal leverage ratio. Why? (2 points)
8. A firm has an irreversible investment project. There is an initial investment requirement of $1600 1060; once the project
is (instantaneously) implemented, it will produce 1 unit of the output per year, and the operating cost is zero. The current
output price is $P per unit, but the price will change next year to either 1.2P or 0.8P (with equal probabilities); and will
remain unchanged thereafter. The appropriate discount rate is 12%. The decision rule is: invest now if P equals or exceeds
P*.
(a) Compute P*. (3 points)
(b) If the company has existing debt, and the new project is financed with equity, will P* be higher or lower than in part
(a)? Why? (2 points)
9. A firm has a leverage ratio (debt to assets) of 80% in market-value terms. Its equity has a market value of $20 million, and
its (perpetual) debt has a yield of 12.5%. There is an investment opportunity requiring an outlay of $20 million, with an NPV
of $6 million. Since additional debt is ruled out, equity holders will have to finance the project, if accepted. If the project is
accepted, default risk will fall, as a result of which the yield on the firm’s debt will fall to 11.5%.
(a) Will the project be acceptable to shareholders? Explain. (3 points)
(b) What is the minimum project NPV that would make it acceptable to shareholders? (2 points)
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F721, Fall 2019. Test 1 answers
1. ROI = C1/ C0 – 1. Let IRR = i; then, NPV = C0 – C1/(1+i) = 0, giving i = C1/ C0 – 1. Thus, ROI = IRR.
2(a). Higher. Because they benefit from tax shield and they are not as worried (as bondholders) about default risk; they
also benefit from the disciplining effect of high debt level on manager (Jensen’s Free Cash Flow hypothesis). (b). Lower.
Because managers’ human capital is NOT diversified, they want lower default risk.
3. rises. Because of higher default risk.
4. negative; because greater leverage results in greater incentives to engage in underinvestment and asset substitution, hence
agency cost is an increasing function of leverage; this results in a lower optimal leverage ratio.
5. underinvestment; dividend reduction helps build up cash unproductive cash reserves, and with surplus cash the firms is
more likely to invest or less likely to under-invest.
6. The negative signal from an equity issue is much greater than the negative signal from a debt issue, hence debt
financing is preferable.
7. positive; because increasing the leverage ratio sends a positive signal (resulting in rise in stock price and equity value).
8.(a) NPV of investing now = P/.12 – 1060 = 8.33P – 1060.
If wait and P rises, NPV = 1.2P/.12 – 1060 = 10P – 1060; if wait and P falls, NPV = 0
Then, NPV of waiting = .5(10P – 1060)/1.12
Invest now if 8.33P – 1060 > .5(10P – 1060)/1.12; gives P* = $152.
(b) P* will be higher; because of Underinvestment.
9. (a) D = 80, coupon = .125*80 = 10. With new project, debt value = 10/.115 = 86.96.
Thus, debt value will rise 6.96. Since project NPV = 6, equity value will fall, and equity holders will
NOT find the project acceptable.
(b) Minimum project NPV = 6.96.
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Name: __________________________________ _______ Student ID#: ___________________
Business F721. Mergers, Restructuring and Corporate Control (Fall 2019)
Test 2
Instructions:
a) This test consists of eight (8) questions over five (5) pages; you have 1½ hours to complete it.
b) The maximum score is 35 points; the point distribution details are given alongside the questions.
c) You are allowed to bring in one page (single side) of formulas.
1(a). The “co-insurance effect” occurs in _________________________ (strategic/financial/conglomerate) acquisitions.
Why? (2 points).
1(b). Co-insurance results in a conflict of interest between shareholders and bondholders because wealth is transferred from
__________________________ to _________________________. (2 points).
1(c). How can shareholders take advantage of the co-insurance effect? (1 point).
2. If you would like to increase your firm’s EPS by means of acquisition(s), you should acquire companies with P-E ratio
_____________ (higher / lower) than your company (everything else remaining the same). Why? (3 points)
3. A well-known defensive (anti-takeover) tactic is to use a Leveraged Recap (issue debt and use the proceeds to buy back
equity). How could this deter potential acquirers? (3 points)
4. When company A acquires a publicly-traded company T using stock financing, A’s event return is generally
_____________________ (higher than / lower than / the same as) when using cash financing. Why? (2 points)
5. What if firm T (in question 4) was a private firm? (2 points)
6. B (bidding company) has 20 million shares and a net income of $40 million, and T (target company) has 10 million
shares and a net income of $10 million. Operating synergies are expected to increase net income by $4 million per year. B
has decided to finance the acquisition with stock.
(a) If neither set of shareholders would find a reduction in EPS (upon acquisition) acceptable, what are the two limits on
the exchange ratio that can be offered? (4 points)
(b) If expected operating synergies were larger, you would expect the spread between the two limits to be _____________
(narrower / wider / the same). (2 point)
7. The stocks of companies B and T are trading at $20 and $15, and the number of outstanding shares 30 and 20, respectively.
Firm B wishes to acquire T, and operating synergies are expected to be worth $145. B’s management believes that T can be
realistically acquired at a premium of 40% if the offer is in cash.
(a) How large should a cash offer be? Will it be acceptable to both sets of shareholders? (3 points)
(b) T is in a different industry, hence there is some uncertainty about the synergy estimate. B’s management would therefore
prefer a stock offer. However, this would send a negative signal, which is expected to be as large as 5% based on past
evidence. On the other hand, a stock offer can be 15% lower than a cash offer because it will be a non-taxable transaction.
Taking these issues into account, what exchange ratio should B offer? (3 points)
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8. Firm A (acquirer) had 2431 million shares trading at $72, and firm T (target) had 780 million shares trading at $75.50.
Firm A wants to acquire T using its own stock, and expects the resulting signaling effect to be 4% in magnitude. Operating
synergies are expected to be worth $25 billion.
(a) If firm A knows that its own shareholders would require a return on acquisition of 3%, what is the maximum exchange
ratio that A can offer T’s shareholders? (5 points)
(b) If, however, firm A ends up offering an exchange ratio of 1.32:1 (that is, 1.32 shares of A for every share of T), what is
the expected event return for A’s shareholders? For T’s shareholders? (3 points)
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F721 Fall 2019. Test 2 Answers
1. (a) Conglomerate. Because the assets of company A can be used to secure the debt of both company A & company T.
Also, the assets of T can be used to secure the debt of both T & A. Thus, the assets are co-insuring the other company’s
debt. However, it is possible only when the assets are not perfectly correlated. Therefore, Conglomerate.
(b) Shareholders, Bondholders. (c) By issuing more debt, which increases equity value because of the resulting tax shield.
This is possible because co-insurance increases the firms’ debt capacity.
2. Lower P-E ratio.
If P-E ratio is lower, it means that for the same price the earnings level of the target company is higher; this boosts the
EPS of the acquiring company. (Note that this does not imply a higher value, just a higher EPS, like in the bootstrapping
example in the courseware, chapter 5).
3. (i) higher leverage makes the company less attractive, and (ii) higher price (because of positive signal of buying back stock)
makes acquisition more expensive.
4. lower; because stock financing sends a negative signal which drives down A’s stock price.
5. higher; for a private firm, risk-sharing is a major requirement since there is uncertainty regarding the value of the target
company (since it is private). Since stock financing has the risk-sharing property that is desired, it gives a higher event
return.
6. (a) B: number of shares = 20, net income = 40, hence EPS = 2; T: number of shares = 10, net income = 10, hence EPS = 1.
Synergies = 4, hence net income of combined firm = 54. If exchange ratio offered is x, then new shares = 10x, so total shares
= 20+10x.
EPS of combined firm = 54/(20+10x). This has to exceed B’s EPS, or 54/(20+10x) > 2, giving x < 0.7.
Also, T’s shareholders will have x for each share they had, so their post-acquisition EPS will be x(54/(20+10x)), and this
should exceed their old EPS or 1. This means x(54/(20+10x)) > 1, giving x > 0.455.
Thus, the two limits are 0.455 and 0.7.
(b) If operating synergies are expected to be larger, the spread between the two limits would be wider.
7. (a) B: 20*30 = 600. T: 15*20 = 300. Synergies = 145. Total = 1045.
Offer $15 * 1.4 = 21 per share, or $420 total. B’s shareholders worth 1045 – 420 = 625. Therefore, it will be acceptable
to B’s shareholders.
(b) B: .95(600) = 570. Total = 570+300+145= 1015. Offer .85(420) = 357.
Offer x shares, then x/(30+x) = 357/1015, or x = 16.28. Exchange ratio = 16.28:20 or 0.814 shares of B for one of T.
8. (a) Values: A = 2431*72 = $175.032 billion, T = 780*75.50 = $58.89 billion, synergies = $25 billion.
But, because of the 4% signaling effect, A’s value falls to 175.032*0.96 = $168.031 at announcement.
Thus, total post-acquisition value = 168.031+58.89+25 = $251.921 billion.
Suppose the offer is x for 1; then, total number of shares post-acquisition = (2431+780x) million; hence, post-acquisition
price of A = 251.921/(2.431+0.78x).
For A’s shareholders to have acquisition event return of 3%, this price should be 3% higher than the initial price of $72, or
72*1.03 = $74.16. This gives 251.921/(2.431+0.78x) = 74.16, or x = 1.2385. Therefore, maximum x is 1.2385.
(b) If A offers 1.32 for 1, total number of shares post-acquisition = (2.431+0.78*1.32) = 3.4606 billion. Then, post-
acquisition stock price = 251.921/3.4606 = $72.80. A’s shareholders’ event return = 72.80/72 – 1 = 1.11%, and T’s
shareholders’ event return = (72.80*1.32)/75.50 – 1 = 27.28%.
---------------------------------------------------------------- END ----------------------------------------------------------------
14
Name: __________________________________ _______ Student ID#: ___________________
Business F721. Mergers, Restructuring and Corporate Control (Fall 2019)
Test 3
Instructions:
a) This test consists of seven (7) questions over four (4) pages; you have 1½ hours to complete it.
b) The maximum score is 30 points; the point distribution details are given alongside the questions.
c) You are allowed to bring in one page (single side) of formulas.
1. In an LBO, two major sources of value are increase in tax shields and reduction of manager-shareholder agency
problems. Which group generally captures most of these benefits?
Additional tax shields: _________________________________ (old shareholders / new [LBO] shareholders). Why? (2
points)
Reduced agency problems: _________________________________ (old shareholders / new [LBO] shareholders). Why?
(2 points)
2. The yield spread on a corporate bond is greater than zero because of: (3 points)
(i)
(ii)
Which of these is more important for AAA-rated bonds? Why?
3. A well-known defensive (anti-takeover) tactic is to use a Leveraged Recap. List three ways in which a leveraged recap can
deter potential acquirers. (3 points)
4. The transferable put right (TPR) method of stock repurchase has the advantage of not requiring pro-rating. List three
advantages of not having to pro-rate. (3 points)
5. You are the sole shareholder of a company you started a few years ago. The company has perpetual debt with coupon
payments of $1 million per year, and the debt has an YTM of 10%. Your after-tax cash flow from the business this year
was $950,000 (clearly not enough to make the interest payment this year), but is expected to grow at 4% in perpetuity.
You now have to decide whether to file for bankruptcy or pay the shortfall from your own pocket. What will you do, and
why? The WACC is 12%.(3 points)
6. Company A has 10 million shares outstanding (20% held by management shareholders), trading at $20 per share. It has
no debt, and faces a tax rate of 30%. There is a proposal to issue $100 million of debt, and use the proceeds to buy back
stock. Bankruptcy costs resulting from the debt issue are expected to be $5 million, and the signaling effect of the recap is
expected to be 4%.
(a) If the company wants to ensure that remaining and exiting shareholders enjoy identical event returns (in expectation),
how many shares should it repurchase, and at what price? What is the (expected) event return? What is the percentage
management shareholding after the LR? (5 points)
(b) If, instead, it has to offer a premium of 25% to repurchase the stock, what will be the (expected) event return to remaining
shareholders? (2 points)
7. Company A’s stock was trading at $20, and the management held 10% of the outstanding equity. It announces a Fixed
Price Tender of 20% of the stock at a 25% premium. After the repurchase is completed, the stock trades at $23.
(a) What is the overall event return? (2 points)
(b) In part (a), suppose the manager decides on a Dutch Auction Repurchase instead of a Fixed Price Tender. She finds
that no shareholder is willing to sell to the company at or below $20, and all shareholders are willing to sell at $35. If
there is a linear relationship between the number of shareholders willing to sell and the price at which they are willing to
sell, and if the total number of shares is 100, what is the supply curve? With this supply curve, what premium would the
company have to offer? What would be the post-DAR supply curve and the post-repurchase stock price? What would be
the overall expected event return? (5 points)
15
F721 Fall 2019. Test 3 Answers
1. Old shareholders; because the value created is easy to (approximately) estimate.
New (LBO) shareholders; because the value created is impossible to estimate.
2. (i) default risk, (ii) systematic risk.
Systematic risk is more important for high-grade bonds because there is very little default risk.
3. (i) higher stock price, (ii) higher management holding, (iii) higher leverage ratio.
4. (i) no unhappy shareholders remaining; (ii) lowest-reservation-price shareholders are the first to leave; (iii) with pro-rating,
an arbitrageur can acquire a large block of shares and be in an advantageous position to bargain for a better deal (higher
premium) from management; this is avoided if there is no pro-rating.
5. Market value of debt = 1/.1 = 10 million. Value of firm’s assets = .95*1.04/(.12–.04) = 12.35 million.
Since asset value exceeds liability value, company should not file for bankruptcy but should pay bondholders from their
own pockets to keep the company alive.
6. (a) Post: V = 200+.3(100)–5+.04*200= 233. E = V – D = 233 – 100 = 133.
Suppose buy back N shares at price P. Then NP = 100 and (10–N)P = 133; gives P = 23.30 and N = 4.29.
Expected event return = 23.30/20 – 1 = 16.5%, management holding = 2/(10-4.29) = 35%.
(b) Offer 1.25*20 = 25. Shares bought back = 100/25 = 4 million, remaining shares = 6, P = 133/6 = 22.17.
Even return = 22.17/20 – 1 = 10.83%.
7. a). 20% shareholders get a return of 25%, 80% shareholders get a return of 15%. ($23/20-1 = 15%);
Overall Event Return = 0.2(25) + 0.8(15) = 17%
b). Intercept = Current Price = $20, No. of shares = 100, All willing to sell at $ 35, = 20 + 0.15 is the supply
curve.
Premium: To buy 20 shares, have to offer price = 20 + 0.15(20) = $23, so premium = 23/20 – 1 = 15%.
Supply curve: (20+15r)/.8 = 25+0.1875r. But paying out 23(20), on a per-share basis, this comes to 23(20)/(80) = $5.75.
This gives: V(r) = 25+0.1875r–5.75 = 19.25+0.1875r.
However, 20 of the shareholders leave, therefore r is replaced with (r+20). This gives: V(r) = 23+0.1875r.
Post-repurchase Price = # 23 Return = 15%
Overall expected event return = 15%
------------------------------------------------------------ END ------------------------------------------------------------
Name: __________________________________ _______ Student ID#: ___________________
M.FIN. F711 C01 (Wednesday) Mergers, Restructuring and Corporate Control (Fall 2019)
Test 1
Instructions:
a) This test consists of seven (7) questions over four (4) pages; you have 1½ hours to complete it.
b) The maximum score is 25 points; the point distribution details are given alongside the questions.
c) You are allowed to bring in one page (single side) of formulas.
1. The real option approach to capital budgeting will be more useful for the _____________________ (food / petroleum)
industry. Why? (1 point)
2(a). Shareholders prefer a _______________ (higher/lower) leverage ratio than bondholders. Why? (2 points).
(b). Managers prefer a _______________ (higher/lower) leverage ratio than shareholders. Why? (2 points).
3. Firm A uses no debt. Its decision rule for expansion is: invest as soon as output price rises to some critical level PA.
Firm B is similar, except that it is levered; its decision rule is: invest as soon as price rises to PB. If both firms finance the
expansion with equity, then PA is ______________________ (greater than / smaller than / equal to) PB. Why? (2 points)
4. If your company switches to a technology with greater production flexibility, how will it affect the firm’s optimal leverage
ratio? Explain. (4 points)
5. Your company is planning to issue convertible bonds with a face value of $1,000, a conversion price of $25, and a
coupon rate of 5%. (i) What is an agency-theory rationale for issuing convertible debt rather than straight (non-
convertible) debt? (ii) If the conversion price was changed to $40, would it strengthen or weaken the argument of part (i)?
Explain. (iii) If you decided on the $40 conversion price, the coupon rate will likely be ________________________
(larger than / smaller than / equal to) 5%. Why? (3 points)
6. A firm has an investment project that is completely irreversible (i.e., no part of the initial investment can be recovered).
The initial investment is $100; once the project is (instantaneously) implemented, it will produce 1 unit of the output per
year (forever), and the operating cost is zero. The current output price is P per unit, but the price will either increase by
20% or fall by 40% next year (with probability 2/3 and 1/3 respectively); and will remain unchanged thereafter. The
appropriate discount rate is 10%.
(a) What is the critical investment price (i.e., the price at which investment should be made today)? (1 point)
(b) Now suppose the firm has existing debt (one-year maturity) with face value of $40. What will be the critical
investment price? (2 points)
(c) What type of agency problem is illustrated in part (b)? And what does it imply regarding the effect of debt on
investment? (1 point)
7. ManU Corp. has two mutually exclusive $50 million projects, which it plans to finance with debt. Project A will pay off
$90 million if the economy is good, but only $20 million if the economy is poor (both are equally likely). Project B will pay
off $60 million for certain. Investors are risk-neutral and the discount rate is 0.
(a) What is the NPV of each project? (1 point)
(b) Suppose ManU can raise the $50 million by issuing a bond with face value of $50 (because the lender naively believes
the company will take the safe project). Which project will ManU’s shareholders prefer? What is the expected payoff to the
naïve lender? (2 points)
(c) If the lender is sophisticated, what will be the face value of the bond, and which project will the company choose? (2
points)
(d) What is the magnitude (dollar amount) of agency cost to shareholders? (2 points)
----------------------------------------------------------- END -----------------------------------------------------------
2
M.FIN. F711 C01 (Wednesday) Test 1 Answers
1. petroleum; because there is more uncertainty in the petroleum industry.
2(a). Higher. Because they benefit from tax shield and they are not as worried (as bondholders) about default risk; they
also benefit from the disciplining effect of high debt level on manager (Jensen’s Free Cash Flow hypothesis).
(b). Lower. Because managers’ human capital is NOT diversified, they want lower default risk.
3. smaller; B will underinvest, since it has debt.
4. With greater production flexibility, firm value will rise, hence optimal leverage ratio higher.
But also greater scope for asset substitution, hence optimal leverage will fall.
Overall effect: not sure, depends on which effect dominates. Thus, optimal leverage ratio might rise or fall.
5. (i) It mitigates the asset substitution problem. (ii) If conversion price is raised, probability of conversion is reduced,
hence convertible holders are less likely to become shareholders; thus, it weakens the argument. (iii) Higher; with higher
conversion price, the conversion option becomes less valuable; the convertible holder will have to be compensated with a
higher coupon rate.
6. (a) NPV of investing now, NPV0 = [(2/3)(1.2P)+(1/3)(.6P)]/0.1 – 100 = 10P–100.
NPV of waiting, NPVw = [(2/3)(12P–100)]/1.1 = (8P–200/3)/1.1
It is optimal to invest now if NPV0 > NPVw, or P > 14.44.
(b) With debt, shareholder payoffs will be different:
NPV0 = 10P–100–40/1.1 = 10P – 150/1.1. NPVw = [(2/3)(12P–100–40)]/1.1
It is optimal to invest now if NPV0 > NPVw, or P > 18.89.
(c) This illustrates under-investment (i.e., delayed investment); the implication is that existing debt has a negative effect on
investment.
7. (a) NPVA = .5(90+20) – 50 = 5 NPVB = 60 – 50 = 10
(b) F = 50. Shareholders payoff: A → .5(40+0) = 20 B → 60 –50 = 10
Shareholders will pick A. Expected payoff to bondholders = .5(50+20) = 35.
(c) Let F = face value. Then, bondholders want .5(F+20) = 50, or F = 80.
With this F, shareholders’ payoff: A → .5(10+0) = 5 B → 60 – 80 = -20. Will pick A.
(d) Because of the agency problem, shareholders payoff is 5 instead of 10. Thus, agency cost = 10 – 5 = 5.
----------------------------------------------------------- END -----------------------------------------------------------
3
Name: __________________________________ _______ Student ID#: ___________________
M.FIN. F711 C01 (Wednesday) Mergers, Restructuring and Corporate Control (Fall 2019)
Test 2
Instructions:
a) This test consists of nine (9) questions over five (5) pages; you have 1½ hours to complete it.
b) The maximum score is 35 points; the point distribution details are given alongside the questions.
c) You are allowed to bring in one page (single side) of formulas.
1. Company A makes a tender offer to shareholders of company T (trading at $P0) at a 20% premium. The managers of
company T, who jointly own 51% of the stock, do not tender; as a result, the tender fails. The price of T after the failure
will be: (1 point)
(a) less than P0 (b) P0 (c) between P0 and 1.2 P0 (d) greater than 1.2 P0
Why? (2 points)
2. Why does issuing callable debt send a positive signal? (2 points)
3. You have to choose between two technologies, A (which has higher fixed operating cost and lower variable operating
cost) and B (which has lower fixed operating cost and higher variable operating cost). If you choose technology A, it would
send a ________________________ (positive/negative) signal to the market. Why? (3 points)
4. If you would like to increase your firm’s EPS by means of acquisition(s), you should acquire companies with P-E ratio
_____________ (higher / lower) than your company (everything else remaining the same). Why? (2 points)
5. A well-known defensive (anti-takeover) tactic is to use a Leveraged Recap (issue debt and use the proceeds to buy back
equity). How could this deter potential acquirers? (2 points)
6. In this figure, the average cost is shown as a function of the output rate, and illustrates increasing returns to scale. After
a year, the average cost will change because of the learning curve. In the diagram, draw (approximately) the average cost
curve after a year. (3 points)
2
4
6
8
10
0.8 1.8 2.8
Average
Cost
Output Rate
4
7. The stocks of companies B and T are trading at $20 and $15, and the number of outstanding shares 30 and 20, respectively.
Firm B wishes to acquire T, and operating synergies are expected to be worth $145. B’s management believes that T can be
realistically acquired at a premium of 50% if the offer is in cash.
(a) How large should a cash offer be? Will it be acceptable to both sets of shareholders? (2 points)
(b) T is in a different industry, hence there is some uncertainty about the synergy estimate. B’s management would therefore
prefer a stock offer. However, this would send a negative signal, which is expected to be as large as 5% based on past
evidence. On the other hand, a stock offer can be 5% lower than a cash offer because it will be a non-taxable transaction.
Taking these issues into account, what exchange ratio should B offer? (5 points)
8. Exxon had 2431 million shares trading at $72, and Mobil had 780 million shares trading at $75.50. Exxon makes a stock
offer to Mobil’s shareholders, 1.32 shares of Exxon for each share of Mobil. The market response to the announcement (i.e.,
event return) is +3.1% for Exxon and +20.6% for Mobil.
(a) Looking at the event return for Mobil (20.6%), and ignoring signaling effects, what is the market’s estimate of the dollar
value of synergies from the merger? (4 points)
(b) Based on the above synergy estimate (from part (a)), what should Exxon’s event return have been (instead of 3.1%)? (1
point)
(c) Now suppose the market expects a signaling effect of 5% because of the stock offer. What would your answer to part (a)
be? (2 points)
9. Firm B (bidder) has 10 million shares outstanding, trading at $35 a share; firm T (target) has 5 million shares
outstanding, trading at $25 a share. Firm B wishes to acquire T using its own stock. Operating synergies are expected to
be worth $35 million in present-value terms. Firm B has been advised by its investment banker that firm T can be
acquired by making an offer worth $30 per share.
(a) What exchange ratio should firm B offer? (3 points)
(b) If, instead, B offers $12.50 cash per share plus 1 share of B for every 2 shares of T, what is the expected price of firm
B’s stock after completion of the acquisition? What is the expected event return for T’s shareholders? (3 points)
------------------------------------------------------------ END ------------------------------------------------------------
5
F711 c01 Fall 2019 (Wednesday section) Test 2 answers
1. d. Because the managers, being insiders, know that 20% is too small a premium (since they reject the offer).
2. Because the firm is willing to pay the option premium (for the option to call) now in return for the option to call later,
which implies that the option is under-valued. This in turn implies that the firm expects default risk to fall more than the
market does.
3. Positive; you choose the high-fixed-cost technology because you expect high business volume or low volatility (both
positive).
4. Lower P-E ratio.
If P-E ratio is lower, it means that for the same price the earnings level of the target company is higher; this boosts the EPS
of the acquiring company. (Note that this does not imply a higher value, just a higher EPS, like in the bootstrapping example
in the courseware, chapter 5).
5. (i) higher leverage makes the company less attractive, and (ii) higher price (because of positive signal of buying back stock)
makes acquisition more expensive.
6. The Average Cost curve after a year will be of the same shape but lower that the current one.
7. (a) B: 20*30 = 600. T: 15*20 = 300. Synergies = 145. Total = 1045.
Offer $22.50 per share, or $450 total. A’s shareholders will find it acceptable. B’s shareholders worth 1045 – 450 = 595.
Therefore, not acceptable to B’s shareholders.
(b) B: .95(600) = 570. Total = 570+300+145= 1015. Offer .95(450) = 427.50.
Offer x shares, then x/(30+x) = 427.50/1015, or x = 21.83. Exchange ratio = 21.83:20 or 1.09 shares of B for one of T.
8. (a) Values: Exxon = 2431*72 = 175 billion, Mobil = 780*75.50 = 58.9 billion. #shares = 2431+1.32*780 = 3460.6
million
Let S = EPV of synergies. Then, post price P = value/#shares = (58.9+175+S)*1000/3460.6.
Must have 1.32*P = 1.206*75.50, or P = 68.98. Substituting into above, we get S = $4.81 billion.
(b) If S = 4.81, Exxon’s event return = 68.98/72 – 1 = –4.19%.
(c) Value = (58.9+175*.95+S), and P = (58.9+175*.95+S)*1000/3460.6. Must have 1.32*P = 1.206*75.50, which gives:
S = $13.56 billion.
9. Values: B = 10*35 = 350, T = 5*25 = 125, Synergies = 35, Total value (post-acquisition) = $510 million.
(a) Want to make offer worth 5*30 = $150 million; say, offer x million shares; then x/(10+x) = 150/510, giving x =
4.1667, or exchange ratio = 4.1667/5 = 0.8333 for 1.
(b) T’s shareholders get (per share) 12.50 in cash plus 0.5 shares of B. Total cash paid out = 5*12.50 = $62.5 million.
Total number of shares (post-acquisition) = 10+2.5 = 12.5 million. Total value (post-acquisition) = 510–62.5 = $447.5
million, and price = 447.5/12.5 = $35.80.
T’s shareholders’ stake is worth = 12.50 + 0.5*35.80 = 30.40, hence event return = 30.40/25–1 = 21.6%.
------------------------------------------------------------ END ------------------------------------------------------------
6
Name: __________________________________ _______ Student ID#: ___________________
M.FIN. F711 C01 (Wednesday) Mergers, Restructuring and Corporate Control (Fall 2019)
Test 3
Instructions:
a) This test consists of nine (9) questions over four (4) pages; you have 1½ hours to complete it.
b) The maximum score is 30 points; the point distribution details are given alongside the questions.
c) You are allowed to bring in one page (single side) of formulas.
1. A company needs to raise funds and plans to issue equity. When would it prefer a subsidiary carve-out over a company
IPO? (2 points)
2. DIP (debtor in possession) financing is “super-priority” financing available to firms in Chapter 11 reorganization, where
the DIP lender becomes the most senior lender. DIP financing is expected to lead to a(n) ___________________ (decrease
/ increase) in the risk shifting or asset substitution incentive. Why? (2 points)
3. The yield spread on a corporate bond is greater than zero because of: (3 points)
(i)
(ii)
Which of these is more important for AAA-rated bonds? Why?
4. In an LBO, value is often added by reducing agency problems between managers and shareholders. This improvement
should show up in the cash flow projections under: (1 point)
(a) capital expenditures (b) tax payments (c) operating margin (d) interest payments
5. When a company buys back its stock, it becomes a __________ (more / less) attractive takeover target. Give two reasons.
(2 points)
6. Sometimes shares are repurchased in order to deter a potential acquirer of the firm. The _______________ (FPT/DAR)
method is more effective for this purpose. Why? (2 points)
7. The stocks of companies A and T are trading at $36 and $17.50 respectively. Firm A wishes to acquire T and makes an
offer (to T’s shareholders) of 0.25 shares of A plus $12 cash for every share of T. At this announcement, the price of A falls
to $34 and that of T rises to $20. If there was no margin and you could get the short-sale proceeds immediately, what zero-
investment arbitrage position would you take at announcement and what dollar profit would this generate? (Ignore
transactions costs) (3 points)
8. A firm with a million shares outstanding wants to buy back 25% of its stock, using a Dutch Auction Repurchase (DAR).
The company collects the following information: no shareholder is willing to sell at or below $100, while all shareholders
are willing to sell at $200; also, there is a linear relationship between the number of shareholders willing to sell and the price
at which they are willing to sell.
(a) What is the supply curve? At what price will the company repurchase the stock? (2 points)
(b) What are the expected event returns for the selling and non-selling shareholders? (1 point)
(c) What will be the post-DAR supply curve? (3 points)
9. Company A had 30% debt and 70% equity (in market value terms). It had 1 million shares outstanding (of which the
management held 30%), with the stock trading at $35; it also had perpetual debt with a yield-to-maturity of 12%. It
decides on a leveraged recapitalization by issuing an additional $15 million of (equal-seniority) debt and using the
proceeds to buy back stock. The value of the old debt falls by 20% as a result of the recapitalization. The company’s tax
rate is 40%. The signaling effect is expected to be 2.5%.
7
(a) If the management wants to buy back the stock at a fair price, how many shares must it buy back and at what price? (6
points)
(b) What will be the leverage ratio (debt to total firm value) after the recap? (1 point)
(c) If none of the managers participate in the share repurchase program, what will be the management shareholding after
the recap? (2 points)
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8
F711 c01 Fall 2019 (Wednesday section) Test 3 answers
1. (i) when subsidiary has a higher growth rate, (ii) when subsidiary has a lower cost of equity, (iii) when parent
company’s stock is underpriced.
2. decrease; because shareholders do not need to “go for broke” (take large gambles) now.
3. (i) default risk, (ii) systematic risk.
Systematic risk is more important for high-grade bonds because there is very little default risk.
4. (c).
5. less; (i) price is higher, and (ii) management ownership is higher.
6. DAR; because the highest-reservation-price shareholders will remain.
7. long 1 T, short 0.25 A and borrow $11.50.
CF0 = -20+0.25(34)+11.50 = 0. CF1 = –0.25A+0.25A+12-11.50(1+i) > 0.
Dollar profit = 12 – 11.5(1+i).
8. (a) V(r) = 100 +100r, where r is in millions. Buy back at $125
(b) expected return to both = 25%
(c) V(r) = (100+100r)/.75 – 125(.25/.75) = 133.33+133.33r-41.67.
But buy back 0.25, hence r is replaced with (r+.25), giving: V(r) = 133.33+133.33(r+.25)-41.67 =
125+133.33r.
9. (a) No. of shares = 1 (.3 management and .7 non-management). E = 35, D = 15, V = E+D = 50
Tax shield = 15(0.4) = 6.
Bankruptcy cost: Coupon on old debt = .12*15 = 1.8; old debt value falls from 15 to 12, hence YTM becomes 1.8/12 = .15.
This is also the YTM of the new debt, since equal seniority. Therefore, YTM increases from 12% to 15% because of default
risk, hence additional interest = 3% of 15 = 0.45. This is the extra cost because of higher default risk, hence this is the
bankruptcy cost per year. The present value of this perpetual stream is 0.45/0.15 = $3 million.
Post-LR values: D = 15 – 3 + 15= 27. V= 50 + 6 – 3 + (2.5% of 35) = 53.875. E = V – D = 26.875.
Say, buy back N shares @P; then, NP = 15, and (1–N)P = 26.875; gives P = $41.875 and N = 0.3582 million shares.
(b) Leverage = 27/(53.874) = 50.12%.
(c) Management owns 0.3/(1–0.3582) = 46.74%.
----------------------------------------------------------------- END -----------------------------------------------------------------
9
Name: __________________________________ _______ Student ID#: ___________________
Business F721. Mergers, Restructuring and Corporate Control (Fall 2019)
Test 1
Instructions:
a) This test consists of nine (9) questions over four (4) pages; you have 1½ hours to complete it.
b) The maximum score is 25 points; the point distribution details are given alongside the questions.
c) You are allowed to bring in one page (single side) of formulas.
1. A one-year project requires an initial investment of $C0 and returns $C1 at the end of the year. Show that the IRR of the
project is the same as the return on investment. (2 points)
2(a). Shareholders prefer a _______________ (higher/lower) leverage ratio than bondholders. Why? (2 points).
(b). Managers prefer a _______________ (higher/lower) leverage ratio than shareholders. Why? (2 points).
3. When a company increases its leverage ratio, its cost of debt _________________________ (rises/falls/stays the same).
Why? (2 points)
4. Bondholder-stockholder agency problems will have a __________________ (positive / negative) on the optimal
leverage ratio. Why? (2 points)
5. A dividend restriction reduces the _____________________ (underinvestment / risk shifting) agency problem of debt.
Explain. (2 points)
6. According to the Pecking Order Hypothesis, firms prefer debt to equity in financing their investments. How can
signaling explain this preference for debt? (1 point)
7. Signaling effects will have a __________________ (positive / negative) on the optimal leverage ratio. Why? (2 points)
8. A firm has an irreversible investment project. There is an initial investment requirement of $1600 1060; once the project
is (instantaneously) implemented, it will produce 1 unit of the output per year, and the operating cost is zero. The current
output price is $P per unit, but the price will change next year to either 1.2P or 0.8P (with equal probabilities); and will
remain unchanged thereafter. The appropriate discount rate is 12%. The decision rule is: invest now if P equals or exceeds
P*.
(a) Compute P*. (3 points)
(b) If the company has existing debt, and the new project is financed with equity, will P* be higher or lower than in part
(a)? Why? (2 points)
9. A firm has a leverage ratio (debt to assets) of 80% in market-value terms. Its equity has a market value of $20 million, and
its (perpetual) debt has a yield of 12.5%. There is an investment opportunity requiring an outlay of $20 million, with an NPV
of $6 million. Since additional debt is ruled out, equity holders will have to finance the project, if accepted. If the project is
accepted, default risk will fall, as a result of which the yield on the firm’s debt will fall to 11.5%.
(a) Will the project be acceptable to shareholders? Explain. (3 points)
(b) What is the minimum project NPV that would make it acceptable to shareholders? (2 points)
10
F721, Fall 2019. Test 1 answers
1. ROI = C1/ C0 – 1. Let IRR = i; then, NPV = C0 – C1/(1+i) = 0, giving i = C1/ C0 – 1. Thus, ROI = IRR.
2(a). Higher. Because they benefit from tax shield and they are not as worried (as bondholders) about default risk; they
also benefit from the disciplining effect of high debt level on manager (Jensen’s Free Cash Flow hypothesis). (b). Lower.
Because managers’ human capital is NOT diversified, they want lower default risk.
3. rises. Because of higher default risk.
4. negative; because greater leverage results in greater incentives to engage in underinvestment and asset substitution, hence
agency cost is an increasing function of leverage; this results in a lower optimal leverage ratio.
5. underinvestment; dividend reduction helps build up cash unproductive cash reserves, and with surplus cash the firms is
more likely to invest or less likely to under-invest.
6. The negative signal from an equity issue is much greater than the negative signal from a debt issue, hence debt
financing is preferable.
7. positive; because increasing the leverage ratio sends a positive signal (resulting in rise in stock price and equity value).
8.(a) NPV of investing now = P/.12 – 1060 = 8.33P – 1060.
If wait and P rises, NPV = 1.2P/.12 – 1060 = 10P – 1060; if wait and P falls, NPV = 0
Then, NPV of waiting = .5(10P – 1060)/1.12
Invest now if 8.33P – 1060 > .5(10P – 1060)/1.12; gives P* = $152.
(b) P* will be higher; because of Underinvestment.
9. (a) D = 80, coupon = .125*80 = 10. With new project, debt value = 10/.115 = 86.96.
Thus, debt value will rise 6.96. Since project NPV = 6, equity value will fall, and equity holders will
NOT find the project acceptable.
(b) Minimum project NPV = 6.96.
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11
Name: __________________________________ _______ Student ID#: ___________________
Business F721. Mergers, Restructuring and Corporate Control (Fall 2019)
Test 2
Instructions:
a) This test consists of eight (8) questions over five (5) pages; you have 1½ hours to complete it.
b) The maximum score is 35 points; the point distribution details are given alongside the questions.
c) You are allowed to bring in one page (single side) of formulas.
1(a). The “co-insurance effect” occurs in _________________________ (strategic/financial/conglomerate) acquisitions.
Why? (2 points).
1(b). Co-insurance results in a conflict of interest between shareholders and bondholders because wealth is transferred from
__________________________ to _________________________. (2 points).
1(c). How can shareholders take advantage of the co-insurance effect? (1 point).
2. If you would like to increase your firm’s EPS by means of acquisition(s), you should acquire companies with P-E ratio
_____________ (higher / lower) than your company (everything else remaining the same). Why? (3 points)
3. A well-known defensive (anti-takeover) tactic is to use a Leveraged Recap (issue debt and use the proceeds to buy back
equity). How could this deter potential acquirers? (3 points)
4. When company A acquires a publicly-traded company T using stock financing, A’s event return is generally
_____________________ (higher than / lower than / the same as) when using cash financing. Why? (2 points)
5. What if firm T (in question 4) was a private firm? (2 points)
6. B (bidding company) has 20 million shares and a net income of $40 million, and T (target company) has 10 million
shares and a net income of $10 million. Operating synergies are expected to increase net income by $4 million per year. B
has decided to finance the acquisition with stock.
(a) If neither set of shareholders would find a reduction in EPS (upon acquisition) acceptable, what are the two limits on
the exchange ratio that can be offered? (4 points)
(b) If expected operating synergies were larger, you would expect the spread between the two limits to be _____________
(narrower / wider / the same). (2 point)
7. The stocks of companies B and T are trading at $20 and $15, and the number of outstanding shares 30 and 20, respectively.
Firm B wishes to acquire T, and operating synergies are expected to be worth $145. B’s management believes that T can be
realistically acquired at a premium of 40% if the offer is in cash.
(a) How large should a cash offer be? Will it be acceptable to both sets of shareholders? (3 points)
(b) T is in a different industry, hence there is some uncertainty about the synergy estimate. B’s management would therefore
prefer a stock offer. However, this would send a negative signal, which is expected to be as large as 5% based on past
evidence. On the other hand, a stock offer can be 15% lower than a cash offer because it will be a non-taxable transaction.
Taking these issues into account, what exchange ratio should B offer? (3 points)
12
8. Firm A (acquirer) had 2431 million shares trading at $72, and firm T (target) had 780 million shares trading at $75.50.
Firm A wants to acquire T using its own stock, and expects the resulting signaling effect to be 4% in magnitude. Operating
synergies are expected to be worth $25 billion.
(a) If firm A knows that its own shareholders would require a return on acquisition of 3%, what is the maximum exchange
ratio that A can offer T’s shareholders? (5 points)
(b) If, however, firm A ends up offering an exchange ratio of 1.32:1 (that is, 1.32 shares of A for every share of T), what is
the expected event return for A’s shareholders? For T’s shareholders? (3 points)
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13
F721 Fall 2019. Test 2 Answers
1. (a) Conglomerate. Because the assets of company A can be used to secure the debt of both company A & company T.
Also, the assets of T can be used to secure the debt of both T & A. Thus, the assets are co-insuring the other company’s
debt. However, it is possible only when the assets are not perfectly correlated. Therefore, Conglomerate.
(b) Shareholders, Bondholders. (c) By issuing more debt, which increases equity value because of the resulting tax shield.
This is possible because co-insurance increases the firms’ debt capacity.
2. Lower P-E ratio.
If P-E ratio is lower, it means that for the same price the earnings level of the target company is higher; this boosts the
EPS of the acquiring company. (Note that this does not imply a higher value, just a higher EPS, like in the bootstrapping
example in the courseware, chapter 5).
3. (i) higher leverage makes the company less attractive, and (ii) higher price (because of positive signal of buying back stock)
makes acquisition more expensive.
4. lower; because stock financing sends a negative signal which drives down A’s stock price.
5. higher; for a private firm, risk-sharing is a major requirement since there is uncertainty regarding the value of the target
company (since it is private). Since stock financing has the risk-sharing property that is desired, it gives a higher event
return.
6. (a) B: number of shares = 20, net income = 40, hence EPS = 2; T: number of shares = 10, net income = 10, hence EPS = 1.
Synergies = 4, hence net income of combined firm = 54. If exchange ratio offered is x, then new shares = 10x, so total shares
= 20+10x.
EPS of combined firm = 54/(20+10x). This has to exceed B’s EPS, or 54/(20+10x) > 2, giving x < 0.7.
Also, T’s shareholders will have x for each share they had, so their post-acquisition EPS will be x(54/(20+10x)), and this
should exceed their old EPS or 1. This means x(54/(20+10x)) > 1, giving x > 0.455.
Thus, the two limits are 0.455 and 0.7.
(b) If operating synergies are expected to be larger, the spread between the two limits would be wider.
7. (a) B: 20*30 = 600. T: 15*20 = 300. Synergies = 145. Total = 1045.
Offer $15 * 1.4 = 21 per share, or $420 total. B’s shareholders worth 1045 – 420 = 625. Therefore, it will be acceptable
to B’s shareholders.
(b) B: .95(600) = 570. Total = 570+300+145= 1015. Offer .85(420) = 357.
Offer x shares, then x/(30+x) = 357/1015, or x = 16.28. Exchange ratio = 16.28:20 or 0.814 shares of B for one of T.
8. (a) Values: A = 2431*72 = $175.032 billion, T = 780*75.50 = $58.89 billion, synergies = $25 billion.
But, because of the 4% signaling effect, A’s value falls to 175.032*0.96 = $168.031 at announcement.
Thus, total post-acquisition value = 168.031+58.89+25 = $251.921 billion.
Suppose the offer is x for 1; then, total number of shares post-acquisition = (2431+780x) million; hence, post-acquisition
price of A = 251.921/(2.431+0.78x).
For A’s shareholders to have acquisition event return of 3%, this price should be 3% higher than the initial price of $72, or
72*1.03 = $74.16. This gives 251.921/(2.431+0.78x) = 74.16, or x = 1.2385. Therefore, maximum x is 1.2385.
(b) If A offers 1.32 for 1, total number of shares post-acquisition = (2.431+0.78*1.32) = 3.4606 billion. Then, post-
acquisition stock price = 251.921/3.4606 = $72.80. A’s shareholders’ event return = 72.80/72 – 1 = 1.11%, and T’s
shareholders’ event return = (72.80*1.32)/75.50 – 1 = 27.28%.
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14
Name: __________________________________ _______ Student ID#: ___________________
Business F721. Mergers, Restructuring and Corporate Control (Fall 2019)
Test 3
Instructions:
a) This test consists of seven (7) questions over four (4) pages; you have 1½ hours to complete it.
b) The maximum score is 30 points; the point distribution details are given alongside the questions.
c) You are allowed to bring in one page (single side) of formulas.
1. In an LBO, two major sources of value are increase in tax shields and reduction of manager-shareholder agency
problems. Which group generally captures most of these benefits?
Additional tax shields: _________________________________ (old shareholders / new [LBO] shareholders). Why? (2
points)
Reduced agency problems: _________________________________ (old shareholders / new [LBO] shareholders). Why?
(2 points)
2. The yield spread on a corporate bond is greater than zero because of: (3 points)
(i)
(ii)
Which of these is more important for AAA-rated bonds? Why?
3. A well-known defensive (anti-takeover) tactic is to use a Leveraged Recap. List three ways in which a leveraged recap can
deter potential acquirers. (3 points)
4. The transferable put right (TPR) method of stock repurchase has the advantage of not requiring pro-rating. List three
advantages of not having to pro-rate. (3 points)
5. You are the sole shareholder of a company you started a few years ago. The company has perpetual debt with coupon
payments of $1 million per year, and the debt has an YTM of 10%. Your after-tax cash flow from the business this year
was $950,000 (clearly not enough to make the interest payment this year), but is expected to grow at 4% in perpetuity.
You now have to decide whether to file for bankruptcy or pay the shortfall from your own pocket. What will you do, and
why? The WACC is 12%.(3 points)
6. Company A has 10 million shares outstanding (20% held by management shareholders), trading at $20 per share. It has
no debt, and faces a tax rate of 30%. There is a proposal to issue $100 million of debt, and use the proceeds to buy back
stock. Bankruptcy costs resulting from the debt issue are expected to be $5 million, and the signaling effect of the recap is
expected to be 4%.
(a) If the company wants to ensure that remaining and exiting shareholders enjoy identical event returns (in expectation),
how many shares should it repurchase, and at what price? What is the (expected) event return? What is the percentage
management shareholding after the LR? (5 points)
(b) If, instead, it has to offer a premium of 25% to repurchase the stock, what will be the (expected) event return to remaining
shareholders? (2 points)
7. Company A’s stock was trading at $20, and the management held 10% of the outstanding equity. It announces a Fixed
Price Tender of 20% of the stock at a 25% premium. After the repurchase is completed, the stock trades at $23.
(a) What is the overall event return? (2 points)
(b) In part (a), suppose the manager decides on a Dutch Auction Repurchase instead of a Fixed Price Tender. She finds
that no shareholder is willing to sell to the company at or below $20, and all shareholders are willing to sell at $35. If
there is a linear relationship between the number of shareholders willing to sell and the price at which they are willing to
sell, and if the total number of shares is 100, what is the supply curve? With this supply curve, what premium would the
company have to offer? What would be the post-DAR supply curve and the post-repurchase stock price? What would be
the overall expected event return? (5 points)
15
F721 Fall 2019. Test 3 Answers
1. Old shareholders; because the value created is easy to (approximately) estimate.
New (LBO) shareholders; because the value created is impossible to estimate.
2. (i) default risk, (ii) systematic risk.
Systematic risk is more important for high-grade bonds because there is very little default risk.
3. (i) higher stock price, (ii) higher management holding, (iii) higher leverage ratio.
4. (i) no unhappy shareholders remaining; (ii) lowest-reservation-price shareholders are the first to leave; (iii) with pro-rating,
an arbitrageur can acquire a large block of shares and be in an advantageous position to bargain for a better deal (higher
premium) from management; this is avoided if there is no pro-rating.
5. Market value of debt = 1/.1 = 10 million. Value of firm’s assets = .95*1.04/(.12–.04) = 12.35 million.
Since asset value exceeds liability value, company should not file for bankruptcy but should pay bondholders from their
own pockets to keep the company alive.
6. (a) Post: V = 200+.3(100)–5+.04*200= 233. E = V – D = 233 – 100 = 133.
Suppose buy back N shares at price P. Then NP = 100 and (10–N)P = 133; gives P = 23.30 and N = 4.29.
Expected event return = 23.30/20 – 1 = 16.5%, management holding = 2/(10-4.29) = 35%.
(b) Offer 1.25*20 = 25. Shares bought back = 100/25 = 4 million, remaining shares = 6, P = 133/6 = 22.17.
Even return = 22.17/20 – 1 = 10.83%.
7. a). 20% shareholders get a return of 25%, 80% shareholders get a return of 15%. ($23/20-1 = 15%);
Overall Event Return = 0.2(25) + 0.8(15) = 17%
b). Intercept = Current Price = $20, No. of shares = 100, All willing to sell at $ 35, = 20 + 0.15 is the supply
curve.
Premium: To buy 20 shares, have to offer price = 20 + 0.15(20) = $23, so premium = 23/20 – 1 = 15%.
Supply curve: (20+15r)/.8 = 25+0.1875r. But paying out 23(20), on a per-share basis, this comes to 23(20)/(80) = $5.75.
This gives: V(r) = 25+0.1875r–5.75 = 19.25+0.1875r.
However, 20 of the shareholders leave, therefore r is replaced with (r+20). This gives: V(r) = 23+0.1875r.
Post-repurchase Price = # 23 Return = 15%
Overall expected event return = 15%
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