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Sample exam questions Question one Zycor stock is worth either $100 per share, $80 per share or $60 per share. Investors believe each outcome is equally likely and the current share price is equal to $80. Suppose the CEO of Zycor announces he will sell most of his holdings of the stock to diversify. Diversification will cost 10 per cent of the share price, that is, the CEO would be willing to receive 10 per cent less than the shares are worth to achieve the benefits of diversification. If investors believe the CEO knows the true value, how will the share price change if he tries to sell? Will the CEO sell at the new share price? Justify your answers. Answer: If the true value of the shares were $100, the CEO would not be willing to sell at the market price of $80 per share, which would be 20 percent below their true value. So, if the CEO tries to sell, investors can conclude the shares are worth either $80 or $60. In that case, share price would fall to the average value of $70. But again, if the true value were $80 the CEO would be willing to sell for $72 but not $70 per share. So, if he still tries to sell, investors will know the true value is $60 per share. Thus the CEO will sell only if the true value is the lowest possible price, $60 per share. If the CEO knows the firm’s stock is worth $100 or $80 per share, he will not sell. Question two It is sometimes suggested that since retained earnings provide the bulk of industry’s capital needs, the securities markets are largely redundant. This is even more so for diversified firms with internal capital markets. With reference to the literature discuss the benefits of internal capital markets versus external capital markets. Answer: Assuming firms are credit-constrained, Stein’s (1997) model argues that the benefits of internal over external capital markets stem from the observation that unlike external bank lending, internal capital allocation gives corporate headquarters the residual rights of control over the assets. Corporate headquarters own the assets. This means they have an incentive to maximise returns on those assets, ie., minimise underinvestment given credit-constraints. This is accomplished by winner picking. Thus, headquarters prefers more valuable to larger empires. Divisional managers have no incentive to do this (maximise their own assets under control), nor external lenders (who do not share in profits and only want their money back). Thus, internal markets reduces underinvestment. Question three You have been given the task by your supervisor to briefly explain the following Table which summarizes market responses to takeover announcements. Total gains Gains to targets Gains to bidders Efficiency or synergy + + + Hubris (overpay) 0 + - Agency problems or mistakes - + - Answer Using event study methodology which identifies stock price reaction to announcement of the takeover Targets always win – bidders only win if the reason is efficiency. Shows that if the reason for takeover is efficiency than all parties gain. If Hubris (where the bidder wrongly believes it can add value) then there is a transfer of wealth from bidders to targets – overall it is a zero sum game. If agency then not only is there a transfer of wealth from bidders to targets but overall all wealth is destroyed. Agency examples include empire building, entrenchment, protection for managers, cross-subsidisation of unprofitable segments Students receive bonus marks if mention literature. Question four What is the underlying premise of the pecking order and how does it relate to the assumption that dividend policy is ‘sticky’, that is, firms are reluctant to change their dividend policy? How does this relate to the maintenance of financial slack? Briefly explain. Answer: The underlying premise of the pecking order is that firms use the ‘safest’ and least costly method of financing first. Firms will use internal funds first – there are no transactions costs associated with using these funds and they are readily available. Then a firm will borrow money, then use hybrid security financing and finally new equity financing. The model assumes dividends are “sticky,” in other words, firms maintain a steady dividend policy, rather than letting the dividend decrease if they have high investment needs and increase in years when they have low investment needs. Firms like to maintain financial slack. They do not want to issue new equity at a discount, which would transfer wealth from old shareholders to new shareholders. They will want to maintain sufficient financial reserves to pay their dividend and not be forced into the position of needing to issue new equity at the expense of existing shareholders. Information asymmetries play a role in this – management knows more than the market knows about the firm, and the market will draw conclusions about the value of the firm based on management’s financing choices. Issuing equity sends a signal that the stock is overvalued, since management would only wish to issue equity when the stock price is high and is expected to go lower in the future. Question five Stock options are the appropriate mechanism to align the interests of shareholders with those of their undiversified executives, yet Yermack (1997) found evidence to suggest his may not be the case. Briefly discuss the benefits of including stock options as part of the executive’s compensation package. How does Yermack’s findings relate to this? Answer: Need to mention that stock options incentivize undiversified executives to take risk (in shareholders’ interests) while at the same time provide protection from downside risk. Yermack (1997) finds evidence that executives are able to influence the option grant by timing issues prior to ‘good’ news announcements. A positive response therefore has two interpretations- options provide incentive to increase effort or given timing options signal good news to come thus not providing incentive. If executives are able to influence the terms and conditions of their option grants then shareholders may be paying more for executive effort than is optimal.