Note: Due to changes in coverage, the following questions are no longer relevant for

NEKN93, fall 2022 (questions in parentheses are borderline relevant): 1 a, b; 4 b, c; 6 a-e; 7

(a), f; 9 a, b

Question 1. (5 p.)

a) Explain in detail why self-selection often leads to an endogeneity problem in empirical

corporate finance. (3 p.)

b) How can propensity score matching help with the self-selection problem? (2 p.)

Answers:

a) Self-selection means that it is the company and not the researcher who decides who is treated.
Treatment in this context could be which company that is bought in an LBO, if a risk management
program is implemented or not, if a company goes through the process to get a credit rating etc.
To take a concrete example say we are interested in the effect on Tobin’s Q on getting a credit rating.
Self-selection will only be a problem if there are unobservable differences that also affect Tobin’s Q
between the companies that decide to get a rating and the companies that do not. This is unfortunately
often the case in corporate finance. Unobservable differences, often called unobservable heterogeneity
are an omitted variables problem which is one of the causes of endogeneity.

b) The fundamental problem with self-selection is that we cannot observe the counterfactual. That is
we cannot observe the difference in treatment effect for the same company that is both treated and
non-treated. The idea with matching is to instead compare the treated company with a non-treated
company. Propensity score matching means that we compare with an untreated company that has the
same probability of treatment as the treated company.
Question 2. (5 p.)

Suppose a firm has an asset value of 500 and debt with a principal of 300 that matures in 2
years. Further suppose that the value of the company 2 years from now is 650 with probability
0.7 and 233 with probability 0.3. Compute the current value of the levered equity and debt.

Answer:

The levered equity value of the firm two years from now is either max(650-300,0)=350 or max(233-
300,0) = 0.

We must now construct a risk free portfolio by taking a long position in the firm’s assets and a short in
equity, denote the size of the short position by e.g d. For the positon to be riskless the value has to be
the same in the upstate and the downstate so we get

650-d*350=233-d*0 so d=1.19. It is also ok to use the formula

directly if you remember it but note that it is not necessary you can also build the riskfree portfolio as
shown above. The investment cost of this portfolio is 500-1.19*E(L), since it is risk free its value has
to equal exp(-2*r)*(650-1.19*350). So we get the value of levered equity today by solving
500-1.19*E(L)= exp(-2*r)*(650-1.19*350). To do this we have to assume some risk free rate since it
was not given, you can use any risk free rate. I pick 2%. That is E(L)=231.6.

We can also directly use the formula

Which gives: E(L)=500/1.19-exp(-2*0.02)*(650/1.19-350)=231.6

Since the asset value today is 500 the value of debt today has to be the difference between the asset
value and the value of equity: 500-231.6=268.4
Question 3. (5 p.)

a) Explain why an increase in asset volatility shifts value from debtholders to equity
holders. (3 p.)

b) Give examples of how banks can protect themselves from risk shifting. (2 p.)

Answer:

a) This is since equity can be seen as a call option of the firm’s assets with strike price equal to the
amount of outstanding debt. An option will always increase in value when the volatility of the
underlying asset increases (the asset value of the firm in this case) so this increases the value of equity
and decreases the value of debt. You can show this with an example but it is not needed.

b) By using covenants on the loans that limits what managers are allowed to do and/or by charging a
higher interest rate.
Question 4. (10 p.)

Which of the Modigliani-Miller assumptions are violated in:

(note it may be more or less than one)

a) Trade-off theory (2 p.)

b) Predation models (2 p.)
c) The Black and Scholes option pricing theory (2 p.)
d) Pecking order theory (2 p.)
e) The Capital Asset Pricing Model (2 p.)

Answers

a) Taxes, bankruptcy/distress costs can also be put as frictionless capital markets and a firm’s cash
flows do not depend on its financial policy

b) In predation models your product market behavior (especially how you price your products)
depends on your capital structure. Financially strong firms try to drive weaker firms out of the market
through low pricing. To be able to do this firms cannot be price takers so the assumption on atomistic
competition for product markets has to be violated, however the MM assumption about atomistic
competition is usually assumed to be for capital markets. You will however get one point if you only
write atomistic competition. For two points you have to mention that the assumption that a firms cash
flows do not depend on its financial policy if violated. That in itself gives two points.

c) None, all answers here give 2p since we did not cover BS in the course.

d) Pecking order is all about information asymmetry so the assumption that “All market participants
share homogeneous expectations” is violated.

e) None
Question 5. (10 p.)

Assume a borrower has private information about her probability of success. The borrower
may be “good‟ e.g. high quality borrower with a probability of success p while a “bad‟ e.g.
low quality borrower has a probability of success q, naturally p > q. Further assume the
borrower has no private wealth. The borrower knows if she is of the good or bad type but
from the investor’s perspective the probability of success is , so is the
fraction of “good” borrowers. Assume (only the high quality borrower is
creditworthy). Further define indirectly as
.

a) Explain and motivate what happens (will they get financing, will they be worse off
because of the adverse selection) to the good and bad borrowers when . (5 p.)

b) Explain and motivate what happens (will they get financing, will they be worse off
because of the adverse selection) to the good and bad borrowers when . (5 p.)

Answers

a)

b)
Question 6. (10 p.)

The table below reports average daily returns for ten U.S. firms that were downgraded by
Standard & Poor’s from an investment grade to a speculative grade credit rating in 2009. The
average returns are calculated over a period of 10 days before the downgrade, and a period of
10 days after the downgrade. Also reported are average 10-day returns for a matched sample
of firms that were not downgraded (one non-downgraded firm for each downgraded one, with
returns calculated over identical time periods).

Downgraded firms Non-downgraded firms

10-day average returns
‒1.15 % ‒0.66 %
before downgrade
10-day average returns after
0.31 % 0.46 %
downgrade

a) What is the single cross-sectional difference in average returns after downgrade? (1 p.)
b) What is the single time-series difference in average returns for downgraded firms? (1
p.)
c) What is the difference-in-difference estimate of the effect of a downgrade on returns?
(2 p.)
d) Explain why (a) and (b) give biased estimates of the causal effect of downgrades on
returns, and how the difference-in-difference estimator overcomes these biases. (3 p.)
e) Specify a regression equation which estimates the difference-in-difference effect of a
downgrade on returns (explain the notation used, including which coefficient that
gives the difference-in-difference estimate). (3 p.)

Answers

a) It’s the difference between treated and non-treated in the post-treatment period, i.e.
0.31 − 0.46 = −0.15 .
b) It’s the post-pre difference for the treated group, i.e. 0.31 − ( −1.15) = 1.46 .
c) It’s the difference between treated and non-treated in the post-pre difference, i.e.
(0.31 − ( −1.15)) − (0.46 − ( −0.66)) = 0.34 . Alternatively, it’s the post-pre difference in the
cross-sectional difference, i.e. (0.31 − 0.46) − (−1.15 − (−0.66)) = 0.34 .
d) (a) does not take into account possible differences in the outcome variable between the treated
and non-treated groups that were there already before the treatment took place (permanent
differences) and therefore contains possible omitted-variables/selection bias. (b) does not take
into account possible time trends in the outcome variable that affect both treated and non-
treated and therefore also contains possible OVB. (c) takes into account the initial difference
between the groups and makes the assumption that the temporal change in the outcome would
have been the same for both groups in the absence of treatment (“parallel trends”), giving a
counterfactual outcome with which the actual outcome is compared.
e) E.g. Rigt =  + Dg + Dt + Dg Dt + u igt , where Rigt is the return of firm i from group g at
time t, Dg is a dummy equal to one for downgraded firms, Dt equals one for the post-treatment
period, and δ gives the difference-in-difference estimate.
Question 7. (6 p.)
Give a one-sentence explanation of the following concepts (1 p. each):
a) Rights offer;
b) Right-to-issue covenants;
c) Vertical merger;
d) Conglomerate discount;
e) Best-efforts method (in IPOs);
f) Clientele effects (in payout policy).

Answers

a) A type of seasoned equity offering where new shares are offered to existing shareholders.
b) Contract feature in debt contracts which prevents the borrower from issuing additional debt
with equal or higher seniority.
c) A merger between firms at different stages of production (up- or downstream) within same
industry.
d) All else equal, conglomerate (diversifying) mergers increase the value of debt at the expense
of shareholders via a reduction in the option value of equity => conglomerates are expected
to trade at a stock price discount relative to non-diversified firms.
e) In IPOs, a type of sale where the underwriter tries to sell as much as possible of the offering
without guaranteeing the sale (the underwriter brokers the sale).
f) Investors have different preferences for cash payouts (depending on, e.g., their tax status) =>
firms will adopt different payout policies to cater to different investor bases (“clienteles”).
Question 8. (5 p.)
Explain the economic intuition (in words, graphically, or using an example) of the result that
payout policy is irrelevant when the Miller-Modigliani assumptions hold.

Answer

From a shareholder’s perspective, a firm’s payout policy is irrelevant because in perfect capital
markets, shareholders can themselves replicate any cash payout by selling (or buying) securities at
zero cost. Equity is always fairly priced and firms and investors face the same interest rate, so it
makes no difference if the firm or the individual investor finances the cash payout. The argument is the
same from the firm’s perspective: it can finance any level of cash payouts simply by issuing new debt
and/or equity with no effect on value (capital structure is irrelevant).
Question 9. (6 p.)
a) Give at least one example of how agency costs of equity can provide an explanation of
why firms engage in risk management/hedging. (3 p.)
b) Give at least one example of how agency costs of debt can provide an explanation of
why firms engage in risk management/hedging. (3 p.)
(Note that agency-cost explanations of hedging do not necessarily imply that hedging is
value-creating.)

Answers

a) (i) Management can reap private benefits from overinvestment and/or perk consumption in
periods of unexpectedly high cash-flows => shareholders may have an incentive to force
management to hedge to reduce cash-flow volatility/reduce likelihood of unexpectedly high
CF (hedging as disciplinary mechanism); (ii) Management may have incentive to hedge to
reduce personal exposure if exposed to firm’s idiosyncratic risk (undiversifiable human
capital investment, disproportionate fraction of personal fin’l wealth in firm).

b) (i) Underinvestment: hedge to reduce likelihood of incurring opportunity costs of passing up

NPV>0 projects due to debt overhang when leverage is high and CF is low; (ii) Risk-shifting:
hedge to reduce likelihood of incurring opportunity costs of passing up (risky but) positive
NPV projects due to strict debt contract terms (e.g. covenants) imposed to prevent risk-
shifting/asset substitution.
Question 10. (8 p.)
Suppose the all-equity firm Alpha Corp has an initial stock price of $10 per share and 270
million shares outstanding. It holds $500 million in cash, and the rest of its value is the
present value of its investment projects. Alpha acquires Omega Inc, another all-equity firm
which has 20 million shares outstanding valued at $25 per share. A mix of 50% cash and 50%
newly issued equity is used to pay for the acquisition. The synergies of the deal are estimated
to have a net present value of $100 million. The post-merger value of the combined firm is $3
billion.

a) Who gains the synergies in this merger – Alpha’s shareholders or Omega’s

shareholders? Motivate your answer carefully. (4 p.)

b) How many shares does Alpha have to issue to cover the equity part of the payment? (3
p.)

c) What is the post-merger stock price of the combined firm? (1 p.)

Answers

a) Alpha Corp’s initial market value is $10*270 mn shares = $2.7 bn. Omega Inc’s initial
market value is $25*20 mn shares = $500 mn. Synergies are worth $100 mn.

The post-merger value of the firm = $3 bn = $2.7 bn + $500 mn + $100mn – X, where X =

cash payment. Consequently, X = $300 mn, which we know is 50% of the acquisition price =>
acquisition price = $600 mn = Omega’s initial value + synergies => Omega’s shareholders
gain all the synergies.

b) Omega’s shareholders get $300 mn in new equity, which is 10% of the value of the combined
firm. Alpha’s initial 270 mn shares make up the rest of the equity, so the total no. of shares
should be 270 mn / 0.9 = 300 mn => Alpha should issue 30 mn new shares.

c) Follows directly from (a): since Omega’s shareholders gain the full value of the synergies, the
stock price of the combined firm will remain unchanged. Also easily verifiable by the result in
(b): total value of $3 bn / 300 mn shares = $10 per share.