Exam (elaborations)
FEM11118 Practice exam
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Question 1Managers could change their firms’ capital structure in an attempt to time the
market. One potential reason for this attempt is that some managers are
overconfident about their firm’s value. Would this managerial overconfidence about
firm value lead to firms issuing or repurchasing equity? Please explain briefly.
Question 2
Regarding agency costs, does the potential of overinvestment provide an advantage
or a disadvantage for the use of debt financing as opposed to equity financing?
Please explain briefly.
Question 3
Myers and Majluf (1984) consider a firm that must issue common stock to raise cash
to undertake a valuable investment opportunity. They assume that managers know
more about the firm’s value than potential investors, and that investors interpret
the firm’s actions rationally. They also assume that management acts in the interest
of the current shareholders. When the firm has slack, assets-in-place, and
investment opportunities (with a positive NPV), they show that firms should only
issue when the increment to firm value obtained by the current shareholders
exceeds the share of existing assets and slack going to new shareholders. Or, in
symbols, firms should issue if
E P
∗( s+a ) ≤ ∗(E+ b)
P+ E P+ E
Assume you are in the Myers-Majluf world. Investors are risk-neutral and the risk-
free interest rate is zero. The firm’s slack is $65 million. The investment opportunity
requires $100 million (i.e. the required equity issue is $35 million), and there are
two equally probable states of nature, with these values (in millions of dollars):
State 1 State 2
Assets-in-place 65 210
NPV investment opportunity 12 25
a. Show the optimal strategy (i.e. issue or not issue) in both states
b. Would the analysis of Myers and Majluf (1984) be more relevant for firms
with good corporate finance or bad corporate finance? Please explain your
answer.
Question 4
a. Survey evidence of Graham and Harvey (2001) indicates that most U.S. firms
have no target debt ratio or range.
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