Exam (elaborations)
FEM11118 Practice exam answers
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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.
Repurchase. Managers believe shares are undervalued, i.e. it’s a good price to
buy them back.
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.
Advantage. Increased payments disciplines manager.
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 oppertunity 12 25
a. Show the optimal strategy (i.e. issue or not issue) in both states
State 1 35/256 * (65 + 65) < 221/256 * (35 + 12), 17.8 < 40.6 issue
State 2 35/256 * (65 + 210) < 221/256 * (35 + 25), 37.6 < 51.8 issue
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.
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