Exam (elaborations)
Bman 30111 Exam Paper 2016/17
- Institution
- The University Of Manchester (UOM)
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BMAN301112 ½ Hours
Formula Sheet provided
Normal Distribution Table provided
THE UNIVERSITY OF MANCHESTER
ADVANCED CORPORATE FINANCE
22 JANUARY 2016
09:45 – 12:15
Answer ANY TWO questions.
All questions carry EQUAL marks.
THIS QUESTION PAPER MUST NOT BE REMOVED FROM THE EXAMINATION
ROOM
Electronic calculators may be used, provided that they cannot store text.
PTO
Page 1 of 7
, BMAN30111
Answer ANY TWO questions
ALL questions carry equal marks
QUESTION 1
A publicly listed firm plans to invest in a positive NPV project. The firm has no
financial slack and must issue equity to new shareholders to invest in the project.
Assume all the assumptions of Myers and Majluf’s (1984) pecking order model hold.
At time t=0 (i.e., the date of the new equity issue), the firm’s management receive
private information about the quality of the firm’s assets-in-place and the NPV of the
investment project. When deciding whether to issue equity and go ahead with the
new project, the management act in the best interest of the passive, existing
shareholders. The key financial information about the firm and its investment
opportunity can be found in the table below.
Firm type High quality Low quality
Probability of firm type 0.4 0.6
Financial slack (in £ million) 0 0
Assets in place (in £ million) 250 120
Initial outlay of new project (in £ 50 50
million)
NPV of new project (in £ million) 15 10
Required:
(a) Derive a rational expectations equilibrium (REE) in which investors’ rational
beliefs at t=0 are consistent with the management’s actions at t=0. Show your
calculations in detail and comment on your results.
(30% marks)
(b) Draw a diagram to illustrate the investment decision rule adopted by the
management in the REE of question (a) and show why there is underinvestment
in the presence of asymmetric information.
(10% marks)
(c) What would the equilibrium outcome of the model be if the firm’s financial slack
was equal to 20 (S=20)? Show the steps in detail and discuss the potential value
of financial slack in mitigating the underinvestment problem.
(20% marks)
(d) Outline the predictions of the pecking order theory and evaluate them using both
survey and regression evidence. Briefly compare and contrast the predictions of
the pecking order theory with those of the market timing hypothesis.
(40% marks)
PTO
Page 2 of 7
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