Topic 1: Options

1. As a call option is an option to buy and a put option is an option to sell – the
opposite is to buying a call is buying a put. Is this statement true or false?
Explain.

Answer: False. This is zero-sum game. A buyer wins a dollar, then a seller loses
a dollar, thus the opposite is to buying a call is selling a call.

2.

Answer: You can buy a put option in this case but this is not the focus of the
question. You should sell the call option since you believe that the share price
will decline which is bad news. The American style call option is unaffected by
the expiry date (1-month). We would never exercise an option based on what we
believe.

3.

Answer: A. The premium is considered sunk cost, you don’t expect to get it
back, thus it is not included in exercise option decision.
Topic 2: Raising capital: Equity

1. Issuing shares in your company to new shareholders makes no sense if you

believe that the company is going to be successful. Why share the upside with
the new shareholders? You’d always be better off borrowing money instead. Is
this statement true or false? Why (why not)?

Answer: False. There is an indirect cost of debt which is the financial risk.
Default risk – when you can’t meet obligations. As returns become more volatile
and riskier, shareholders required higher return. Equity = start to cash out of the
business through IPO. Sell down interest. Diversify.

2.

Answer: B. You are buying share that is less than $3.50, there is a delusional
impact. The share price falls has exactly the same entitlement and rights as other.
The share price falls to reflect average price of shares.
Topic 3: Raising capital: Debt and Leasing

1.

CF – operating cash flows

k – cost of capital

Answer: The risk of the asset is not affected. When leverage increases, beta increases. If k
stays the same, the market value of the firm stays the same. The risk (financial risk) increases.
If expected cash flows are negative, the asset shouldn’t exist. Expected cash flows should
use expected rate of return.

2. Shareholders in a leverage firm have a long position in a call option and hence they may
have an incentive to encourage management to increase the risk (but not financial risk) of
the firm’s cash flows. Is this statement true or false?

Answer: True. Look at the payoff to shareholders. Shareholder is risk averse.

The value of the option goes up because of the asymmetrical payoff. If the shareholders get
nothing, then the sunk cost is gone, that’s why it is a payoff diagram, not payoff. The
company is trying to maximise the payoff for shareholders. Asymmetric returns for
shareholders (long call position). As firm does really well and poorly, there is only a small
difference between market value and intrinsic value – minimal loss. Increasing risk will
increase likelihood of ending up at extremities of graph. When intrinsic value < debt, you
are essentially playing with debtholders’ money, not your own (gambling). Asset
substitution effect.
3. When dealing with an asset whose value is very sensitive to the risk of
obsolescence – in most cases it is going to make more sense to lease the asset
rather than purchase it. True or false? Why (not)?

Answer: False. The lessor will build into the lease payment required the risk of
obsolescence and other risks. In finance lease, the risks are transferred to the lessee. Risk
payment will go up to reflect the risk they are bearing. As a lessor, I would charge you more
to reflect the risk of obsolescence. You cannot get out of the finance lease early.
Topic 4: Issues with WACC and capital structure policy

1. Coleman, Maheswaran and Pinder (2010) asked 1387 financial managers:

How frequently would your company use the following discount rates when
evaluating a new project in the Australian market?

Discount rate Your ranking C, M and P ranking

A different discount rate for each
5 5
cash flow with different risk
Discount rate for the Australian
1 3
market
Discount rate for the entire
3 1
company
Risk matched discount rate for
2 2
the project
Divisional discount rate
4 4

Different risk profile. Not all companies are the same as they have different ways
to come up with discount rate and different evaluation.
4th We estimate the net cash flows with market returns, different approach from
the 5th one because 5th looks at the systematic risk and covariance and uses
estimated beta.

2. Which of these projects should be accepted? A or B?

Answer: You cannot answer for this because you need more information (i.e. the
risk profile of the project or the market yield).

Simply the graphical representation of the trade-off between risk and expected
return implied by the CAPM.
You need security market line (SML) to choose the project. Always invest in all
positive projects but take consideration of the companies that have many different
project with risk profile will not use a single hurdle rate but divisional discount rate
(in this case, Wesfarmers). This is why we are worried about WACC, because if you
use WACC uncritically, you will tend to take high risk projects and it may be a
negative NPV project since the value reduces.

If you are just operating in company (e.g. supermarket), you will use an appropriate
WACC, but conglomerate firm don’t use WACC normally. If capital structure does
change, you need to update your WACC.

If the company applies the single discount rate k to all projects, then the project
suggested by the retail division will be rejected. Its expected rate of return is less
than k, even though it is greater than the required rate of return consistent with its
systematic risk, BRetail.
Topic 5: Payout Policy

1. Suppose the firm in our previous example decided the project would not go
ahead and that $400,000 was paid out as dividend? Would the value of the
company now change? Why/Why not?

Answer: The value of the company would change because the project may be a
positive NPV project and shareholders will lose out. If it is a negative NPV
project, shareholders will gain. We are changing the assumption of M&M
Dividend Irrelevance Theory, that is – the firm has a set investment plan with a
fixed level of debt financing.

2.

Companies cannot make use of franking credit themselves, only useful in the
hands of shareholders. But if you declare special dividends, all your shareholders
get to receive the special dividends (resident and non-resident shareholders)
Topic 6: Advanced topics in capital budgeting: Sensitivity, break-even and
decision tree analysis

1. On the basis of the rankings provided – suggest two specific actions that you
will recommend that the company takes:
One before the project is accepted; and one after the project commences?

Answer: Get a better estimate, but be specific!

• Do some market research before the project is accepted
• After the project commences, think about increasing sales price, but how?
o Negotiate the contract: could lock in the price with customer in long
term but need to give some return to them in terms of sales volume
(sales volume is the least sensitive so that’s okay)

2. On the basis of only the information on the previous 2 slides, which of the
following variable would you concentrate your efforts on?
a. Sales Price (falls by 5.75%)
b. Variable Costs (increases by 10.34%)
c. Sales Volume (falls by 12.96%)
d. Need more information (tell me what you need)

Answer: D. You assume the equal probability across the choices above, but this
is not how the world works. Because you need information on the probability/
likelihood of those choices. We are likely to focus on events that are most likely
to occur.
Topic 7: Real Options Analysis

1. Your option to expand operations is about to expire. For what present value of
incremental cash flows would you exercise your option? Assumed that the
option holder is a profit maximiser.
a) > £ 60,000
b) > £ 61,000
c) > £ 0
d) Need more information

Answer: A. £1,000 is a sunk cost. Because If the PV is £60,400, we would lose

£600 but if we don’t exercise, we would lose £1,000 as the option is about to
expire. Simply realise intrinsic value

2. As the value of a real option is a positive function of volatility, the lesson is

simple: As risk increases, the value of a real option always increases. True or
False? Explain.

Answer: False. Based on 𝐸 (𝑅 ) = 𝑅' + 𝛽* [𝐸 (𝑅, ) − 𝑅' ). If total risk then it

would increase the value of the option which is True. But if only systematic risk
increases (𝛽 increases), then the value of option would decrease which is False.
Sigma increases, total risk increases, increases across the moneyness. If
systematic risk increases, then the value of option would decrease. If put option,
the statement would be true.

Shift from B to C: Changed in beta may be change in sigma i; beta may also
increase because of correlation with market increases (higher systematic risk).
Key takeaway: Think about what type of risk (systematic risk or
diversifiable risk)
Topic 8: Real Options Analysis

1. Portfolio theory tells us that takeovers are in the best interests of acquiring
shareholders. They allow companies to diversify their cash flows which
reduces unsystematic risk. True or false and why (not)?

Answer: False. First statement is false; second statement is true. SD is measure

of total risk. Unsystematic risk is reduced through diversification. Systematic risk
is averaged, not reduced.

𝐸 (𝑅* ) = 𝑅' + 𝛽* [ 𝐸(𝑅, − 𝑅' ]

𝜃* 𝜃, 𝜃*,,
𝐵* = 2

𝜃,

If shareholders want to diversify their own portfolio, they can just pay market
price. For example, if company wants to buy another firm for diversification.
Shareholder can buy the shares on market. From shareholders’ perspective, the
bidding firm needs to pay a control premium to acquire a company (which is
above market price); whereas shareholders can just diversify on their own more
cheaply and match their own preferences (risk level). Diversification is a reason
for acquisition.

From a to b, increase in total risk, but no change in beta.

From a to c, increase in total risk, but also increase in systematic risk.
From a to d, no change in total risk, but increase in systematic risk (if
correlation goes up)
Systematic risk goes up, expected return to shareholders in a competitive market
also goes up. So as you diversify, beta for the portfolio weighted average of
individual assets might go up or down, depends on the nature of business
operating on.

Separate issue to diversification:

o Taking out competitor and enhancing our own profit margin (standard
way of market)
o The competitor’s returns are highly correlated to my own returns because
we are operating in the same industry, so this is not a diversification-
based acquisition.

2. Provided that there are definite and significant synergies in a takeover – such
that the combined value of the target and bidder firms is greater than the sum
of the value of the firms operating independently – a takeover should definitely
proceed from the perspective of bidder shareholders
If V(B+T) > V(B) + V(T)
The takeover should proceed from B’s perspective.
Recall that T disappears post-takeover.
True of false and why (not)?

Answer: There is offsetting effect here. We are comparing gain from acquisition.
There are definite gains from acquisition – synergies benefit. The question for
bidder shareholder is are we overpaying for it. The new present synergies do not
motivate the acquisition, from a bidder’s point of view. If there is $10m of
synergies, but you are paying $30m for control premium, then that is too much
and need to walk away from the deal.

Now we move on to economic rationale of acquisition. Think about value

creation and economic rationale. Not just the present value of projects of the
target company are in place, it includes all the value associated with the real
options (expansion etc. that can impact on the premium payment) Question is
what is the NPV for the bidder shareholders (their wealth position).

If cost (amount you pay) > gain (Target company value + synergy), then it is
not worth it.
Topic 9: Corporate Restructure

1. Of course it makes sense for companies to sell off a division. They will increase
firm value by raising a whole lot of cash and investing that cash to generate
additional earnings. True or false and why (not)?

Answer: False. It only makes sense to sell of a division when the net present value
of continuing the operation is less than zero. Giving up future earnings from
selling the asset (loss in earnings we face). In present value terms, in some cases
value is not created by selling the asset.