QUESTION 2 (a) At time t=-1, a publicly listed firm owns some assets in place and a positive NPV project in which the firm could invest at time t=0. However, both the firm's managers and the outside investors do not know the precise values of the firm's assets in place and of the NPV of the project. The firm has no financial slack and must issue equity to new shareholders to invest in the project at time t=0. All the assumptions of Myers and Majluf's (1984) pecking order model hold. At time t=0, the firm's management receive private information about the values 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 0.35 0.65 Financial slack (in million) 0 0 Assets in place (in million) 320 110 Initial outlay of new project (in million) 45 45 NPV of new project (in million) 22 9 Required: (i) Derive a rational expectations equilibrium (REE) in which investors' rational beliefs at time t=0 are consistent with the management's actions at time t=0. Show your calculations in detail and comment on your results. (15 marks) (ii) Compute the value of the firm at time t=-1. Compare this to the value of the firm at time t=-1 with symmetric information, i.e. assuming that the managers and the outside investors simultaneously observe firm type at time t=0. Explain the difference (if any). (7 marks) (iii) What would the equilibrium outcome of the model be if the firm's financial slack was equal to 40 (S=40)? Show the steps in detail and discuss the potential value of financial slack in mitigating the underinvestment problem. (8 marks) Question 2 continued (b) Describe the assumptions, implications and predictions of the pecking order theory. Explain why asymmetric information frictions can lead to underinvestment. Based on the pecking order theory and its implications, what is the relationship between a firm's financial slack and the likelihood that the firm underinvests? Also, is the probability of underinvestment in a particular project affected by the expected value of the project? [Word limit: 300 words] (15 marks) (c) Academics argue that a firm's effective tax advantage of debt T should be considered by the firm's managers to improve their financing choices. However, what are the practical challenges and complexities managers face to estimate T? Describe the complex issues that practitioners may face when estimating T. Word limit: 350 words] (20 marks) (d) Graham and Harvey (2001, The theory and practice of corporate finance: evidence from the field, Journal of Financial Economics) find that two of the most important factors that affect the decision to issue debt are Financial flexibility and Interest tax savings. As for the decision to issue equity, two relevant factors are Magnitude of equity undervaluation/overvaluation" and "If recent stock price increase, selling price 'high'". Comment on whether these findings and the related content of the survey are consistent with the predictions of the pecking order theory. [Word limit: 300 words] (15 marks) (e) Empirical papers often focus on the relationships between leverage and several variables. The following is a list of well-known determinants of capital structure: - Firm size - Asset tangibility - Profitability - Market-to-book (MTB) ratio - Industry capital structure For each of these variables, describe the sign (positive or negative) of the relationship that is typically observed with leverage. Also, explain whether such a relationship is expected based on the trade-off theory or on the pecking order theory. Word limit: 350 words] (20 marks) QUESTION 2 (a) At time t=-1, a publicly listed firm owns some assets in place and a positive NPV project in which the firm could invest at time t=0. However, both the firm's managers and the outside investors do not know the precise values of the firm's assets in place and of the NPV of the project. The firm has no financial slack and must issue equity to new shareholders to invest in the project at time t=0. All the assumptions of Myers and Majluf's (1984) pecking order model hold. At time t=0, the firm's management receive private information about the values 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 0.35 0.65 Financial slack (in million) 0 0 Assets in place (in million) 320 110 Initial outlay of new project (in million) 45 45 NPV of new project (in million) 22 9 Required: (i) Derive a rational expectations equilibrium (REE) in which investors' rational beliefs at time t=0 are consistent with the management's actions at time t=0. Show your calculations in detail and comment on your results. (15 marks) (ii) Compute the value of the firm at time t=-1. Compare this to the value of the firm at time t=-1 with symmetric information, i.e. assuming that the managers and the outside investors simultaneously observe firm type at time t=0. Explain the difference (if any). (7 marks) (iii) What would the equilibrium outcome of the model be if the firm's financial slack was equal to 40 (S=40)? Show the steps in detail and discuss the potential value of financial slack in mitigating the underinvestment problem. (8 marks) Question 2 continued (b) Describe the assumptions, implications and predictions of the pecking order theory. Explain why asymmetric information frictions can lead to underinvestment. Based on the pecking order theory and its implications, what is the relationship between a firm's financial slack and the likelihood that the firm underinvests? Also, is the probability of underinvestment in a particular project affected by the expected value of the project? [Word limit: 300 words] (15 marks) (c) Academics argue that a firm's effective tax advantage of debt T should be considered by the firm's managers to improve their financing choices. However, what are the practical challenges and complexities managers face to estimate T? Describe the complex issues that practitioners may face when estimating T. Word limit: 350 words] (20 marks) (d) Graham and Harvey (2001, The theory and practice of corporate finance: evidence from the field, Journal of Financial Economics) find that two of the most important factors that affect the decision to issue debt are Financial flexibility and Interest tax savings. As for the decision to issue equity, two relevant factors are Magnitude of equity undervaluation/overvaluation" and "If recent stock price increase, selling price 'high'". Comment on whether these findings and the related content of the survey are consistent with the predictions of the pecking order theory. [Word limit: 300 words] (15 marks) (e) Empirical papers often focus on the relationships between leverage and several variables. The following is a list of well-known determinants of capital structure: - Firm size - Asset tangibility - Profitability - Market-to-book (MTB) ratio - Industry capital structure For each of these variables, describe the sign (positive or negative) of the relationship that is typically observed with leverage. Also, explain whether such a relationship is expected based on the trade-off theory or on the pecking order theory. Word limit: 350 words] (20 marks)