Examiners' commentaries 2011

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92 Corporate finance 2 defined as the ratio of the partial differentiation of its expected return over the partial differentiation of its expected risk of the portfolio with respect to a. In equilibrium, all marketable assets are included in the market portfolio and there is no excess demand or supply for any individual asset. This implies that ∂ E ( R ) / ∂a pt E( R ) – E ( R ) (1.3) it mt = 2 ∂E ( σ ) / ∂a ( σ – σ ) / σ pt im m m a = 0 Also note that the MRS at the market portfolio is the same as the slope of the capital market line (CML) at the point of tangency to the efficient frontier. It can be shown that E ( R ) E ( R ) E ( R ) E( R ) MRS = it − mt it − mt = 2 ( σ − σ ) σ σ im m Rearranging the equation (1.4), we have E( R ) = R + β E ( R ) − R it ft i m [ ] mt ft m = Slope of the CML (1.4) (1.5) where = / . Equation (1.5) shows that there is an exact linear i im m relationship between an asset’s return and its beta. Students may approach this question differently from the suggested guide here. An alternative approach is to discuss how the portfolio theory, two fund separation theorem and other related theories may lead to the CAPM. b. ‘The CAPM is untestable.’ How far do you agree and disagree with this statement? Critically evaluate this statement. (15 marks) Reading for the question Subject guide, pp.37–39; BMA, Chapter 8, pp.223–27. Approaching the question The key points are: i. The validity of CAPM depends on whether the market portfolio is mean-variance efficient. ii. But the true market portfolio is not observable. iii. Proxies for the market portfolio are often taken from broad-based equity indices which do not contain all the tradable securities or non-financial assets such as real estates, durable goods and even human capital. iv. This renders CAPM untestable. A good answer should cover the above points with emphasis on the emboldened words or phrases. As this question specifically asks students to evaluate the statement critically, high marks would only be given if such critical analysis is provided in the answer.
Question 2 a. Explain clearly how an efficient takeover may occur. (15 marks) Reading for the question Subject guide, pp.140–41. Approaching the question It should be noted that this question asks for the second part of Grossman and Hart (1980). Some students discuss the impossibility of an efficient takeover instead. Many students regurgitate the materials from the subject guide. Some key points worth noting are: i. The free-rising problem can be solved by the dilution effect. a. The raider can extract the value from the target if the takeover is completed. b. As long as the value that can be extracted by the raider exceeds the cost of the acquisition, shareholders are willing to tender their shares for the takeover (as free-riding is no long optional to them) ii. Existence of large shareholders may facilitate a takeover. a. Shareholders will tender their shares if p > z (where p is the premium paid by the raider and z is the value improvement after the takeover) b. Large shareholders will tender their shares if z > (1-a)p + c where a is the proportion of shares held by the large shareholders and c is the cost of acquisition. c. To satisfy both conditions a and b, az > c. So large shareholders will ensure the success of a takeover if the value improvement accrued to their shareholders exceeds the cost of acquisition. b. Outline the arguments for the agency cost on equity. Explain how the use of short term bonds might mitigate the agency conflict between equity-holders and debt-holders in financially distressed firms with high debt to equity ratios. (10 marks) Reading for the question Subject guide, pp.112–15. Approaching the question This question centres on the agency cost of outside equity. It should be explained clearly including the following key points: i. Consider the rewards and costs facing a manager/equity-holder. ii. More equity held by outsiders, less effort spent by the managers/ equity-holder. iii. Issuing debt to replace the outside equity will then increase the leverage and the % of outstanding equity held by manager/equityholder. As his/her share of the residual value of the firm increases, he/she will choose to supply more effort, leading to increased firm value. iv. Conflicts between shareholders and debt-holders: a. The problem of asset substitution and risk shifting may arise. b. Using short-term debt gives debt-holders an early opportunity to review the firm’s managerial effect. Examiners’ <strong>commentaries</strong> <strong>2011</strong> 3
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Examiners' commentaries 2011

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