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Corporate Finance Assignment
There are TWO questions – please answer ALL questions
Unless otherwise stated – all questions assume zero discounting and risk neutrality
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1.
(a) Explain why the agency paradigm predicts that outside capital (debt or equity) in general leads to agency costs of financing. How should the firm minimize these agency costs?
(b) Explain why a corporate debt liability that may lead to underinvestment (debt overhang) can also prevent overinvestment (free cash flow theory). How should the firm minimize the costs of distortions to the investment policy?
(c) Explain why agency costs of financing arise, in essence, from a problem of incomplete contracting. If ‘complete’ debt or equity contracts were possible, what additional elements would be included in the contract in your view?
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(a) Explain why financial constraints may be caused by agency problems or asymmetric information problems.
(b) In what ways do financial constraints influence investment policy. Be as comprehensive as you can in your answer.
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BE350 Corporate Finance Assignment
Hand in by deadline posted on Moodle
There are FOUR questions – please answer ALL questions
Unless otherwise stated – all questions assume zero discounting and risk neutrality
1. Consider a firm whose only asset is an investment opportunity that has a cost of 1 and a cash flow at some
future date of ~x. The firm has also a debt liability of B which is due at the same future date. Suppose
~x Uniform[0; 5], and that the realisation of x becomes known before the investment decision is made.
(a) Suppose B = 0. Work out the value of the equity ex ante (i.e. before the realisation of x is known).
(b) Suppose B > 0. Work out the value of the equity and the debt ex ante (as functions of B).
(c) Explain why there is a B such that the value of debt ex ante is maximized. Also explain why any debt
liability B > B is unlikely to be paid in full at the due date.
2. (a) Explain why the agency paradigm predicts that outside capital (debt or equity) in general leads to
agency costs of financing. How should the firm minimise these agency costs?
(b) Explain why a corporate debt liability that may lead to underinvestment (debt overhang) can also
prevent overinvestment (free cash flow theory). How should the firm minimize the costs of distortions
to the investment policy?
(c) Explain why agency costs of financing arise, in essence, from a problem of incomplete contracting. If
‘complete’ debt or equity contracts were possible, what additional elements would be included in the
contract in your view.
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3. Suppose a firm has assets that have high cash flow XH with probability p and low cash flow XL with
probability 1 p. The firm is considering an investment that will improve the probability of high cash
flow by an amount (assume p + < 1), and which has a cost I. The firm is currently owned by an
entrepreneur who has no wealth of his own. New capital issued to outside investors promise a cash flow RH
if cash flow is XH and RL if cash flow is XL (assume RL RH and 0 Ri Xi, i = H; L).
(a) What is the net present value of the investment project? What is the value of the firm if investment is
not made?
(b) Now suppose the entrepreneur is of a ‘good type’ where p = pG or of a ‘bad type’ where p = pB,
where pG > pB. The outside investors believe a good type entrepreneur has likelihood and a bad
type entrepreneur has likelihood 1
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