UNC Charlotte Ph.D. in Business Administration Comprehensive Exam Day 2. January 27, 2011

Transcription

1 UNC Charlotte Ph.D. in Business Administration Comprehensive Exam Day 2 January 27, 2011 Directions: Today s exam consists of 6 questions. Please answer each question. This exam begins at 11:00am on Thursday, January , and ends exactly at 3:00pm. No exam will be accepted after 3:00pm. You will be given a 5 minute warning at 2:55pm, and a 1 minute last call at 2:59pm. The proctor is not allowed to accept exams after 3:00pm exactly. Failure to turn in your exam at 3:00pm will result in your failing the exam. Do not write your name on your answer sheet or on any exam page other than this cover sheet. You have been assigned an identification letter below. Write this identification letter on each of your answer pages and on each of the test sheets. Please note that we will not accept any answer sheet pages with your name on them; if your name is on the sheet we will not grade it and you will fail that question. Your identification letter for this exam is: Student name (print) Student Signature:

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3 1. Discuss and describe generally the evolutionary process of the development and application of real options valuation and investment decision making from its origin to today. What extensions to this work would be a logical next step in this process?

4 2. In the theoretical framework, real options have proved to be very important in investment decision making and the valuation of real projects. Discuss the empirical work that has been done which tests the theoretical prediction of the real option pricing model. Cite at least two papers and talk about their methodology, data, and results. How do they confirm the theoretical findings?

5 3. Underinvestment due to Debt-Overhang: (This problem illustrates the debt overhang problem, first modeled by Myers (1977), which relates to the inability of a firm with profitable investment opportunities to finance them because it has excessive amount of debts relative to its assets.) Assume the following scenario: At time 0, a firm has positive NPV project, whose cash flow will be realized at time 2. For the project to be implemented, firm management has to invest an amount I=$80 million in the (non-divisible) project at an intermediate date t=1, after observing an underlying economic variable (the state ) which will be realized between time 0 and 1, and which affects the profitability of the project. The probability distribution of the various states at time 0 and the gross project cash flows in each state are as follows: State: S1 S2 S3 S4 Prob: Cash Flow: (millions) If firm management (who acts in the interest of equity holders) chooses to go ahead and invests in the project, they will raise the amount I, net of any debt issued at time 0, by selling new equity; if they do not invest in the project, the project is not implemented, and zero cash flows are realized. The state is observable by both managers/insiders who make the investment decisions as well as outsiders, but not contractible (no enforceable contracts can be written on the state). Assume that the firm has no assets in place, and the new project is the only source of value to the firm (if any). All agents are risk-neutral, and the risk free rate of return is zero. a. To begin with, assume that there is no debt issued at time 0. Give the investment policy chosen by management as a function of the state. What will the firm s equity value be at time 0 in this case? b. Assume now that the firm has issued pure discount debt of face value $30 million at time 0, maturing at time2. Assume for the purposes of section (b) that debt contracts are NOT renegotiable. i. How will the firm s investment policy change in this case? ii. Given the above investment policy, what will be the market value of debt at time 0? What will be the value of the entire firm at time 0? Value of equity at time 0? iii. What is the expected-value of the value loss due to debt (agency cost of debt), as computed at time 0?

6 3. continued c. Assume that, as in (b), there is debt outstanding of $30 million face value at time 1, but that debt contract is re-negotiable. Assume further that the state observed at time 1 is S3. If firm management (equity holders) approach the debt-holder(s) and propose the following deal: write down (forgive) the debt to the tune of $10.5 million (so that the remaining debt is only $19.5 million), in exchange for 50% of the equity in the firm. Should the debt-holders accept? Why or why not? d. Assume that the debt market anticipates that the kind of deal specified in (c) will always be done in states where there might be no investment due to debt overhang. What is the effect of such an anticipated deal on debt pricing? (You may assume the specific deal mentioned in (c) in computing the price of debt at time 0). How will the time 0 market value of the firm change under this anticipation? Compute the agency cost of debt in this case. e. Suppose a consultant has suggested that, in order to get around the debt overhang problem, debt covenants specify that firm management should always invest in the project at time 1, regardless of the state realized. Is this a good idea? How will time 0 firm value change relative to the value in (b) above if it were known that such covenants were attached to the debt issued?

7 4. Jensen and Murphy (1990) and Hall and Liebman (1998) suggest that stock price based incentive compensation would be appropriate for senior management. Why do some firms provide stock and stock options to non-executive employees? Discuss the empirical evidence that bears on this. Cite and discuss at least two articles related to this topic, with one of the papers being published in 2000 or later.

8 5. Consider an example in the spirit of Leland and Pyle (1977). Unlike in Leland and Pyle (1977), assume that while entrepreneurs are risk-averse (with initial wealth w 0 = 100, and utility function of end of period wealth given by U(w 1 ) = E(w 1 ) - 2σ w 2 ), all outside investors are risk-neutral. Assume further that an entrepreneur can choose between only two assets: the risk-free asset and the stock in her own firm. There are two types of firms in the economy. A firm can be either of type G ( good ), or of type B ( bad ). Each firm has an investment project which involves a capital outlay K = 5, and a future return μ + x ~. A type G firm s expected end-of-period project value is μ G = 20, while the corresponding value for a type B firm is μ B = 10 (note that x ~ is a random variable with zero mean and variance σ 2 = 100). The risk-free rate of return is normalized to 0. Further, assume that each firm will only use equity financing (i.e., the firm will not issue any debt). Each entrepreneur chooses their time 0 wealth allocation between the risky asset (their own firm s stock) and the risk-free asset to maximize their expected utility of end -of-period (time 1) wealth. a. To begin with, assume that there is no information asymmetry in the economy (i.e., all the investors know the true type of firms) at time 0. What fraction of their firm will each type of entrepreneur retain? b. Now assume that the entrepreneur has private information about her own firm value at time 0, i.e., the entrepreneur knows the type of her own firm, but outside investors only know a prior probability distribution over firm types: outsiders believe that with probability ¼, the entrepreneur s firm is of type G, and with probability ¾ the entrepreneur s firm is of type B. What fraction of equity in her own firm will each type of entrepreneur retain in this case (in a separating pure strategy equilibrium)?

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