Answers to exam January 15, 2012, Theory of Corporate Finance Question 1
a) v (investors are better positioned to manage systematic risk themselves) b) i, iii, iv, v
e) ii (diversification reduces risk, thereby shifting risk from creditors to owners) Question 2
ai) True. Closely held firms typically suffer less from agency problems, so don’t need the dividend constraints to the same extent.
aii) True. If FDA were to approve the drug, the firm’ stock would rise in value and the call options would pay off and provide partial funding. This is a form of contingent equity financing that pays off exactly when Cephalon needs the money and that is not exposed to the traditional deadweight costs (the only exposure is to inefficiencies in the options markets). As such, Cephalon would not face any deadweight costs from external financing, but it would avoid having to face deadweight costs from external financing to finance continued expansion. There might be a risk-shifting effect, since the firm exchanges riskfree cash for risky call options, but on its own stock.
b) A dividend clientele is a set of investors who are attracted to the stocks of firms that have the dividend policy they prefer, based on their tax or liquidity circumstances. Agency problems could also differ between owners. Closely held firms presumably suffer less from agency and information-asymmetry problems, as do firms with large management equity stakes.
a) Agency theory
Main assumptions: information asymmetry and all actors being rational utility maximizers conflicts of interests whenever one less informed party (principal) depends on the actions of another better informed party (agent).
Characteristics: info asymmetry makes it impossible for principal to perfectly determine agent’s marginal productivity. This creates an incentive for agents to shirk, as agent enjoys full benefit of shirking, while the cost of shirking is shared by the principal. This shirking-loss...
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