Corporate Finance Conceptual

Quentin says that if managers act in the interests of shareholders, then managers will never take on projects where the IRR is below the prevailing cost of capital. If true, please explain and provide an example to support your argument. If false, please explain and provide an example to support your argument.

Quentin’s statement is false.
Managers acting in shareholders’ interests may still undertake projects with IRR below the cost of capital when these projects (i) enable complementary high-return investments, (ii) generate valuable real options, or (iii) are mandatory maintenance or regulatory investments necessary to preserve future cash flows.

Dongxian adamantly argues that if two firms have the same market values of assets, the same asset betas, and the same costs of debt, then the two firms must have the same equity betas. If true, please explain and provide an example to support your argument. If false, please explain and provide an example to support your argument.

Dongxian’s statement is false.
Even if two firms have identical market values of assets, identical asset betas, and identical costs of debt, their equity betas will differ as long as their leverage differs. Equity beta increases with the debt-to-equity ratio according to
βE=βA(1+D/E)
Thus, two firms with the same asset risk can have very different equity risk if their capital structures are different.

Explain the main differences between the WACC, APV and FTE methods of valuing a firm.

The WACC method discounts the firm’s free cash flow using the weighted average cost of capital and is appropriate when leverage is stable.
The APV method separates the value of the unlevered firm from the present value of financing effects such as tax shields and is most appropriate when leverage is changing.
The FTE method discounts free cash flow to equity using the cost of equity and is useful when valuing from a shareholder perspective or when debt flows can be clearly forecast.

Which valuation method would you use to value i. a leveraged buyout and ii. a commercial bank? Why?

Leveraged buyout - APV method, as it calculates the tax shields separately, and since the leveraged buyout would involve changing capital structure, the APV allows more flexibilty.

Commercial bank - Given they are highly regulated and thus are expected to have stable capital structures, WACC would be used as it is simpler, more well understood and thus easier to communicate with shareholders

Define the following terms: [4 marks]

1. IPO underpricing,

2. Merger arbitrage,

3. IPO bookbuilding,

4. A stock-based takeover.

1. IPO underpricing

IPO underpricing is the practice of setting the offer price of newly issued shares below their expected market value, causing the stock to jump in price on the first day of trading.

✅ 2. Merger arbitrage

Merger arbitrage is an investment strategy that profits from price differences between a target firm’s stock price and the acquisition offer price, typically by buying the target’s shares and sometimes shorting the acquirer’s shares.

✅ 3. IPO bookbuilding

IPO bookbuilding is the process through which underwriters gather investor demand to determine the appropriate offer price and allocation of shares in an IPO.

✅ 4. A stock-based takeover

A stock-based takeover is an acquisition in which the acquirer pays for the target company using its own shares rather than cash.1. IPO underpricing

IPO underpricing is the practice of setting the offer price of newly issued shares below their expected market value, causing the stock to jump in price on the first day of trading.