1. Who owns a corporation? Describe the process whereby the owners control the firm’s management. What is the main reason that an agency relationship exists in the corporate form of organization? What kinds of problems can arise?
Answer: In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect the directors of the corporation, who in turn appoint the firm’s management. This separation of ownership from control in the corporate form of organization is what causes agency problems to exist. Management may act in its own or someone else’s best interests, rather than those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm.
2. According to the CAPM, the expected return on a risky asset depends on three components. Describe each component, and explain its role in determining expected return.
Answer: The CAPM suggests that the expected return is a function of (1) the risk-free rate of return, which is the pure time value of money, (2) the market risk premium, which is the reward for bearing systematic risk, and (3) beta, which is the amount of systematic risk prese
nt in a particular asset. Better answers will point out that both the pure time value of money and the reward for bearing systematic risk are exogenously determined and can change on a daily basis, while the amount of systematic risk for a particular asset is determined by the firm’s decision-makers.
3. Based on M&M without taxes and with taxes, what is optimal capital structure theory of M& M under these two cases?
Answer:  1. the no-tax case
Proposition Ⅰ: Vl = Vu
•The value of the firm is NOT affected by changes in the capital structure.
•The cash flows of the firm do not change; therefore, value doesn’t change.
Proposition II: RE = RA + (RA – RD)(D/E)
•deductibleThe WACC of the firm is NOT affected by capital structure.
•The cost of equity rises as the firm increases its use of debt financing.
2. the tax case
      Proposition Ⅰ : Vl = Vu + Tc * D
        Debt financing is highly advantages, and in the extreme, a firm’s optimal capital structure is 100 percent debt.
          A firm’s weighted average cost of capital (WACC) decreases as the firm relies more heavily on debt financing.
    Proposition Ⅱ:
              Re = Ru + (Ru – Rd) * (D/E) * (1-Tc)
4. Answer all of the following questions:
a)Why does asymmetric information push companies to raise external funds by borrowing rather than by issuing common stocks?
b)Describe the clientele effect. Does the existence of a clientele effect mean that firms can alter their market value by altering their dividend policy? What does the clientele effect imply about the type of dividend policy a firm should adopt?
Solution
a) In raising finance, managers often appear to follow a pecking order, where internal funds are preferred, followed by debt, hybrid securities and then, as a last resort, the issue of ordinary shares.  Myer (1984) explains this pecking order as being a result of information asymmetry, whereby:
∙All relevant information is not know by all interest parties; and,
∙This typically involves company insiders (managers) having more information about the company than outsiders (shareholders and lenders).
In other words, according to this argument, the choice of debt or equity will depend on whether management believes that the firm is overvalued or undervalued relative to some “
intrinsic” value.  More specifically:
∙If management believes the firm is undervalued, they will choose to issue the security that is least undervalued in order to raise funds: in other words, management will issue debt as it is less sensitive to mispricing than is equity; but,
∙If management believes the firm is overvalued, they will choose to issue the security that is most overvalued in order to raise funds: for the same reasons as above, they will choose to issue equity.
a)The term clientele effect describes the situation whereby investors choose to purchase shares in companies with characteristics meeting their specific requirements, particularly those relating to dividends.  One example of such an effect would be shareholders who can best make use of tax credits investing in firms who tend to pay fully franked dividends.  The existence of a clientele effect does not imply that a firm can alter its value simply by changing its dividend policy: By changing its dividend policy, the firm merely swaps one clientele for another, with this change having no effect on the firm’s value.  The clientele eff
ect implies that companies should select a stable dividend policy, or choose a clientele and stick with them.