A30696

Business School/Finance Department

MSc in Financial Management 2015-2016

Corporate Financial Management/07 26685
Final Examination
Main Summer 2016 Examinations

Time Allowed: 3 hours

Answer ALL QUESTIONS
[100 marks in total]

Text books permitted: None

Notes permitted: None
Paper dictionaries permitted: None
Electronic dictionaries permitted: None
Calculators permitted: Calculators may be used
provided they are not financial
calculators and must not be
used to store text. Calculators
with the ability to store text
should have their memories
deleted prior to the start of the
examination.
Formula sheet: Some useful formulas are
provided at the end of exam
paper
A30696 Specified calculator

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Answer ALL QUESTIONS

1. Part A [30 marks]

2. Part B [40 marks]

2. Part C [30 marks]

[100 marks in total]

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A30696 Specified calculator
Instructions

1. You will have 3 hours to complete the exam.

2. The exam has three parts (A, B and C). Part A consists of 20 Multiple Choice Questions
(MCQs). Part B consists of Numerical and/or Descriptive Questions. Part C consists of 1
descriptive question. You must answer ALL questions of each part of the exam.
3. In the case of the MCQs, you are advised to plan your answers on this document and/or
scrap paper and then transfer them to the answer sheet before the end of the exam.
However, make sure that you leave sufficient time for completing the MCQ answer sheet.
4. Part A: MCQs – Machine-readable answer sheet.
 Use the special machine-readable answer sheet provided to answer the questions. From
the answers provided for each question, choose the single best answer (i.e., A, B, C, D,
or E) and mark it carefully on the answer sheet against the relevant question number.
Note that this may involve separating the one false statement from other true ones.
 Use a pencil only to carefully mark one letter per question with a heavy horizontal line
within the appropriate brackets. You must not use erasers or wipe-out with the answer
sheet. If you make a mistake, or want to change and answer, then raise your arm to
request a new answer sheet.
 Write your full name and student number in the relevant boxes on the answer sheet, and
ALSO use a pencil only to mark your student number on the machine readable part of the
form.
 Write the module number (i.e., 07 26685) and date in the relevant boxes on the answer
sheet.
5. Part B: Numerical and/or Descriptive Questions and Part C: Descriptive Only Questions –
Answer book(s)
 Please use the answer book(s) provided for your answers, beginning a fresh page of the
answer book(s) each time you begin a new question. If you use more than 1 answer book
then tie them together using the supplied treasury tag. We will not accept any loose-leaf
paper. Think first, write later!
 Use pen only for this part of the exam – no pencils should be used in the answer book(s).
 Write your full name and student number in the relevant boxes on the answer book(s),
and seal down the anonymity flap on your answer book(s).
 Write the module number (07 26685) and date in the relevant boxes on the answer sheet.

TURN OVER

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A30696 Specified calculator

Part A. Multiple Choice Questions (MCQs)

Part A comprises 20 MCQs, each worth 1.5 marks.
You must answer all of these MCQs [30 marks in total].
You will not receive negative marks for any incorrect answers.

1) The following table summarizes prices of various default-free zero-coupon bonds

(expressed as a percentage of face value):

Maturity (years) 1 2 3 4 5
Price (per $100 face value) 94.52 89.68 85.40 81.65 78.35

Based upon the information provided in the table above, you can conclude

A) that the yield curve is flat.

B) nothing about the shape of the yield curve.
C) that the yield curve is downward sloping.
D) that the yield curve is upward sloping.

Answer: C

2) One can best describe the term structure of interest rates as the relationship
between:

A) spot interest rates and bond prices.

B) spot interest rates and stock prices.
C) spot interest rates and time.
D) yields of coupon bonds and their maturity.

Answer: C

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 3) Given the following costs (in £) of operating two machines and a 7% cost of
capital, choose the machine with the lowest cost:

Machine Year 0 Year 1 Year 2 Year 3 Year 4

A -16 -6 -6 -6
B -9 -4 -4
C -25 -5 -5 -5 -5

A) A
B) B
C) C
D) Both B and C have the same lowest cost

Answer: B
EACA = -£31.75/ 2.62 = -£12.10
EACB = -£16.23 / 1.81 = -£8.98
EACC = -£38.12 / 3.39 = -£11.25

4) VBC is expected to pay a $2.00 dividend at the end of this year. If you expect
VBC's dividend to grow by 5% per year forever and VBC's equity cost of capital
is 13%, then the value of a share of VBC stock is closest to:

A) $25.00
B) $40.00
C) $15.40
D) $11.10

Answer: A
P0 = Div1/(rE - g) = 2.00/(.13 - .05) = $25.00

Use the table for questions 5-6 below.

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Consider the following probability distribution of returns for Alpha Corporation:

Current Stock Stock Price in Return Probability

Price ($) One Year ($) (R) (PR)
£35 40% 25%
£25 £25 0% 50%
£20 -20% 25%

5) The expected return for Alpha Corporation is closest to:

A) 6.67%
B) 5.00%
C) 10.00%
D) 0.00%
Answer: B

E[R] = PR × R = .25(40%) + .50(0%) + .25(-20%) = 5%

6) The variance of the return on Alpha Corporation is closest to:

A) 0.050
B) 0.0475
C) 0.03625
D) 0.0375

Answer: B
E[R] = PR × R = .25(40%) + .50(0%) + .25(-20%) = 5%
Var(R) = PR × (R - E[R])2 = .25(.40 - .05)2 + .50(.00 - .05)2 + .25(-20 - .05)2 =
.0475 or 4.75%

7) Suppose that the market portfolio is equally likely to increase by 24% or

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 decrease by 8%. Security "X" goes up on average by 29% when the market
goes up and goes down by 11% when the market goes down. The beta for
security "X" is closest to:

A) 0
B) 0.80
C) 1.00
D) 1.25

Answer: D
Change in Market = 24% - (-8%) = 32%, change in security = 29% - (-11%) = 40%,
Beta = 40%/32% = 1.25

8) Use the information in the table to answer the following question:

Company Ticker Beta

Ford Motor Company F 2.77
International Business Machines IBM 0.73
Merck MRK 0.90

If the market risk premium is 6% and the risk-free rate is 4%, then the expected
return of investing in Ford Motor Company is closest to:

A) 10.0%
B) 16.2%
C) 17.1%
D) 20.6%

Answer: D
Explanation: Return = 0.04 + 2.77(0.06) = .2062 → 20.62%

9) Suppose that in the coming year, you expect Exxon-Mobil stock to have a
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 volatility (standard deviation) of 42% and a beta of 0.9, and Merck's stock to
have a volatility of 24% and a beta of 1.1. The risk free interest rate is 4% and
the market's expected return is 12%. The cost of capital for a project with the
same beta as Exxon Mobil's stock is closest to:

A) 11.6%
B) 11.2%
C) 12.8%
D) 7.6%

Answer: B
E[R] = Rf + Beta × Risk Premium = .04 + .9 × (.12 - .04) = .112

10) The difference between scenario analysis and sensitivity analysis is that:

A) scenario analysis is based upon the IRR and sensitivity analysis is based
upon NPV.
B) only sensitivity analysis allows us to change our estimated inputs of our NPV
analysis.
C) scenario analysis considers the effect on NPV of changing multiple project
parameters.
D) only scenario analysis breaks the NPV calculation into its component
assumptions.

Answer: C

11) H&M has an outstanding bond with the face value of £100, paying annual
coupon of 5% and maturing in one year. Currently the bond trades at par.
Analysts estimate the probability of H&M defaulting on its debt to be 2% and a
50% recovery rate in the event of default. What is the bond’s promised yield
and what is the expected return on H&M’s debt?

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 A) The bond’s promised yield and the expected return on debt are both 5%.
B) The bond’s promised yield is 3.95% and the expected return on debt is 5%.
C) The bond’s promised yield and the expected return on debt are both 3.95%.
D) The bond’s promised yield is 5% and the expected return on debt is 3.95%.

Answer: D.
Promised yield = coupon = 5%. Given the default probability, the investor receives
the payment only with probability of 98% → expected return = 0.98*105 + 0.02*52.5 =
103.95 → E[rd] = 3.95%

12) Modigliani and Miller’s Proposition I states that:

A) The market value of any firm is independent of its capital structure.

B) The market value of a firm’s debt is independent of its capital structure.
C) The market value of a firm’s common stock is independent of its capital
structure.
D) None of the options above.

Answer: A.

13) Merck Services starts life with all-equity financing and a cost of equity of 15%.
Merck pays taxes at a marginal rate of Tc=40%. Suppose the company
refinances to the following capital structure:

Debt (D) 30% At rD=8%

Equity (E) 70%

Use MM’s proposition 2 to compute Merck’s new cost of equity and the after-tax
weighted average cost of capital after refinancing.

A) rE=16.8% and rwacc=13.2%

B) rE=18.0% and rwacc=15.0%

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 C) rE=17.1% and rwacc=14.4%
D) rE=17.1% and rwacc=15.0%

Answer: A
rE = 0.15 + (30/70)*(0.15-0.08)*(1-0.4) = 0.168 or 16.8%
rwacc = 0.168*0.7 + 0.08*0.3*(1-0.4) = 0.132 or 13.2%

14) CFM Corp. borrowed £1,000 for one year at an annual interest rate of 8%. The
marginal corporate tax rate is 35%. The present value of interest tax shields
generated by this loan is closest to:

A) £80
B) £35
C) £74
D) £26

Answer: D
PV(tax shield) = (Tc*rD*D)/(1+rD) = (0.35*0.08*1,000)/1.08 = £26

15) Which of the following statements is false?

A) Modigliani and Miller’s (MM) propositions assume perfect financial markets, with
no distorting taxes or other imperfections.
B) Borrowing does not increase financial risk and the cost of equity if there is no
risk of bankruptcy.
C) MM’s proposition 1 says that corporate borrowing increases earnings per share
but reduces price-earnings ratio.
D) MM’s proposition 2 says that the cost of equity increases with borrowing and
that the increase is proportional to D/E, the ratio of debt to equity value.

Answer: B. False: debt amplifies variations in equity income even if there is no risk of
bankruptcy.

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16) Which of the following statements is correct concerning the standard deviation
of an inefficient portfolio?

A) The greater the diversification of a portfolio, the greater the standard deviation
of that portfolio.
B) The standard deviation of a portfolio can often be lowered by changing the
weights of the securities in the portfolio.
C) Standard deviation is used to determine the amount of risk premium that should
apply to a portfolio.
D) Standard deviation measures only the systematic risk of a portfolio.
E) The standard deviation of a portfolio is equal to a weighted average of the
standard deviations of the individual securities held within the portfolio.

Answer: B

17) The overall cost of capital for a firm in a zero tax environment is:

A) Equal to the expected earnings divided by the market value of the same
unlevered firm.
B) Equal to the rate of return for that firm’s business risk class.
C) Equal to the overall rate of return required on the same levered firm.
D) Is constant regardless of the amount of leverage.
E) All of the above.

Answer: E

18) A security that is overpriced will have a return ________ the security market
line?

A) Below
B) On or below
C) On

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 D) On or above
E) Above

Answer: A

19) You invested in a firm’s stock when it was financed solely with equity. The firm
is now using debt in its capital structure. To unlever your position, you need to:

A) Borrow some money and purchase additional shares of the firm’s stock.
B) Maintain your current position as the debt of the firm did not affect your personal
leverage position.
C) Sell some shares of the firm’s stock and hold the proceeds in cash.
D) Sell some shares of the firm’s stock and loan out the proceeds such that you
create a personal debt-equity ratio equal to that of the firm.
E) Create a personal debt-equity ratio that is equal to exactly 50% of the debt-
equity ratio of the firm.

Answer: D

20) When managers pursue selfish shareholder strategies such as taking risks or
paying excessive dividends, these will result in:?

A) No action by debt holders since these are equityholders’ concerns.

B) Positive agency costs as bondholders will impose various restrictions and
covenants that will diminish firm value.
C) Investments of the same risk class that the firm is in.
D) Value-enhancing projects being undertaken.
E) Lower agency costs as shareholders have more control over the firm’s assets.
Answer: B
Total for Part A: 30 marks

PLEASE CONTINUE TO PART B OF THE EXAM

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 Part B. Numerical and/or Descriptive Questions.
Answer all questions in this part [40 marks in total].
You must show all workings where indicated to get full marks.

1) NewStreet Technologies (NST) is considering a new capital budgeting project

that will last for three years. NST will need a new production line for the project.
The upfront cost of setting up the production line is £90,000, which will be
depreciated straight-line over 3 years (until Year 3). If the company decides to
launch the project, it will have to incur the cost of £20,000 to establish an after-
sales customer service strategy. The two costs are to be incurred in Year 0.
From Year 1 to Year 3, the predicted sales volume of the new product is 50,000,
the predicted unit cost of production is £1 and the predicted price of each unit is
£4. NST will also have to invest in working capital from Year 1, which will be fully
recovered in Year 3. Predicted working capital balances are shown in the
following table:

Year 0 Year 1 Year 2 Year 3

Inventory £0 £6,000 £6,000 £0

Accounts receivable £0 £2,000 £1,500 £0

Accounts payable £0 £3,000 £3,500 £0

In Year 2, the firm will be required to pay an additional fee of £4,000 to the local
carbon emissions authorities. The corporate tax rate is 25% (assuming losses give
rise to tax savings). Assume that cash flows arrive at the end of each year. The
project will be financed by issuing new equity.

(i) Using the information described above, calculate the free cash flow that
will be generated by the project for each year. Briefly explain each step of
your calculation.
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 [15 marks]

Year 0 1 2 3

Sales 200 200 200 [2 marks]

- Cost 50 50 50 [2 marks]

- Depreciation 30 30 30 [2 marks]

- Other Costs 20 4 [2 marks]

EBIT -20 120 116 120 [2 marks]

- Taxes (25%) -5 30 29 30

Net Income -15 90 87 90 [2 marks]

- CapEx 90

- ΔNWC 5 -1 -4

+ Depr. 30 30 30

FCF -105 115 118 124 [3 marks]

(ii) Suppose that a comparable firm in the same industry as the NewStreet
Technologies (NST) has a beta of 1.5. The market risk premium is 8% and
the risk-free interest rate is 4%. Using the information from question (i),

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 calculate the net present value (NPV) of the NST’s new project. Would you
recommend investing in the project?
[5 marks]

Cost of capital = 4 + 1.5*(8-4) = 10% [2 marks]

NPV = -105 + 115/1.1+118/1.12 + 124/1.13 = 190.23 [2 marks]

Invest - NPV > 0 [1 mark]

2) Your investment portfolio consists of £15,000 invested in only one stock – Cisco.
Suppose the risk-free rate is 5%, Cisco stock has an expected return of 12% and
a volatility of 40%, and the market portfolio has an expected return of 10% and a
volatility of 18%. Under the CAPM assumptions,

(i) What alternative investment has the lowest possible volatility while
having the same expected return as Cisco? What is the volatility of this
investment?

[5 marks]

E R p   rf  x  E R m   rf   5%  x  5%

=12%

X = 7%/5% = 1.4

Borrow $15,000*0.4 = $6000 and invest $15,000*1.4 =21000 in the

market

SD=1.4*18=25.2%

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 (ii) What investment has the highest possible expected return while having
the same volatility as Cisco? What is the expected return of this
investment?

[5 marks]

SD  R p   xSD  R m   x 18%
=40%

X=40%/18% = 2.22

Borrowing 1.22*$15,000 = $18,300 and investing $33,500 (=18,300 + 15,000)

in the market will have the same volatility as Cisco (=40%), but highest
possible expected rate of return (16.11%).

E R p   rf  x  E  R m   rf   5%  2.222  5%  16.11%

(iii) State the equations for the security market line and the capital market line.
Define all the symbols you are using carefully. Which point(s) the two lines
have in common? Explain under what condition(s) is a portfolio situated on
the security market line and under what conditions is a portfolio situated on
the capital market line?
[10 marks]

R j ,t  R f   j  Rm,t  R f    j ,t
SML:
E R j ,t   R f   j  E Rm,t   R f 
or :

  Rm,t  R f    j   j ,t
1
R j ,t  R f 
CML: m

E R j ,t   R f   E Rm,t   R f    j
1
or : m

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  
Common points: Point 1: Market portfolio  m  1 und  m - corresponds to E Rmt

Point 2: Risk-free asset with

r  0   r
f f
- corresponds to
 R
E Rr
f rf

- in equilibrium all stocks / portfolios lie on the SML

- all combinations from a risk-free investment and the market portfolio lie on CML

Total for Part B: 40 marks

PLEASE CONTINUE TO PART C OF THE EXAM

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 Part C. Descriptive only Question
Part C comprises of 1 Descriptive only Question worth 30 marks in total.
You must answer this part of the exam.

One of the theories attempting to explain how firms choose the optimal capital structure is
the Trade-off Theory. Discuss this theory. Provide algebraic and graphical explanations.
Compare the Trade-off Theory and its predictions with the Pecking Order theory.

Brief answer: (more complete required) The trade-off theory weighs the benefits and
costs of debt financing. The benefits of debt come from shielding cash flows from
taxes and agency benefits of leverage (agency costs of equity: reduction in shirking,
consumption of perks, “overinvestment”(empire-building)). The costs of debt are due
to financial distress costs and agency costs of leverage (e.g., asset substitution, debt
overhand/underinvestment).

According to this theory, the total value of a levered firm equals the value of the firm
without leverage plus the PV of the tax savings from debt and the PV of the agency
benefits of debt minus the PV of financial distress costs and PV of the agency costs
of debt → algebraic formula ...

Explanations are assessed together with graphical and algebraic representations.

The pecking order argument is based on the information asymmetry assumption:
managers know more about the firm than the market and so are concerned with
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timing of equity and new debt issues. Implication for investors: fear of buying
overvalued new shares → refrain from buying the shares. Implications for financial
managers: a pecking order is security issuance → retained earnings, debt, hybrid
securities, equity.

Trade-off model prediction: optimal leverage does exist.

The pecking order argument is based on the information asymmetry assumption:

managers know more about the firm than the market and so are concerned with
timing of equity and new debt issues. Implication for investors: fear of buying
overvalued new shares → refrain from buying the shares. Implications for financial
managers: a pecking order is security issuance → retained earnings, debt, hybrid
securities, equity.

Pecking order: optimal leverage does not exist; realized leverage results from
financing needs, firms issue equity according to pecking order.

Total for Part C: 30 marks

TURN OVER
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 FORMULA SHEET

Present value of perpetuity

𝑐
𝑃𝑉 =
𝑟

Present value of growing perpetuity

𝑐
𝑃𝑉 =
𝑟−𝑔

Present value of annuity

𝑐 1
𝑃𝑉 = (1 − )
𝑟 (1 + 𝑟)𝑇

Present value of growing annuity

𝑐 1+𝑔 𝑇
𝑃𝑉 = (1 − ( ) )
𝑟−𝑔 1+𝑟

Interpolation formula for IRR

𝑁𝑃𝑉𝐿𝐷𝑅
𝐼𝑅𝑅 = 𝐿𝐷𝑅 + × (𝐻𝐷𝑅 − 𝐿𝐷𝑅)
𝑁𝑃𝑉𝐿𝐷𝑅 − 𝑁𝑃𝑉𝐻𝐷𝑅

Some statistical concepts

𝑉𝑎𝑟(𝑎𝑋̃ + 𝑏𝑌̃ + 𝑐) = 𝑎2 𝑉𝑎𝑟(𝑋̃) + 𝑏 2 𝑉𝑎𝑟(𝑌̃) + 2𝑎𝑏𝐶𝑜𝑣(𝑋̃, 𝑌̃)

𝐶𝑜𝑣(𝑎𝑋̃ + 𝑐, 𝑏𝑌̃ + 𝑑) = 𝑎𝑏𝐶𝑜𝑣(𝑋̃, 𝑌̃)

TURN OVER

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 𝐶𝑜𝑣(𝑎𝑋̃, 𝑏𝑌̃ + 𝑐𝑍̃) = 𝑎𝑏𝐶𝑜𝑣(𝑋̃, 𝑌̃) + 𝑎𝑐𝐶𝑜𝑣(𝑋̃, 𝑍̃)
𝐶𝑜𝑣(𝑋̃, 𝑌̃)
𝐶𝑜𝑟𝑟(𝑋̃, 𝑌̃) = 𝜌𝑋̃,𝑌̃ =
𝜎𝑋̃ 𝜎𝑌̃

For expected outcomes

𝐸(𝑋̃) = ∑ 𝑝𝑖 𝑋𝑖
𝑖
2 2
𝑉𝑎𝑟(𝑋̃) = 𝐸 (𝑋̃ − 𝐸(𝑋̃)) = ∑ 𝑝𝑖 (𝑋𝑖 − 𝐸(𝑋̃))
𝑖
𝐶𝑜𝑣(𝑋̃, 𝑌̃) = 𝐸 (𝑋̃ − 𝐸(𝑋̃)) 𝐸 (𝑌̃ − 𝐸(𝑌̃)) = ∑ 𝑝𝑖 (𝑋𝑖 − 𝐸(𝑋̃)) ((𝑌𝑖 − 𝐸(𝑌̃))
𝑡

Capital Asset Pricing Model

𝐸[𝑟𝑖 ] = 𝑟𝑓 + 𝛽𝑖 (𝐸[𝑟𝑚 ] − 𝑟𝑓 )

Modigliani-Miller Proposition I with corporate taxes

𝑉𝐿 = 𝑉𝑈 + 𝑡𝐶 𝐷

Modigliani-Miller Proposition II with corporate taxes

𝐷
𝑟𝐸 = 𝑟𝐴 + (𝑟 − 𝑟𝐷 )(1 − 𝑡𝐶 )
𝐸 𝐴

Miller (1977) Model

(1 − 𝜏𝑐 )(1 − 𝜏𝑒 )
𝑉𝐿 = 𝑉𝑈 + [1 − ]𝐷
(1 − 𝜏𝑖 )

END OF FORMULA SHEET

END OF PAPER

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