IB 2360 Finance 2: Corporate Finance Warwick Business School Solutions to Summer 2008 Exam Paper

[Note: Contents of Questions 8, 11(b) and 11(c) are not covered in 2009-2010.] Question 1: Answer B LEA: Asset beta = 0.8 / (1+0.6) = 0.5 COV: Equity beta = 0.5 * (1+0.2) = 0.6; r = 5+0.6*10 =11%.

Question 2: Answer D Cost of equity=rf+beta(rm-rf)=3%+1.5(8%-3%)=3%+7.5%=10.5%; After-tax cost of debt =10%*(1-0.3)=7% WACC = 0.8*10.5%+0.2*7%=8.4%+1.4% = 9.8%

Question 3: Answer E c = p + S –PV(X) = 3.7 +8 -10/1.05 = 2.18 >1.4 The call is under-priced.

Question 4: Answer E

Question 5: Answer B PV(interest tax shield) = TC DL (since the debt is perpetual and riskfree and there are no costs of financial distress) VU = VL − VTS = VL − TC DL = £10m − 0.2 × £6m = £8.8m

Question 6: Answer A

then S=60 e. d = 36/54 = 2/3. 575 = 57 . the payoff S/3 -20 = 90/3 -20 =10 You should draw the payoff function: Payoff 10 0 60 90 S Part b Risk-neutral method: Let π be the risk-neutral probability with which the stock price will go up.4x10) = 190 mil New Share Price = 190 / 14 = 13.57 Value of Rights needed to buy a share = 13.g. 5 % . u = 72/54= 4/3.57 / (10/4) = 1. if S=90.Question 7: Answer D Question 8: Answer A Current Market Value = 10 x 15 = 150 mil Total Shares = 10 + 10*0.43 Question 9 Part a If the payoff S/3 -20 =0.57 – 10 = 3. 10 / 2 = ( 4 / 3 ) π + ( 2 / 3 )( 1 − π ) ⇒ π = 0 . 1 + r f = u π + d (1 − π ) 1 + 0 .4 = 14 mil New Market Value = 150 + (10*0.57 Value of a Right = 3.

81) Value of the derivative = value of tracking portfolio = -3. . You have an immediate riskless profit of 6-1-3.81 = £1. and then you go short on 1/9 underlying assets generating cash inflow of 6.575 ⋅ 4 ) = 2 . and you lend £3.81 + 1/9*54 = 2.05 = -3. the call is worth max (72/3-20.10 / 2) = 0 Δ = ( 4 − 0) /(72 − 36) = 1 / 9 β = ( 4 − 72 / 9) / 1. 0) = 4. beta = (0 – 36/9) / 1.If the stock price rises. the call is zero. 72Δ + β (1 + 0.05 = −3.425 ⋅ 0) + (0. if it falls.19 Part d You buy one derivative so you have cash outflow of 1.81 (alternatively. 05 Part c Tracking-portfolio method: We replicate the payoff of the derivative with a portfolio composed by Δ underlying asset and β risk free bonds.19. Thus the value of the derivative is: (0.05 = −4 / 1.10 / 2) = 4 36Δ + β (1 + 0. 19 1 .81.

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