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EXAMINATION PAPER: ACADEMIC SESSION 2007/2008

Campus Maritime Greenwich

School Business

Department Accounting & Finance

Course Code FINA1027

Course Title Finance

Level 3

Duration THREE HOURS

Date May 2008

Course co-ordinator: Becksndale Masawi

INSTRUCTIONS TO CANDIDATES

Answer FOUR questions only.

All questions carry equal marks.

This is a CLOSED book examination.

May 2008
Course Title Finance
Course Code FINA1027
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Question One

You are given the following data relating to HSBC equity options which are trading
on the New York Stock Exchange.

Underlying security price = 192

Strike Call Put

Price May Aug Nov May Aug Nov
177 20.00 24.75 28.25 2.75 7.50 11.00
203 6.50 11.26 17.75 10.75 16.50 20.25

(a) Determine the intrinsic values of call and put options above. (4 marks)

(b) What is the difference in meaning between intrinsic and time value of
an option. (3 marks)

(c) Discuss how an increase in (i) interest rates (ii) volatility of share price
and (iii) share price, (iv) the term to expiry and (v) a lower strike price
would affect the value of a put option. (15 marks)

(d) In relation to the data given above Masawi bought 2500 August call
options with a strike price of 203p. At the time he exercised them, the
underlying security price has risen to 285p. Ignoring interest calculate
his payoff. (3 marks)
(Total 25 marks)

Question Two

(a) Discuss the theories that explain the term structure of interest rates.
(12 marks)

(b) The Central Bank in Zimboland has given indications that the inflation rate
is likely to fall from 9% to 6% by the end of next year. Discuss how this
could impact on the price of bonds listed on the London Stock Exchange.
(3 marks)

(c) Company X is wholly equity financed but is contemplating introducing

debt into its capital structure. It would like to issue a bond of nominal
value of £100m with a coupon of 12% per annum payable quarterly with a
term of 5 years and maturing at a premium of 2%. What should be the
price of the bond for it to yield 8% per annum to maturity?
(5marks)

(d) If a firm is subject to a corporation tax rate of 30%, income tax on debt of
9% and tax rate on equity income 20% and the value of the ungeared firm
is £150m, what will be the value of the firm at a gearing level of 50%?
(5 marks)
(Total 25 marks)
May 2008
Course Title Finance
Course Code FINA1027
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Question Three

Value creation has increasingly become one of the chief mandates of the financial
manager of today.

(a) Discuss what the financial manger could do to ensure that value is created
within a firm. (10 marks)

(b) Compare and contrast the various metrics that could be used to measure
shareholder value creation. (8 marks)

(c) Shareholder Value Analysis (SVA) by Rappaport (1986) provides a framework

for linking management decisions and strategies to value creation. Identify and
discuss the key value drivers, explaining how they emanate from the strategic
focus of the business. (7 marks)
(Total 25 marks)

Question Four

(i) Consider a three-factor Arbitrage Pricing Theory (APT) model based on the
following factors and risk premia:

Factor Risk premium

Change in GDP +5%
Change in energy prices -1%
Change in long-term interest rates +2%

The risk-free interest rate is 7%.

Calculate expected rates of return on the following stocks:

(a) a stock with average sensitivity (i.e. a sensitivity of 1) to each factor;

(3 marks)

(b) a pure-play energy stock with high sensitivity (i.e. a sensitivity of 2) to

the energy factor but zero sensitivity to the other two factors;
(3 marks)

(c) an aluminium company stock with average sensitivity to changes in

interest rates and GDP but negative sensitivity (-1.5) to the energy
factor. (3 marks)

(ii) Describe the Capital Asset Pricing Model (CAPM) giving assumptions behind it
and outlining its overall purpose. (8 marks)

(iii) Explain how CAPM may be used by finance professionals and why you may
have reservations about its usefulness. (8 marks)
(Total 25 marks)
May 2008
Course Title Finance
Course Code FINA1027
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Question Five

(i) XYZ plc prides itself on a consistent dividend policy. Past data suggest that its
target payout ratio is 50%. However, when earnings increase, XYZ invariably
raises its dividend only half-way towards the level that the target dividend
payout ratio would indicate. The last dividend was £1 per share and XYZ has
just announced earnings for the recently ended financial year of £3 per share.
What dividend per share would you expect the Board to recommend?
(6 marks)

(ii) Discuss some of the key factors that the senior management of a listed
company should consider when making a decision on the size of the annual
dividend to be paid to its shareholders. (9 marks)

(iii) Discuss how the existence of capital market imperfections would invalidate
the dividend policy irrelevance proposition by Miller and Modigliani of 1961.
(10 marks)
(Total 25 marks)

Question Six

NW is a company which is paying dividends as a fixed proportion of earnings per

share of 40%. It earnings per share are rising at 5% per annum and the figure for the
current year is £0.35. The required rate of return for the company is 10%

(a) What would you expect to be the price of a share? (5 marks)

(b) If the firm decided to change its payout ratio today and announced its intention
and the market believed its statement that its payout ratio will now be 50%
what do you think would be the rise in the share price of NW as a result.
(5 marks)

(c) What is the PE ratio of NW when the payout rate is 40% and what is the PE
ratio when the payout rate is 50%? (5 marks)

(d) Explain how the Gordon Growth Model can provide an effective mechanism
for valuing the firm and in particular why it should provide a result consistent
with the present value method.
(10 marks)
(Total 25 marks)

Question Seven

To what extent do you regard all the different techniques of corporate valuation just
simplifications of the calculation of expected present value?
(25 marks)

May 2008
Course Title Finance
Course Code FINA1027
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Question Eight

Assume that the following data gives a correct representation of the distribution of
returns on assets A and B.

All figures for return in

%

Year 1 2 3 4 5 6 7 8 9 10

Return
A 7 8 7 8 9 -5 5 8 8 7
Return
B 2 9 8 -1 -2 15 8 9 6 8

(a) Calculate the average return, standard deviation of returns and Value at Risk
(VaR) at 10% level and Expected Tail Losses (ETL) at 10% level.
(10 marks)

(b) Compare the choices and indicate the choice made by a standard risk averse
investor may not reflect investors’ attitude to risk.
(15 marks)
(Total 25 marks)

May 2008
Course Title Finance
Course Code FINA1027
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