Advanced Finance – GEST-S-402 – 19 January 2016

Professor: Laurent Gheeraert

ADVANCED FINANCE
EXAM

19 January 2016

1. This is an individual, closed-book exam; any attempt to cheat will be penalized by the
immediate cancellation of the exam.

2. The exam is closed-book, however every student is allowed to use during the exam one page
(two-sided) containing personal notes (photocopies will not be accepted).

3. You may answer in British English, American English, or French. An English dictionary is
allowed during the exam.

4. The exam duration is 3 hours sharp.

5. The exam will be graded on 20 points. Each question (market by a number) is worth one point.

6. One error is penalized only once. In case you estimate that a piece of data is missing or
ambiguous, state clearly your hypothesis in your answer and go ahead with solving the
question.

7. Your answers to the qualitative questions (where no calculation is required) should not be
long, but precise.

8. All types of classical calculators (including graphic / financial calculators) are authorized. The
use of a computer, smartphone and/or computer-like calculator is not authorized. Students
are requested to use their own calculator and may not borrow from or share a calculator with
another candidate during the exam.

9. Answer all questions in a thorough, clear and readable manner. Any ambiguous or unreadable
answer plays against you.

10. You are allowed to use draft paper, however ONLY your final copy will be corrected.

11. Upon completion of the exam, you are requested to hand over to the supervisor ALL exam
material, including the exam questionnaire.

12. Write your name on ALL the pages.

13. Check that your questionnaire contains 4 pages.

14. Good luck!

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 Advanced Finance – GEST-S-402 – 19 January 2016

Professor: Laurent Gheeraert

Part 1. Risk-Return
You have access to the following data concerning the Lion’s company and the market portfolio:

 Variance of returns on the market portfolio = 0.04326

 Covariance between the returns on Lion’s and the market portfolio = 0.0635.
 Volatility of returns of the Lion’s stock value = 20%
 Expected market risk premium = 9.4%
 Expected return on Treasury Bills = 4.9%

1) What is the beta of Lion’s? Interpret your answer.

2) Explain carefully the difference between the volatility and the beta.

3) What is the required return on Lion’s stock?

Suppose now that the beta of Lion’s is -0.3.

4) How does its required return compare to the risk-free rate, according to the CAPM? Does
this result make sense? Why would any investor invest in Lion’s?

5) The management of Lion’s company just announced that it is about to borrow a large
amount of money from a consortium of banks in order to pay back some shares. Will there
be an impact on the company beta? If yes, which one. Explain carefully and indicate which
beta you are talking about.

Part 2. Portfolio Management

Suppose that you have 100,000 € in cash, and you decide to borrow another 15,000 € at a 4%
(risk-free) interest rate to invest in the stock market. You invest the entire 115,000 € in a stock
Goldfinger (market capitalization of 15 million) with a 15% expected return and a 25% volatility.

6) What are the expected return and volatility of your portfolio (as a reminder, your portfolio
has a market value of 100,000 €)?

Suppose now that you decide to invest only in risky assets (you don’t borrow anymore) and that
there is only one another stock available on the financial market (called Moosehead) with an
expected return and volatility respectively equal to 22% and 32%. The correlation between the
returns of the stocks is equal to 0.5. The market capitalization of Moosehead is equal to 25 million.

7) If you want to create a portfolio with a return of 18%, what are the weights invested in
each stock? What is the volatility of this portfolio?

8) What are the expected return and beta of the market portfolio? Explain carefully your
reasoning.

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 Advanced Finance – GEST-S-402 – 19 January 2016

Professor: Laurent Gheeraert

Suppose you are allowed to invest in the risk-free asset, and that your utility function can be
expressed as: 𝑈 = 𝐸(𝑅𝑝 ) − 𝑎𝜎𝑝2 where Rp represents the expected return on your portfolio, 𝜎𝑝 is
the standard deviation of your portfolio and a is your risk aversion.

9) If your risk aversion is equal to 1, what is your optimal portfolio?

10) Using the utility function, check that the portfolio calculated in 9) is the most preferable
for you (compared to previous situations).

Part 3. Capital Structure

Your triple diploma from UCL, ULB and ICHEC has impressed the CFO of a reputable company. As
a result, he has hired you, after the first interview, as his main financial advisor. The company is
considering a project of €475 million. This project should generate an unlevered free cash flow
(FCFU) of €180 million during 4 years. The unlevered cost of equity is kA = 20%. The cost of debt
(kD) = 10%. The marginal corporate tax rate is 34%.

11) Would you accept the project if financed at 100% by equity?

The firm finances 25% of the project with debt. The debt stays the same during the project life,
and is reimbursed upon project termination.

12) Use the APV method to find out the value of the project.

13) Compute the Cash Flows to Equityholders (CFE). Hint: for each year, first compute the
free cash flows of the levered company, then add the change in debt.

Suppose the company now has a target debt-to-value ratio of 0.25.

14) Use the WACC method to determine the value of the project.

Assume all-equity financing of the project.

15) What is the impact on the value of the project if the FCFU does not stop after year 4 but
instead grows after year 4 at a perpetual annual growth rate of 2%?

Part 4. Company valuation

You are a financial analyst. You spent several days scrutinizing the market and you discovered a
very promising start-up company which expects to launch an excellent solar panel technology for
private consumers. You estimate the company unlevered FCF as follows (the company has a
patent on the new technology protecting it from competition over the next two years):

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 Advanced Finance – GEST-S-402 – 19 January 2016

Professor: Laurent Gheeraert

Numbers in 2015 2016 2017 2018 From 2019

million euros onwards
(perpetuity)

Unlevered FCF of -100 100 100 50 25

the company

All cash-flows occur at year end (31 December). The company is not publicly quoted yet. The risk-
free interest rate on the market is 4%, and the expected market return is 10%. The corporate tax
rate is 30%. You estimate the company beta of equity to be 1.5. The company has debt-to-equity
ratios of 50% and 75% respectively in market and book values (you assume that these ratios will
stay stable over time). Assume that the company cost of debt is 6%.

16) What is the company cost of equity?

17) What is the WACC of the company?

18) The company envisages to get financed on the equity market through an IPO (Initial Public
Offering, i.e., the process through which shares of the company are being sold to the
general public for the first time through a stock exchange), but the timing is still uncertain.
Please compute the company market capitalization and the company value, if the IPO
takes place on 31st December 2018 (after the payment of the FCF2018).

19) Please compute the company market capitalization and the company value, if the IPO
takes place on 31st December 2016 (after the payment of the FCF2016).

20) You observe that the company is underleveraged compared to many other companies in
the sector. Could the company management increase the company value by increasing or
decreasing the debt? What would be the effect on the company WACC? Thoroughly
explain (without calculation).

Part 5. Bonus
We are in the real world and markets are not perfect.

21) Please refer to questions 12 and 14. Explain two potential sources of differences in the
valuation using the APV versus the WACC method.

22) Thoroughly define the notion of “agency costs” between bondholders and shareholders.
Choose one type of such agency costs and clearly show why it is a cost. Feel free to refer
to Myers’ paper (“Capital Structure”, Journal of Finance, 2001).

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