MASTER OF FINANCIAL ECONOMICS

Department of Economics, University of Colombo

FINAL EXAMINATION 2021/2022
SEMESTER TWO
MFE 06 Financial Market
Time Allowed: Three (03) Hours
Answer Any Five (05) Questions Only

Question 1 (Based on Exhibit 2)

The management forecasts of various key indicators which was provided by Twitter management to the
two investment banks, Goldman Sachs (GS) and JP Morgan (JPM), are provided below:

TABLE 1 For the Financial year ended 31 Dec,

(All figures in $ Millions) 2022 2023 2024 2025 2026 2027
Revenue 5,928 7,200 8,481 9,793 11,264 12,917
Adjusted EBITDA 1,602 2,685 3,243 3,846 4,558 5,399
Adjusted Operating Income (Adj, EBIT) (47) 1606 1286 2,743 2059 2455
ⴕ
Cash Taxes - 165 215 273 348 442
Depreciation and Amortization 702 868 985 1,091 1,196 1,301
Capital Expenditures 968 982 1,018 1,077 1,014 1,033
Increases in Net Working Capital (11) 259 111 125 150 181
* Assume Twitter has 797.6 million outstanding shares. ⴕ Refer Formula Sheet for adjustment of cash taxes

A. Starting from adjusted Operating Income, calculate the Free Cash Flow to the Firm for each of the
years 2022 to 2027 based on data provided in Table 1. (6 Marks)

B. Using the average perpetual growth rates and average cost of capital provided in Paragraph D,
calculate the fair value of a Twitter share as at Dec 31, 2021. Assume that the market value of net debt
on Dec 31, 2021 is negative $1,364 million. (6 Marks)

C. Assuming, JPM calculated a best-case and worst-case estimate of price by using the range of perpetual
growth rates and cost of capital estimates provided in the exhibit, justify what two combinations of
each variable could be used to arrive at the best-case and worst-case estimate of price. (2 Marks)

D. Both JPM and GS had nearly completely relied on internal management forecasts provided in Table 1
to arrive at a fair value for Twitter. While this is not uncommon practice, discuss at least one shortfall
of this action and safeguards which could have been adopted to mitigate such problems. (2 Marks)

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E. The ratio of peer companies’ firm value to adjusted EBITDA (earnings before interest, taxes,
depreciation and amortization less stock-based compensation) calculated by JPM, as of April 22,
2022, are given below. Using the appropriate adjusted EBITDA (from Table 1) and the average of the
peer companies P / EBITDAADJ multiples, calculate the implied fair value of a Twitter share using
relative valuation methodology. Justify your choice for adjusted EBITDA utilized. (4 Marks)

Selected Peer Alphabet Inc. Meta Platforms, Inc. Pinterest, Inc. Snap Inc.
P / EBITDAADJ 10.4× 6.7× 11.2× 30.2×

(Total 20 Marks)

Question 2 (Question A to C are based on Exhibit 3)

A. Explain the mechanics of a rights issue and how a rights issue differs to a secondary offering of a
company’s shares. Is it correct to compare a rights issue to a call option? Why or why not?(5 Marks)

B. Compare and contrast the similarities and differences between a typical rights issue and the Limited
Duration Shareholder Rights Plan described under the exhibit. (3 Marks)

C. Assume that on April 30, 2022 Musk triggered the poison pill by acquiring 15% of Twitter at an
average price of $ 50.00. On April 30th Twitter had 800,641,166 shares of common shares outstanding.

a. Calculate the number of shares held by Musk and by other shareholders on 30-Apr-22. (2 Marks)

b. How many new shares can other shareholders buy once the poison pill is triggered (Round-down
your answer to the nearest whole share). (1 Marks)

c. How many new shares would be issued in total and what would be Musk’s shareholding
immediately after the poison pill is enacted by shareholders? (2 Marks)

D. Twitter went public in 2013 at a price of $ 26 per share via an offer for subscription of 70 million
shares. The underwriters had the option to purchase up to an additional 10.5 million shares in case of
over-subscription. The Underwriting commission was $ 0.845 per share. (7 Marks)

a. State at least two reasons as to why companies choose to go public through an IPO.

b. Explain the terms Offer for Subscription, Oversubscription and Underwriting Commission.

c. How much net proceeds would Twitter have raised if the over-subscription option was exercised?

(Total 20 Marks)

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Question 3 (Based on Exhibit 4)

A. Explain the concept of hedge funds including the objective and structure of a hedge fund. Compare
and contrast how a typical hedge fund’s objective, structure, investors, investments etc. may differ
from a typical mutual fund. (4 Marks)
B. Evaluate the rationale provided in the exhibit for going long on Twitter while shorting Tesla shares.
What are possible scenarios where the authors analysis may be flawed? (4 Marks)
C. Assume that on 12-Oct, a hedge fund decided to short 10.0 million Tesla shares and simultaneously
decides to purchase an equivalent value of Twitter shares of which part would be financed on margin.
Assume the initial margin is 60% and the maintenance margin is 30% for both transactions.
a. If the price of Tesla on 12-Oct is $ 217.24 and Twitter is $ 49.94, calculate the number of Twitter
shares the hedge fund would purchase (round-down your answer to the nearest whole number).
How much would the margin provider have lent to purchase the Twitter shares? (2 Marks)

b. Using separate T-diagrams indicate the short position and long position of the hedge fund as at
28-Oct if the Tesla share price on that day is $ 228.52 and Twitter is $ 53.60. (8 Marks)

c. Calculate and assess if either position would be subject to a margin call as at 28-Oct (2 Marks)

(Total 20 Marks)

Question 4 (Based on Exhibit 5.1)

A. Explain the meaning of underwriting with respect to corporate bonds, including the difference between
the underwriting process in the U.S. compared to Sri Lanka. How might the Banks have incurred
underwriting losses alluded to in paragraph E and F of the exhibit? (4 Marks)

B. What is loan syndication? How do Investment Banks participate in this process? What is the rationale
for a bank to take part in a loan syndication without lending directly to the borrower? (3 Marks)

C. Explain the difference between fund based and fee-based activities in investment banking and identify
whether underwriting, loan syndications and M&A should be classified as fee-based or fund-based
activities for a typical U.S. investment bank. Justify your choices made. (4 Marks)

D. Discuss the difference between secured junk bonds and unsecured junk bonds and explain why the
exhibit refers to unsecured debt as the riskiest debt. (3 Marks)

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E. Based on the coupon and maturity details provided in paragraph E calculate the Yield to Maturity of
the Twitter bonds having a price of 85 cents per $ 1.00 Face Value (Assume coupons are paid semi-
annually and all interest rates provided are p.a. rates compounded semi-annually). (6 Marks)

(Total 20 Marks)

Question 5 (Question A and B are based on Exhibit 5 and Question C is based on Exhibit 6)

A. Answer the following questions based specifically on information in Exhibit 5.2. (5 Marks)
a. Identify three risk premiums that investors may have considered to arrive at their required rate of
return when they bid to purchase the debt at a price of 60 cents per $ 1.00 Face Value. Briefly
explain each risk premium you have identified.

b. Other than demand and supply, why might the bid price be quoted as low as 60 cents when
compared to the information in Exhibit 5.1 which infers the fair value of the debt to be 85 cents?

B. Assume that investors believe that if Twitter declares bankruptcy, they will receive only 70% of the
Face Value of the bond at maturity. Based on the reduced estimate of Face Value and resulting
coupons, justify that the price of 60 cents quoted by investors is not too low when the average market
yields on comparably-rated bonds quoted in Paragraph D of Exhibit 5.1 is utilized (Use information –
other than price information - provided in Paragraph D and E of Exhibit 5.1 for your calculations;
Assume coupons are paid semi-annually and that all interest rates provided are p.a. rates compounded
semi-annually). (6 Marks)

C. Answer the following question based on Exhibit 6

a. Explain the underlying mechanics of Blockchain and explain why the exhibit states that
Blockchain works on the concept of decentralization. (4 Marks)

b. Using how blockchain works and the concept of decentralization, explain how Musk can
potentially “authenticate all real humans” and eliminate fake accounts on Twitter. (2 Marks)

c. What is the token-based reward system that originally resulted in the mainstream use of blockchain
since 2008? Based on your answer, explain why a similar token-based voting system may be
important when implementing the scenario in ‘b’ above. (3 Marks)

(Total 20 Marks)

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Question 6 (Based on Exhibit 9)

A. Explain why the exhibit states that TIPS are structured differently to conventional US government
Treasuries and that “the value of TIPS rises with inflation and decreases with deflation”. (3 Marks)

B. Extracts from the Notice of a recent Primary Auction conducted by the U.S. Treasury for Treasury
Inflation Protected Securities (TIPS) and Investor Guidance Information on TIPS is provided below:

TIPS at a Glance TIPS Primary Auction Notice

(Investor Information) (Extracts)
Issued in Electronic form only Term / Type of Security 5-Year TIPS
Available Maturities 5, 10, or 30 years Offering Amount $21,000,000,000
Interest rate Rate is fixed at auction Auction Date October 20, 2022
Interest paid Every six months Original Issue Date October 31, 2022
Minimum purchase $100 (Face Value) Maturity Date October 15, 2027
In increments of $100 Real Yield / Coupon Determined at Auction
Maximum purchase non-competitive bids – Reference CPI Value 296.22858
$10 Mn (Consumer Price Index) as
competitive bids – 35% at 15-Oct-2022
of amount offered
Eligible for STRIPS? Yes Interest Payment Dates April 15 and October 15

Results of the Treasury TIPS Auction held 20-October-2022

The auction received $ 256,034,500 non-competitive bids and $49,790,150,000 competitive bids.
The full amount offered was accepted. The lowest bid accepted was 1.627% while the highest bid
accepted was 1.732%. The weighted average was 1.669% and Coupon rate was set at 1.625%.

Assume Investor X placed a $ 20,000 competitive bid in the above auction at a yield of 1.7% while
Investor Y placed a $ 9,000 non-competitive bid at a yield of 1.65%.

a. Explain non-competitive and competitive bidding and based on the amount accepted at the
auction, calculate the success ratio for each category of bids made. (3 Marks)

b. Identify any inconsistencies in the statement made regarding Investor X and Investor Y. Determine
whether each investors’ bid (after correcting any errors identified) would have been successful at
the auction. If “YES”, at what yield would each investor have been allocated TIPS? Justify your
answer by comparing the auction process followed in the U.S. versus in Sri Lanka. (5 Marks)

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 c. Assume ‘Z’, who was allocated 100,000 TIPS at the above auction, decided to sell his quantity on
15-Nov-2022 on SPOT settlement basis. If the reference CPI on 15-Nov is 296.46827, calculate
the adjusted Face Value. How much accrued interest will ‘Z’ receive from the sale? (Ignore the
issue date and use the hypothetical last coupon date for your calculations) (3 Marks)

C. Critically analyze Musk’s tweet that buying property or company shares is a good investment in a high
inflation environment. (4 Marks)

D. Why is Gold generally considered a good hedge against inflation? (2 Marks)

(Total 20 marks)

Question 7 (Questions A to C are based on Exhibit 7)

A. Explain the mechanics of a Private Equity Buyout and discuss what may be possible reasons for Musk
to delist Twitter and take it private? (4 Marks)

B. Discuss the role of general partners and limited partners in private equity transactions. Graphically
depict the parties to the transaction, by mapping the Twitter transaction to a Private Equity Buyout
structure as described in the exhibit. (5 Marks)

C. Discuss the lifecycle of a Private Equity Buyout Fund and explain how investors in these funds expect
to make a return on their investment. Is your rationale valid for Musk’s equity partners? (4 Marks)

D. Twitter divides its revenue into two categories: the sale of advertising services and data licensing and
other services. While a majority of Twitter’s revenue is generated through selling advertising space
on its platform to global advertisers, 11% of its revenue is from data licensing that enable its data
partners to access and analyse historical and real-time data of its users - Investopedia.

a. Identify the features of assets that can be securitized and briefly discuss whether the required
criteria are satisfied in the case of Twitter. (3 Marks)

b. Exhibit 5.1 implies that Twitter’s debt is rated ‘CCC’. Clarifying the difference between
investment grade and junk bonds, discuss the implication of being rated ‘CCC’. In case Twitter
was able to securitize its cash flows, would it be possible for such securitized debt to carry a higher
credit rating? Why or why not? (4 Marks)

(Total 20 marks)

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Question 8 (Based on Exhibit 8)

A. According to Paragraph B, use options terminology to explain how you “bet on Twitter shares rising
above $43 by April 29”. Explain the meaning of open contracts and the significance of the 21,706
open contracts mentioned in Paragraph D. (4 Marks)

B. Calculate the option premium per share paid by the investor who purchased the Call options mentioned
in Paragraph D and calculate his total payoff and profit at the expiry of the option if the Twitter share
price at expiry of the option is $ 49.02. (3 Marks)

C. Based on data provided in paragraph F, calculate the gain investors would have made by trading in the
said option from Thursday (31-Mar) to Monday (04-Apr). How does this compare to trading directly
on the Twitter share over the same period if the share price on each day was $ 38.69 and $ 49.97
respectively? What may be possible reasons for the difference between your answers? (4 Marks)

D. Based on Efficient Market Hypothesis, according to information available in the exhibit, what can you
infer about the form of efficiency prevailing in the market? Justify your choice. (4 Marks)

E. cnbc.com (28-Apr-2022): “Twitter just released its earnings for the first quarter of 2022. Earnings per
share stood at 04 cents (vs 3 cents expected, according to a Refinitiv survey of analysts) while total
revenue was $1.2 billion”

a. What do you expect to happen to the Twitter share price as soon as the results are released? Why?
(3 Marks)

b. As alluded to in paragraph E, how can activity in the options contracts be justified to have been
due to Twitter's March quarter earnings results which were expected to be released on April-28?
(2 Marks)

(Total 20 Marks)

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Question 9

Following Musk’s disclosure that he owns 9% of Twitter on April 04th, Investor X speculates that the
billionaire will eventually take over the company. ‘X’ currently does not own Twitter, but would like to
get a significant exposure to the share as he believes share prices would further increase.

A. On 05-April, ABC Bank offers ‘X’ a six-month equity swap based on a $ 509.8 million notional value
of 10 million Twitter shares. The two parties would exchange net cash flows every 05th of each month
based on the total share return from Twitter over each period against a fixed rate of 11.75% p.a.

a. Explain the mechanics of an equity swap and discuss what might be Investor X’s rationale to enter
in to an equity swap versus directly purchasing shares. (4 Marks)

b. Diagrammatically show the details of the Equity Swap, clearly identifying parties to the transaction
and the basis of the cash flow that would be paid / received by each party periodically. (4 Marks)

c. Calculate the net amount that would be exchanged on May 05, 2022 if the price of Twitter on the
day was $ 50.36. Clearly identify the party that would make the net payment. (4 Marks)

B. On 14-April an article published on Bizjournal states that “Mutual Funds controlled by Vanguard
Group stand to gain at least $770 million in value if Twitter accepts Elon Musk's offer to buy the social
media company” Investor X starts to assesses the feasibility of investing in Twitter via a Vanguard
Fund. Vanguard is an investment company offering multiple mutual funds and ETFs and had just
disclosed that they became the largest shareholder of Twitter after acquiring a 10.3% stake or 82.4
million shares in the company.

a. Explaining the concept of a mutual fund explain how investor X can get exposure to Twitter price
movement by investing in a Vanguard Mutual Fund. (4 Marks)

b. Explain the concept of NAV in a mutual fund. Is it correct to state that if Twitter share prices move
up by 10% on a particular day, there will be a 1.03% (i.e. 10% of 10.3%) contribution to the
movement of total NAV of the particular Vanguard mutual Fund Investor X chooses to invest in?
Why or why not? (4 Marks)

(Total 20 Marks)

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 FORMULA SHEET

Variance of Returns 2 = p(s)[r(s) – E(r)]2 or 2 =  [(r(s) – E(r)]2/(n-1) Standard Deviation 2

The security Market Line: E(ri) = rf + i[E(rm) – rf]

Covariance: ij = ij ij Coefficient of correlation: ij = ij / ij = Cov(ri,rj)/ ij

Beta of security i: i = Cov(ri,rm)/Var(rm) = ri,rm / 2m

Sharpe Ratio: (E(ri) – rf) / i

Expected rate of return on a portfolio with weights w i in each security: E(rp) =  [wi×E(ri)]

Variance of Portfolio rate of Return for a two asset portfolio: 2 = w1212 + w2222 + 2w1w2 1 2ij

Standard Deviation of Portfolio rate of Return for a two asset portfolio when ij = 1 :  = w11  w22

Geaometric Average Return: rG = [(1+r1)(1+r2)………(1+rn)](1/n) – 1

Present value and Future Value of an Annuity:

Bond Price: P = [C { 1 – (1+ i)-n}/i ]+ [FV / (i+i)n]

Price of a discounted security: P = FV/(1 + r×d1/d2) where d2 = 360,364,365,366 etc.

No Growth Dividend Discount Model: Vn = Dn/k

Constant Growth Dividend Discount Model: Vn = Dn+1/(k-g) where Dn+1 = Dn(1+-g)

Growth Rate of Dividends: g = ROE × b

Present Value of Growth Opportunities: PVGO = V0 – E1/k

Price Earnings multiple: P/E = (1-b)/[k – (ROE × b)] or P/E = (1/k)[1+ {PVGO/ (E1/k)}]

Free Cash Flows to Firm: FCFF = EBIT – Cash Tax + Depreciation – CapEx – Increases in NWC

Free Cash Flows to Equity: FCFE = FCFF – interest expense (1-Tax) + increases in net debt

Value of Firm Equity = PV of FCFF – Existing market value of Debt

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