Summer 2018 examination

FM212/FM492
Principles of Finance

Suitable for all candidates

Instructions to candidates

This paper contains six questions: three in Section A and three in Section B. Answer two questions from
Section A and two questions from Section B. All questions will be given equal weight (25%).

Time Allowed - Reading Time: None

Writing Time: 3 hours

You are supplied with: No additional materials

You may also use: No additional materials

Calculators: Calculators are allowed in this examination

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Section A: Answer two questions from this section and another two from Section B

Question 1

a) Three US government bonds, A, B and C, each with face value $1000, are currently selling in the
market for prices of $938.97, $955.55 and $1001.68 respectively. Bond A is a zero-coupon bond
with one year to maturity, bond B has a coupon rate of 5% and two years to maturity and bond C has
a coupon rate of 8% and three years to maturity? All coupons are paid annually.

i. Infer the US spot rate curve from these data. [7 marks]

ii. Give two possible explanations that might be used to explain why the curve takes the shape that it
does. [3 marks]

b) Bond D was issued by the UK government and is selling for its face value of £100. It has four years
to maturity and its coupon rate is 8.5%. Coupons are paid annually. Work out its duration and thus
the change in price you would expect for this bond if its yield to maturity increased by 0.1%. [6
marks]

c) Consider a bond with three years to maturity with a face value of $F. At the end of each year it pays
a cash coupon of $C. Denote its yield to maturity by y.
i. You buy the bond today for a price of $P0 and sell it in one year (just after the payment of the
coupon) for $P1. If the yield to maturity does not change over time, write down expressions
for P0 and for P1 in terms of C, F and y. [2 marks]
ii. Define the return from holding the bond for that year in the normal fashion (i.e. the return is
equal to the sum of its change in price over the period and any end of period cash payments,
all divided by the initial price). Show how this return is related to the bond’s yield to maturity.
[4 marks]
iii. Based on your preceding answer, discuss when yield to maturities are likely to be decent
indicators of the returns from holding bond positions. [3 marks]

Question 2

a) Today you have purchased one tonne of commodity A for price S. You are concerned that the price
per tonne of commodity A is going to fall over the next few months and wish to protect against this
eventuality. You decide to use a put option written on commodity A, with strike price S and 3 months
to maturity, to deliver this protection. Show, analytically and graphically, how the put option, when
held in conjunction with the position in the underlying commodity, helps you achieve your goal. Be
clear about how the option premium, p, affects your profits. [Note: when computing the profits from
your combination of the option and the underlying, there is no need to account for the time value of
money] [6 marks]

b) You wish to arrange a forward purchase of 1 unit of commodity B with delivery in 3 months. The spot
price of B is £350 per unit and the stated annual 3-month interest rate is 4%. If the commodity costs
£10 per quarter to store (payable at the end of the quarter) develop an arbitrage argument which
allows you to work out the delivery price you should be prepared to pay in 3 months. [6 marks]

c) The stated annual 1 month interest rate is 1.80%. You wish to price a 1 month at-the money
European put option on stock C. You believe that every month, stock C will either rise in price by 2%
or fall in price by 1.5%. One share of C is currently priced at 375p. Stock C is not expected to pay a
dividend over the coming months.
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 i. Use the risk-neutral method to work out the fair premium for the put. [5 marks]
ii. If you wished to construct a risk-free portfolio containing one of the put options
described above and a position in the underlying stock C, how many units of C would
you need to hold? [3 marks]
iii. A colleague wishes to gamble on the possibility that stock C will be very volatile over
the next 1 month and thus wishes to construct an at-the-money straddle position.
Compute the cost of the straddle, then draw the profit profile that your colleague will
obtain from purchasing it and explain how it allows her to bet on volatility. [5 marks]

Question 3

a) The expected return on stock Z is 21% while the risk-free rate is 5%. Z has a return volatility of 40%
and has a return correlation of 0.4 with the market portfolio. If the volatility of the market portfolio is
20%, use the CAPM to compute the expected return on the market. [3 marks]

b) Stock Y has an expected return of 25% and a beta of 1.25. Using the data provided in (a) and your
previous calculations, work out whether Y is priced fairly according to the CAPM. If not, what should
its expected return be and how can one build a portfolio of the market and risk-free asset that has
that same expected return. Justify your answers and illustrate them via a plot of the security market
line. [5 marks]

c) Assume that Y’s expected return adjusts to its CAPM level. If you expect its earnings to be $5 per
share next year and for every future year and it pays all of its earnings as dividends, what is Y’s
price? [3 marks]

d) Firm W is identical to firm Y except its management has uncovered a new project that will require the
company to reinvest one third of its earnings and after investing in the project its return on equity will
be 36%. If it invests in the project, exactly how will W’s price differ from Y’s? [4 marks]

e) When firm W has made the decision to invest in the new project, but before the investment decision
has been announced to the public, a dishonest director of firm W buys shares under an assumed
name and makes an enormous profit by selling them just after the new investment is eventually
disclosed to the world (but before the investment generates any cashflows). What do these facts tell
us about the efficiency of this stock market? [5 marks]

f) If an investor can construct a portfolio of stock that has a long-run mean return that is reliably above
the mean return on the market, is this evidence that the investor has some skill in picking stocks?
Justify your answer. [5 marks]

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Section B: Answer two questions from this section and another two from Section A

1) Project valuation

A purely equity financed firm is considering project ABC. The project generates the following stream of net
income (earnings after tax):

Year 0 Year 1 Year 2

$0 -$5 $0 or $8 each with 50% probability

The required investment at year 0 is $20, which is depreciated by 50% in each of the next two years. At
the end of year 2, the investment can be sold for $5.
The project only requires $5 net working capital in year 1, which is recovered at the end of the project.

Tax rate is 40%. Discount rate is 10%.

a) Explain in the net present value analysis, why do we discount free cash flow instead of the net
income? State and explain at least two key differences between free cash flow and net income. (5
marks)

b) What is the free cash flow of project ABC in each year? (8 marks)

c) What is the NPV of project ABC? Should we implement this project? (2 marks)

Suppose in year 2, after the net income is realised, you can CHOOSE to spend $2 (after-tax value) to
double this year’s net income immediately.

d) What is the free cash flow of project ABC in each year? (5 marks)

e) What is the NPV of project ABC? Should we implement this project? (2 marks)

f) Why does the value of the project change? What the source of the difference? (3 marks)

2) Conflict between debt and equity

Suppose a company has $10 which can be invested into three projects with the following random payoffs
next year:

Project 1 Project 2 Project 3

Good $40 (w/ prob 0.2) $12 (w/ prob 0.5) $15 (w/ prob 0.4)
Bad $0 (w/ prob 0.8) $10 (w/ prob 0.5) $8 (w/ prob 0.6)

For simplicity, there is no time discount.

a) Suppose the firm is purely equity financed. How does the firm rank the three projects? Show your
work. (4 marks)

b) Suppose the firm carries debt maturing in the next year with face value $10. How do equity holders
rank the three projects? How do debt holders rank the three projects? For face value $1, redo the
rankings. (6 marks)

c) What is the risk shifting problem? (2 marks) Comparing your findings in b) and a), briefly discuss the
relation between risk shifting and the face value of debt. (3 marks)

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 d) What is the debt overhang problem? (2 marks) Suppose the face value of debt is $10, and the firm
implements project 1. In addition, the company can CHOOSE to add a side project that costs $X>0
and returns $Y for sure (regardless of the state is “good” or “bad”). Can you design a pair of X and Y to
show the debt overhang problem? (5 marks)

e) Suppose the firm implements project 2, and everything else is the same as in d). Can you design X
and Y to show the debt overhang problem? Explain your findings. (3 marks)

3) Mergers and acquisitions

Suppose you are the sole owner of company ABC. The market value of your company is $100 and there
are 20 shares. Now you are thinking about acquiring the target company XYZ with a standing alone
market value of $50 with 25 shares outstanding. The synergy of the two companies is $20. Except for part
e), we assume the cost of the merger is zero, meaning target shareholders break even.

a) Suppose you pay XYZ’s shareholders in cash from your company ABC. What is the total firm value
post-merger? What is the share price? (4 marks)

b) Suppose you instead create new shares to pay XYZ’s shareholders. How many shares do you need
to create? How many shares do you need to pay for each share in XYZ? (6 marks)

Instead of $20, in the remainder of the question, we assume the synergy is -$10.

c) Redo part a) under the new synergy. Would you choose to acquire company XYZ? Discuss your
finding in comparison with a). (5 marks)

Suppose you hold only 2 shares (recall: total number of shares is 20) in company ABC, but still have
control rights in the company (meaning that you can decide on ABC’s acquisition of XYZ). In addition,
you also have 15 shares (out of 25 total shares) in company XYZ.

d) What is your payoff WITHOUT any acquisition? (2 marks)

e) Suppose you have the opportunity to have company ABC acquire company XYZ by offering 4 newly
created shares of ABC for every share of XYZ. What is the post-merger share price after the
acquisition? What is your payoff? Do you proceed with the proposed merger? Hint: do NOT forget
your payoff from ownership in company XYZ. (6 marks)

f) Based on your findings in c) and e), discuss how ownership structure (especially ownership in the
target company) affects acquirers’ tendency to take over targets with negative synergy. (2 marks)

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