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Summer 201 7 examination

FM212lFM492
Principles of Finance

Suitable for all candidates

I nstructions to cand idates

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

Give all answers to 1 decimal place

a) Bond A is a 6-year bond with face value $100 and is selling at a price of $95. lts yield to maturity is
5%. What is its coupon rate? Assume that coupons are paid annually. (5 marks).
b) Bond B also pays annual coupons. lt has two years to maturity, a coupon rate of 8% and a face
value of $100. lf the one-year spot rate is 2.6% and the bond's yield to maturity is 6.1%, what is the
two-year spot rate? (5 marks)
c) Using the data from part (b), compute the foruvard rate of interest for the period beginning one year
from today and ending two years from today. Give a brief interpretation of your result. (3 marks)
d) Bonds C and D both pay annual coupons, both have face values of !100 and both have two years to
maturity. Bond C has a coupon rate of 5% and bond D a coupon rate of 2%. Bond C's price is
Ê101 .93 and bond D's price is €96.25. Use absence of arbitrage to infer the price of a zero coupon
bond with 1 year to maturity and face value Ê100. (5 marks)
e) A bond's duration can be used to infer how the bond's price will react to a change in yield to maturity
Give a brief overview of how the duration measure is derived and thus why it is informative about the
relationship between prices and yields. What are its shortcomings as a measure of the sensitivity of
prices to yields? (7 marks)

Question 2

a) A portfolio manager has been able to beat the market over the last 5 years (i.e. her portfolio has a
mean return over the last 5 years that exceeds the market's mean return over the same period).
Does this provide evidence against the efficient markets hypothesis? Discuss. (5 marks)
b) Today, the 2-year spot interest rate in the UK is 0.1%. The 2-year spot interest rate in the US is
1.160/o. The spot FX market tells me that â1 is worth exactly $1.25 today. lf the market two-year
forward exchange rate of Sterling for US Dollars is $1.29 per Ê1, demonstrate whether an arbitrage
is available and, if so, demonstrate how to exploit it. (5 marks)
c) Prove that the premium on a European put option must always be below the present value of its
exercise price. Demonstrate that if this condition does not hold, an arbitrage profit is possible. (5
marks)
d) Today, you have taken out a 1O-year loan to buy a car. The car cost $25,000 and you paid this
amount today with the proceeds of your loan. Loan repayments are made on a quarterly basis and
the stated annual interest rate, with quarterly compounding, is 8%. After 5 years have elapsed, how
much of the loan amount remains outstanding, assuming no changes to interest rates in the
economy? (5 marks)
e) Two companies, X and Y, are entirely financed by equity and analysts expect that neither of them
will experience any growth in dividends. The ratio of X's most recent dividend to its ex-dividend price
is two and a half times the value of the same ratio for Y. lf X's required rate of return is 10%,
estimate Y's. lf the risk-free interest rate is 1%, estimate the ratio of the beta of X to that of Y? (5
marks)

Question 3

a) You are a portfolio manager, You are aware that investment strategy A has a return volatility of 20%
and a mean return of 14o/o while investment strategy B has volatility of 10% and a mean return of
6%. The two strategies have uncorrelated returns. You wish to invest in that linear combination of
the strategies that has the smallest possible overall standard deviation. What are the mean return
and return standard deviation of this combination? (6 marks)

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 b) lf you were to rank the two individual investment strategies, the combination derived in (a) and an
equally weighted portfolio of the two strategies according to their Sharpe ratio, which would you
select? Assume a risk-free rate of 2% (4 marks)
c) Use your answers to (a) and (b) to comment on the way in which risk preferences may impact upon
portfolio selection. (3 marks)
d) Assume a CAPM world with three stocks, labelled 1, 2 and 3. The market portfolio weight of stock I is
denoted by wr. The variance of the market portfolio return can be written as;

oî,t = wl ol + wlol + w!o! * 2(w1w2o1,2 * w1wso13 * w2w3o23)

where of is tne variance of the return on stock iand o¡,¡is the covariance between the returns on
stocks I and i, Show that this expression can be written as shown below;
3

oi, =Zwi a;u

i=1

where o¡,¡a is the covariance between the returns on stock i and the market portfolio. Thus argue that
a stock's CAPM beta can be thought of as the contribution of a stock to the risk of the market
portfolio. (7 marks)
e) Why, if at all, should the evidence for positive returns to momentum portfolios (i.e. portfolios that go
long stocks which have recently performed well and short stocks with recent poor pedormance) lead
us to doubt the validity of the Capital Asset Pricing Model? (5 marks)

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

1) Mergers, Acquisitions, and Capital Structure

Suppose company Alpha is considering a takeover of company Beta that is deeply burdened with debt
and is on the verge of bankruptcy. Alpha generates perpetual free cash flow of Ê10M per year and thê
required return on equity is 5%. ln addition to the free cash flow, Alpha has €50M cash inside the
company. Alpha is all equity financed, with 10M shares. Beta has 90% market leverage ratio and 1M
shares currently traded at t15 per share. The takeover will improve the value of Beta's assets by 1A%.
Assume that shareholders of Alpha and Beta will equally share the gain in this takeover.

a. What is the market value of Beta's asseús without a takeover? What is the price that Alpha pays
for Beta's total equitfi (6 marks)

b. Suppose Alpha uses cash in the corporate account to take over Beta's existing shares. How much
should Alpha pay for each share of Beta? What is the capital structure (debt equity composition) of
the merged company? \lr/hat is the share price of the post-takeover Alpha? (6 marks)

c. Suppose Alpha issues equity to compensate Beta's shareholders. How many shares of Alpha per
one share of Beta should be issued to Beta's shareholders? (Hint: the shares that Beta's
shareholders receive are equity claims on the merged company.) What is the ownership structure
and capital structure of the merged company? (Hint: ownership structure means percentage
ownership of the merged company by Alpha's and Beta's original shareholders respectively) (8
marks)

d. Calculate the leverage ratios in b. and c. Explain why they are the same or different? Can you say
something about how payment methods in takeover affect the size of the merged company? (5
marks)

2l Payout Policy
Suppose company XYZ's free cash flows grow al5% per year. This growth is not affected by the firm's
payout policy. The first free cash flow per share in the next year (year 1) will be $3. The discount rate is
15o/o.XYZ is considering two potential payout policies.

Policy A: Pay out all free cash flows as dividend. The first dividend will be paid in year 1. Questions a
and b. are based on policy A.

a. Recall that share price is the discounted value of all future dividends. What is the share price
today? (2 marks)
b. What will the cum-dividend and ex-dividend price be in year 1 and year 2? (6 marks)

Policy B: XYZ uses year 1 free cash flow to repurchase shares. After the repurchase, the firm will pay out
all future free cash flows as dividends starting from year 2. Questions c. and d. are based on policy B.

c. What fraction of total shares can be repurchased in year 1? What is the dividend per share in year
2 and year 3? (8 marks)
d. Based on c., what is the ex-dividend price and cum-dividend price in year 2? (4 marks)

e. Compared your answers in b, and d., does your result confirm or contradict Miller-Modigliani
dividend policy irrelevance theorem? Why? (5 marks)

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 3) Conflicts of lnterests and Financing Securities

Suppose you are the owner of company ABC. The company has debt maturing next year with face value
100. Current operation of ABC will produce two possible outcomes next year when the debt is due: The
company will have 120 or 60 with equal probability. There is no further production after the next year.
Assume risk neutrality and no discounting.

a. Based on the information, what is the market value of debt and equity? (2 marks)

b. Now suppose you have an opportunity to invest another 20 that can yield additional 25 with
certainty on top of the currently projected outcomes. What is the NPV of this additional
investment? What is the market value of debt and equity after the investment? lf you, as the
owner, have to fund the investment out of pocket, should you invest? (5 marks)

c. Explain your intuition for part b WITHOUT using numbers. (4 marks)

d lf you instead issue new equity to finance the investment, what fraction of the new company do
you need to sell? Should you issue equity and invest? Compared with b., discuss how out-of-
pocket equity finance and external equity finance affect your investment decision? (7 marks)

e. lf you issue debt that is more senior than the current debt to finance the new investment, what is
the fair face value? What is the market value of the original debt and equity? Should you issue this
deþt and invest? Compared with d, briefly discuss your investment decision. (7 marks)

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