HA/RUC

2nd Re-Exam Finance 25th of March 2015

4 hours written exam

Open Book

It is not allowed to connect to the Internet

during the exam.

The exam consists of 4 questions. A percentage is given to each question, which is

guidance concerning their weights on the total points.
Question 1 (25%) – Equity Pricing

Suppose you are evaluating the opportunities of investing in stocks of 3 different

companies. More information to these companies can be found in the table below:

Dividend just Expected

paid annual growth
forever
Company 1 DKK 1.00 0
Company 2 DKK 1.00 2%
Company 3 DKK 1.00 4%

a) If the investor’s required return for these companies is 13%, calculate the
“fair” price of Company 1.

b) For the same required return, calculate the “fair” prices of the companies 2 and
3.

c) If you take a look at the market prices for the stocks of these companies, you
may observe that the stocks of the Company 1 are being traded for 8 DKK
each. Besides, stocks of the Company 2 are being traded for 10 DKK each and
those of the Company 3 are being traded for 12 DKK each. Would you buy
any of these stocks?

d) A friend of yours advises you that the table above is not fully correct since
Company 3 has actually expected to grow 12% in the first 3 years and
afterwards grow constantly at 4% forever. According to your friend, what
would be the “fair” price of each stock of the Company 3? After calculating
this new price, would you change your answer of question c?

e) Is it likely that the investor will require 13% in any of these 3 stocks, when
their growth rates are so different? Please comment the connection between
risk, systematic risk, unsystematic risk and required rate of return as discussed
in class.

Hint: You can answer question e without answering any of the previous questions.

Question 2 (25%) – Bond Pricing

Two Debentures (corporate bonds) of the same company have 10% coupons and
make annual payments. They are both priced at par value (par value = 1000). The
short term debenture has 3 years to maturity and the long term debenture has 20 years
to maturity.

a) If the market yield of the short-term debenture suddenly rises for an additional
of 1%, what will be its new price?

b) If the market yield of the long-term debenture suddenly rises for an additional
of 1%, what will be its new price?
 c) What would have happened with the price of the short-term debenture if the
yield has fallen 1% instead of risen 1%? Please calculate the new price for the
short-term debenture in this situation.

d) What would have happened with the price of the long-term debenture if the
yield had fallen 1% instead of risen 1%? Please calculate the new price for the
long-term debenture in this situation.

e) When observing your answers in the prior questions, which of the debentures
are more sensible to yield changes? Please comment why prices of bonds of
different maturities present different sensibilities to changes in their yields.

Hint: You can answer question e without answering any of the previous questions.

Question 3 (25%) – Portfolio, Risk and Return

Consider the information about the Equities 1 and 2 and answer the following
questions:

Probability of Rate of return if state of economy occurs

State of
the state of
economy Equity 1 Equity 2 Equity 3
economy
Recession 0,18 0,13 0,42 0,22
Normal 0,43 0,38 -0,14 0,16
Irrational
0,39 0,17 0,29 0,33
exuberance

The market risk premium is 9,6%, and the risk-free rate is 5%.

a) Calculate expected returns on portfolio for each state of economy, and identify
what is the expected return on an equally weighted portfolio of these three
equities.

b) Calculate the systematic risks for the each equity.

c) Calculate variance and standard deviation (total risk of the asset) for all three
equities.

d) What is the difference between systematic and unsystematic risk?

e) What is the security market line (SML)?

Hint: You can answer question d and e without answering any of the previous
questions.
Question 4 (25%) – WACC and NPV

Currently, Wayne Enterprise has its target debt equity ratio of 0.70. The company is
considering developing a new telecommunication product which needs an initial
investment of DKK 100 million. After tax cash flows of this investment are expected
to be in the order of DKK 10 million forever. For this new investment the CEO Mr.
Fox is offered 2 different financing options:

1) A new issue of equity. Required return on company’s new equity is 19%.

2) A new issue of 10 years corporate bonds (debentures). These bonds are being
sold at par value (1000 DKK) and paying an annual coupon of 8%.

a) Calculate WACC (use a tax rate of 30% and ignore flotation costs in your
calculations).

b) What is the NPV of the new investment? Use the WACC you found in
question a as discount rate. If you were Mr. Fox, would you make the
investment according to the NPV criterion?

c) Would you change your mind if the after tax cash flows of this investment
presented a growth rate of 5% every year forever?

d) Comment the risks of using a company WACC to calculate the NPV of any
new project. What could be the problem of doing so?

e) Explain by your own words two methodologies of capital budgeting analysis

you learned in your lecture of corporate finance at RUC other than the NPV.

Hint: You can answer question d and e without answering any of the previous
questions.

Good Luck!!!