RUC

Corporate Finance
Exam 2015

4 hours written exam

Open Book

Remarks:

1) It is not allowed to connect to the Internet during the exam.

2) The exam consists of 4 questions. A percentage is given to each question, which is a guidance
concerning their weights on the total points.
3) Students are entitled to assistance concerning the interpretation of the exam questions during the
first 30 minutes of the exam.

Good Luck!!!!
1. Future and Present Values (25%) - You find out that you have an old and rich uncle far away from
Denmark. He decides to make a testament, so that a part of his fortune will be transferred to you when he
dies. He is expected to live 10 more years. When this happens, you will receive from him 50,000,000 DKK.
Assume that you do not want to leave anything from your uncle’s money to your children nor to any
member of your family when you die, since you do not want to incentive “laziness” in your own family.
Thus, your idea is to spend all the 50,000,000 DKK during your own life.

In order to ease your calculations, assume a discount rate of 12% per year compounded monthly, and
ignore taxes and transaction costs.

a) Calculate the effective monthly rate of the problem.

12% / 12 = 1%

b) Suppose that you expect to live 50 more years after you receive the money from your uncle. You
plan to invest the 50,000,000 DKK in a fund from a bank that will make equal monthly payments to
you during the rest of your life (50 years). Calculate the fixed monthly amount you should receive
from the bank in order to leave a balance of zero in the fund in the expected day of your death.

Suppose now that you do not want to wait the death of your uncle. You definitely want to start enjoying life
today by using his money and stop working immediately. Thus, you go to the bank and explain the
situation. You expect to live 60 more years. You would like to receive the entire money from your uncle in
equal monthly payments, but starting already in the end of this month. To make this work, you are willing
to give your house to the bank as collateral (guarantee).

c) How much would you receive in equal monthly payments from the bank during the next 60 years in
order to leave a balance of zero in the fund’s account in the expected day of your death?
d) Now, suppose that the bank offers an alternative to you so that you can immediately anticipate the
50,000,000 DKK from your uncle in a lump sum (all at once). How much would you immediately
receive in this case?
The lump sum would be simply the PV of the 50,000,000 DKK = 15,149,738. Calculation can be seen
in the answer for question “c”.

e) Explain the concept of time value of money and its importance to this specific problem.
Money today is more worthy than money tomorrow. Time value of money can also be seen as the
cost of opportunity of not having the money for immediate use today, and thus not having the
condition to invest your money in other activities or to simply spend it in consumption. In this
exercise, because of the effective discount rate of 1% per month, one can observe that the
anticipation of the money implies that you will receive less than the 50,000,000 your uncle is
expected to transfer to you when he dies. Summarizing, there is no free lunch!
2. Stocks & Bonds (25%) - Suppose you would like to evaluate some assets of two different companies to
invest your money. Further information is provided in the table below:

Stock A:
Just paid dividend 10.00 DKK
Expected growth rate (per year) 5% in the first 2 years, 1% afterwards forever
Beta 1.5
Yield to maturity on bonds (per year) 4%
Maturity of bonds 10 years

Stock B:
Just paid dividend 10 DKK
Expected growth rate (per year) 1% forever
Beta 2.5
Yield to maturity on bonds (per year) 5%
Maturity of bonds 15 years

Market expected return (Rm) 6% per year

Risk free rate of the economy 2% per year

a) Calculate the cost of equity capital using the CAPM for each of the companies.

b) Use the costs of equity capital you found in “a” to calculate the “fair” price for 1 stock of Company
A and for 1 stock of Company B.

c) You ask one friend to check your calculations in questions “a” and “b”. He observes that the
discount rate you calculated in “a” only takes into consideration the systematic risk of stocks A and
B through the measurement of beta. According to his opinion, when discounting the dividends of a
stock, you should also take into consideration the part of the risk that is not systematic (non-
systematic risk). Do you agree with your friend? Explain.
 No, I definitely do not agree with my friend. The rational investor is fully diversified and does not
incur in non-systematic risk, since this risk is diversifiable. If one were to use the non-systematic risk
to discount dividends, the logic would be that the investor should be rewarded to incur in a risk
that is diversifiable. That would make no sense. The society should only reward investors for
incurring in risk that is not diversifiable.

d) If both companies pay 8% in coupons per year on their bonds and if the face values of the bonds
equal 50,000 DKK (per bond), calculate the market price (PU) of one bond of Company A and of one
bond of Company B.

e) Suppose that after one year, a big shock happens in the Danish economy and interest rates increase
sharply. What will happen to the bond prices? Will they increase or decrease? Which of the bonds
(of company A or B) will have the biggest movement in its price following this shock of interest
rates? Please explain the logic of how interest rates affect bond prices and how the magnitude of
this effect varies according to the bonds’ maturities.

If interest rates increase sharply, this will affect the bond prices in the opposite direction. Thus,
prices of both of the bonds of companies A and B will decrease. Because the bonds of company B
have a longer duration, its price will decrease more relative to the fall in price of the company’s A
bond. Basically this stronger effect has to do with the fact that the owners of B bonds are bind to
the investment longer.

Hint: No calculation is needed to answer question “e”.

3. Modigliani & Miller with taxes (30%) - You have been working with the propositions of Modigliani and
Miller in class. Based on these propositions, answer the following questions.

The table below gives some numbers of Company X and of the market economy.

t 0.40
D/E 0.69
D/E (long term target) 0.5
Rd 7% per year
EBIT (every year) 140,000,000
Equity Beta 2.18

Rf 1% per year
Rm 5% per year

“D” is the market value of debt, “E” is the market value of equity, “Rd” is the cost of debt before taxes,” t”
is tax rate, “EBIT” is earnings before interest and taxes, “Rf” is the risk free rate of the economy, “Rm” is the
market return of the stock index and “Beta” is a measurement of systematic risk of the company. Assume
that the value of depreciation equals CAPEX (capital expenditures), and that changes in net working capital
are expected to equal zero. All net income is paid out as dividends so that retained earnings equal zero.

a) What beta value should you use in order to calculate the cost of equity capital? Explain with your
own words your calculations.

b) Calculate the cost of equity capital of Company X using the CAPM.

c) Calculate WACC (weighted average cost of capital).

d) Calculate the total value of this company, the total value of equity and the total value of debt.
e) What would the value of equity of this company be if its operations were only financed by equity?
V = VU + t D  VU = V- t D  VU = – 0.4 * = 983,783,784
f) Reflect upon the following statement: “The choice of capital structure affects the total value of the
company”. Is this statement correct for this exercise? Explain.
Yes, in the presence of taxes and according to the propositions of Modigliani and Miller, changing
the weights of equity and debt will have an influence in the total market value of a company. The
reason for that is given by the so called tax shield. Companies are authorized to deduct interest
expenses before paying taxes. This creates a benefit for using debt. Thus, the total value of the
company increases when leverage increases according to the propositions of MM with taxes.
4. Options (20%) - Suppose you want to buy 1,000 shares of one company, and each of these shares costs
30 EUR in the market. However, you realize that you cannot buy them now, because you do not have so
much money at the moment. You are stressed because you strongly believe in the fundamentals of this
company and expect the price of its shares to increase sharply in the next 2 years. After going through the
course of corporate finance at RUC, you have the idea to buy 1,000 call options (European options) of this
share with strike price of 30 EUR and maturity of 2 years. The risk free rate of the economy is given by 2%
per year compounded continuously. Over the past years, the price of this share has increased 25% yearly,
with an annual standard deviation of 10%. In order to simplify your calculations, assume that transaction
costs and taxes equal zero.

a) Explain with your own words how a contract of call options works. Explain also what is the
maximum you can lose and earn by buying call options?
Buying a contract of call options is the same as purchasing the right to buy the stock for a given
price (strike price) in a given date in the future. This means that after buying a call option, the seller
of the option has an obligation with the buyer to sell the stock for the strike price in the day of the
maturity if the buyer decides to exercise his option. The maximum one can lose by buying call
option is equal to the premium one pays to have this option. If the share price is for example below
the strike price in the day of the maturity, the buyer of the option will have no incentive to exercise
his right. Thus, he will end up losing the premium he paid for the option. On the other hand, if the
price of the stock increases and is above the strike price in the day of the maturity, he will exercise
the option by buying the stock for the strike price. In this case, he will always earn the difference
between the market price of the stock and the strike price of the option, subtracting also how
much he paid for the option (option premium). Maximum you can lose =100% maximum you can
earn = infinite.

b) Calculate how much you would have to pay to buy these 1,000 call options using the Black and
Sholes model.
S0 = 30
E = 30
Rf = 2%
 Total payment would be 1000 * 2.311923 = 2,311.92 EUR

c) Suppose that at the day of the maturity of your options, the price of the stock is 40 EUR. In this
case, how much did you make in profit or loss in the entire operation? Besides, calculate how much
you would have earned if you had bought stocks in the beginning for the same amount you have
spent when purchasing the 1,000 options?

Total profit in options = (40-30)*1,000 – 2,311 = 10,000 – 2,311 = 7,689 EUR

Calculating profit with stocks:

Would have bought: 2,311.92 / 30 = 77.0641 stocks
Profit: 77.0641* (40-30) = 770.641

d) Would you agree that investing in options “increases the gains” in this exercise? Explain and reflect
upon your explanation.

Yes, investing in options increases gains because we are talking about an asset that is a derivative of
the stock. This derivative has a much higher volatility than the stock itself. Thus, if the stock of this
example had come to the maturity day of the call option with the price below the strike level for
example in 1 EUR, the buyer of the option would lose 100%, while with the stock this would not be
the case (stock would still have a value of 29 EUR. Thus, the same way that investing in options may
increase gains; it could also increase losses if the story were different.

Good Luck!!!