Module Code: AFM                         Module Title: Advanced Financial

Programme(s): MBA/MSc Finance

Student ID:

Examination Date:           15-Feb-11

Examination Duration:       3 hours

No. of Pages (including cover sheet): 3

                                      ALLOWABLE MATERIALS

    Open Book Examination

                                INSTRUCTIONS TO CANDIDATES

  1. All questions are compulsory
  2. This exam is worth 50% of the final marks for this module.
      You are required to achieve a minimum of 40% in this examination to pass.
  3. All answers must be written in the answer booklet provided.

       This paper MUST NOT BE REMOVED from the examination venue
                              ALL QUESTIONS ARE COMPULSORY

Question One

You have just been hired as a risk manager in the treasury department of a large oil exploration
company. You are asked by the legal team to draft a clear in-depth report on the advantages and
disadvantages of using the following derivatives, and how it could benefit the oil company.


Prepare a report (using a clear reporting format) analysing the following risk management

    a.   Forward Rate Agreements                                                      (8 marks)
    b.   Futures                                                                      (8 marks)
    c.   Swaps                                                                        (8 marks)
    d.   Options                                                                      (8 marks)

Your terms of references for this report are as stated below:

        How are they priced?
        Where or when, could they be used?
        And what the risks and exposures with each product.

                                                                                    (Total 32 marks)

Question Two

The managers of Lone Ranger Inc are investigating a potential $25 million investment. The
investment would be a diversification away from existing mainstream activities and into the
printing industry. $6 million of the investment would be financed by internal funds, $10 million by
a rights issue and $9 million by long term loans.

The investment is expected to generate pre-tax net cash flows of approximately $5 million per
year, for a period of ten years. The residual value at the end of year ten is forecast to be $5
million after tax. As the investment is in an area that the government wishes to develop, a
subsidized loan of $4 million out of the total $9 million is available. This will cost 2% below the
company’s normal cost of long-term debt finance, which is 8%.

Lone Ranger’s equity beta is 0.85, and its financial gearing is 60% equity, 40% debt by market
value. The average equity beta in the printing industry is 1.2, and average gearing 50% equity,
50% debt by market value.

The risk free rate is 5.5% per annum and the market return 12% per annum. Issue costs are
estimated to be 1% for debt financing (excluding the subsidized loan), and 4% for equity
financing. The corporate tax rate is 30%.

UoW/LSBF                                                                               February Resit Exam
AFM/MBA/Msc/Level 7                                                                             Page 2 of 3

a) Estimate the Adjusted Present Value (APV) of the proposed investment.             (20 marks)

b) Comment upon the circumstances under which APV might be a better method of evaluating a

capital investment than Net Present Value (NPV).                                       (8 marks)

                                                                              (Total = 28 marks)

Question Three

    a) Discuss how a decrease in the value of each of the determinants of the option price in the
       Black-Scholes option-pricing model for European options is likely to change the price of a
       call option.                                                                   (4 marks)

    b) AVT Inc is considering the introduction of an executive share option scheme. The scheme
       would be offered to all middle managers of the company. It would replace the existing
       scheme of performance bonuses linked to the post-tax earnings per share of the
       company. Such bonuses in the last year ranged between $5,000 and $7,000. If the option
       scheme is introduced, new options are expected to be offered to the managers each year.

It is proposed for the first year that all middle managers are offered options to purchase 5,000
shares at a price of 500 cents per share after the options have been held for one year. Assume
that the tax authorities allow the exercise of such options after they have been held for one year.
If the options are not exercised at that time, they will lapse.
The company’s shares have just become ex-div and have a current price of 610 cents. The
dividend paid was 25 cents per share, a level that has remained constant for the last three years.
Assume that dividends are only paid annually.
The company’s share price has experienced a standard deviation of 38% during the last year.
The short-term risk free interest rate is 6% per annum.


i) Discuss the relative merits for the company of the existing bonus scheme and the proposed
share option scheme.                                                               (12 marks)
ii) Evaluate whether or not the proposed share option scheme is likely to be attractive to middle
managers of AVT Inc.                                                               (12 marks)
iii) When told of the scheme, one manager stated that he would rather receive put options than
call options, as they would be more valuable to him.
Discuss whether or not AVT should agree to offer him put options.                  (6 marks)
iv) Calculate whether or not he is correct in his statement that put options would be more
valuable to him.                                                                   (10 marks)
                                                                            (Total = 40 marks)

                                END OF QUESTION PAPER

UoW/LSBF                                                                            February Resit Exam
AFM/MBA/Msc/Level 7                                                                          Page 3 of 3

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