Exam questions by Levone

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                                   Two hours

                            Formula Sheet Attached

                       UNIVERSITY OF MANCHESTER


                                  22 May 2008

                                 09:45 – 11:45

                     Answer all questions from SECTION A,
                        ONE question from SECTION B,
                      and ONE question from SECTION C.

   Answer Section A on the special answer sheet for multiple choice questions.
                Answer Section B in separate answer booklet(s).
                Answer Section C in separate answer booklet(s).
       (i.e. do not put answers to sections B and C in the same booklet)


         Electronic calculators permitted provided they cannot store text



                                  Page 1 of 10

                               SECTION A (30 marks)
 Answer ALL questions from this section. Each correct answer is awarded 3 marks.
              Each incorrect answer attracts a penalty of 1 mark.

1.   Which of the following statements contradicts the weak form of the efficient
     market hypothesis?

     A)   Investors can consistently gain superior profits when trading stocks by
          exploiting announcements of takeover offers and similar public
          announcements from companies.
     B)   Stock prices follow a random walk in that successive price changes cannot
          be predicted by using past price changes.
     C)   Traders like technical analysts are likely to earn superior trading profits
          given that the information contained in the record of past stock prices is
          useful to predict future price changes.
     D)   Investors can gain superior returns by using private undisclosed

2.   It is often stated that the Internal Rate of Return (IRR) rule has several
     drawbacks when compared with the Net Present Value (NPV) rule. Which of the
     following statements does not describe one of the drawbacks of the IRR rule?

     A)   When the project has multiple IRRs, it is particularly hard to decide whether
          or not the project should be accepted based on the IRR rule.
     B)   In contrast with the NPV rule, the IRR rule does not take the time value of
          money into consideration.
     C)   It is impossible to use the IRR rule to evaluate projects that do not have
          any IRR (i.e. no values of the discount rate that make the NPV of the
          projects equal to zero).
     D)   When choosing between two mutually exclusive projects, by using the IRR
          rule managers may mistakenly select the project that adds the lower
          amount of value to their company (i.e. the project with the lower NPV).

3.   A firm has a capital structure which includes equity and debt. The payoffs at the
     end of the year to bondholders and equity holders depend on whether the
     company goes bankrupt. If the firm goes bankrupt, the bondholders receive £10
     million. If the firm survives, the bondholders receive £20 million and equity
     holders receive £20 million. The firm’s beta is equal to 0, the risk free rate is 5
     percent, and there is a 5 percent chance of bankruptcy. What is the total value
     of the firm’s securities at the beginning of the year (to one decimal place)?

     A)   none of the answers below
     B)   £ 38.5 million
     C)   £ 41.3 million
     D)   £ 36.7 million

                                     Page 2 of 10

4.   The firm ABC has overall expected return of 10 % per annum. The expected
     return on the debt is 4% per annum. The market value of the debt is £50M and
     the market value of the total firm is £100M. The risk-free rate is 3% per annum
     and the expected market return is 8% per annum. What is the equity beta (to
     one decimal place)?

     A)   2.5
     B)   2.8
     C)   2.6
     D)   none of the answers above

5.   The trade-off theory of capital structure:

     A)   argues that the capital structure does not affect firm value
     B)   argues that bankruptcy costs do not influence the optimal capital structure
     C)   explains the cross-sectional pattern of capital structure across industries
     D)   implies that a firm with low costs of financial distress will choose low levels
          of debt

6.   Which of the following statements is wrong:

     A)   If a stock lies below the security market line (SML) there is an opportunity
          for arbitrage as the stock is overvalued.
     B)   Fama-French three factor model comprises the market factor, the size
          factor (SMB), and the book-to-market factor (HML).
     C)   The aim of diversifying a portfolio is to reduce its sensitivity to changes in
          the market return.
     D)   The beta of a portfolio is the weighted average of the betas of the stocks
          comprised in the portfolio.

7.   Three of the following four terms denote the same thing. Indicate the one term
     that is different to the others.

     A)   Unsystematic risk.
     B)   Firm-specific risk.
     C)   Idiosyncratic risk.
     D)   Market risk.

                                      Page 3 of 10

 8.   Which of the following statements is false?

      A)   Firms adjust dividends relatively frequently, and therefore dividends are as
           volatile as earnings. This practice of constantly changing dividends is
           called dividend signalling.
      B)   When a firm increases its dividend, it sends a positive signal to investors
           that the management expects to be able to afford the higher dividend for
           the foreseeable future.
      C)   The average size of the stock price reaction increases with the magnitude
           of the dividend change, and is larger for dividend cuts.
      D)   When managers cut the dividend, it may signal that they have given up
           hope that earnings will rebound in the near term and so need to reduce the
           dividend to save cash.

9.    What kind of corporate debt must be secured by real property?

      A)   Notes
      B)   Mortgage Bonds
      C)   Asset-backed Bonds
      D)   Debentures

 10. Which of the following statements regarding bond covenants is false?

      A)   If the issuer fails to live up to any covenant, the issuer goes into
      B)   The stronger the covenants in the bond contract, the less likely the issuer
           will default on the bond and so the lower the interest rate investors will
           require to buy the bond.
      C)   Covenants are restrictive clauses in a bond contract that limit the issuer
           from taking actions that may undercut its ability to repay the bonds.
      D)   Bond agreements often contain covenants that restrict the ability of
           management to pay dividends.

                                                     (Total 30 marks for this question)


                                     Page 4 of 10

                                  SECTION B (35 marks)
                                   Answer ONE question


a) XYZ Plc is considering selling a new product from next year (year 1). The
   expected economic life of the product is three years (from year 1 to year 3). To
   manufacture the new product, XYZ Plc needs to purchase a new machine. The
   cost of the machine is £11000 (in year 0) and its scrap value (resale value) is
   predicted to be £3000 (in year 4). The accountants of XYZ Plc have prepared the
   following data related to the production and sale of the new product for the entire
   economic life of the project:
Year                               1                      2                    3
Level of investment
                                 1300                   2000                 1700
in working capital
Revenues from sales              7000                   7500                 8500
Cost of materials                1500                   1800                 2000
Cost of labour                   2300                   2500                 3500
Depreciation                     2500                   2500                 2500

      The following additional information has been provided:

      •   the machine that XYZ Plc has to purchase to manufacture the new product is
          expected to be sold at its scrap value in the year after the end of the project
          (year 4);
      •   the whole investment in working capital is expected to be recovered in year 4;
      •   XYZ Plc does not pay any taxes on the profits generated by the project;
      •   all figures are expressed in nominal terms;
      •   the nominal opportunity cost of capital of the project is 25%.

      Using the information provided above and explaining what you are doing as you
      proceed and the reasons for your decisions, calculate the NPV of the project and
      advise XYZ Plc as to whether it should undertake the new project.

                                                                              (15 marks)

                                                     Question 11 continued on next page

                                        Page 5 of 10

Question 11 continued

b) You are the financial manager of ABC Plc. You need to evaluate the validity of a
   new project using the Internal Rate of Return rule (IRR). This project requires an
   initial cash outlay of £7000 at the current time (year 0). The accountants of your
   company have provided you with the following information about the net cash
   flows of the project:

Year              0                  1                 2                  3
Net cash flow     -7000              2500              3500               4000

   Compute the IRR of the project using a trial and error strategy and the
   interpolation rule (hint: start trying discount rates of 17% and of 20%).
   Given that the opportunity cost of capital of the project is 22%, would you advise
   your company to accept the project?

                                                                                 (10 marks)

c) Briefly describe what finance academics mean when they say that a market is
   informationally efficient (i.e. describe the efficient market hypothesis). Also, briefly
   outline the differences between the three forms of informational efficiency: weak
   form, semi-strong form and strong form.

                                                                                 (10 marks)

                                                       (Total 35 marks for this question)


                                      Page 6 of 10

12. An investor needs to decide whether to invest in German treasury bonds or in
    U.S. treasury bonds. (Below EUR denotes the Euro currency, USD denotes US

   a) First she considers a German treasury bond with a face value of EUR100, a 3
      percent coupon rate and a remaining term to maturity of four years. Coupons
      on this bond are paid once a year, and the next coupon is due in 12 months.
      The yields to maturity of comparable bonds are currently 4 percent per annum.
      Using a present-value approach, calculate the price of the bond. Briefly
      explain your solution method and answer.                            (7 marks)

   b) Next she considers a U.S. treasury bond with a coupon rate of 3 percent per
      annum, a two-year term to maturity, and a face value of USD1000. The
      coupon payments are made twice a year (semi-annually) with the first coupon
      to be paid in six months. The yields to maturity of U.S. bonds are quoted as
      semi-annually compounded yields. Currently, the yields to maturity of similar
      bonds are 4 percent per annum (note: this is the stated rate for a 12-month
      period–not the equivalent annually compounded rate). What is the price of this
      bond? Briefly explain your solution method and answer.

                                                                             (7 marks)

   c) While the investor is still undecided, she finds out that interest rates were
      raised, and the yields of comparable bonds have risen from 4 percent to 5
      percent in both Germany and the U.S.
      i    Re-calculate the prices of both the U.S. and German bonds.        (7 marks)
      ii   Compare and contrast the impact of the yield rise on the prices of each of
           the two bonds (the U.S. and the German bonds), and explain any
           similarities and differences.                                   (7 marks)

   d) The investor expects that yields to maturity will rise to 6 percent by the end of
      the next 12 months in both the U.S. and Germany. She wants to invest all her
      savings in either the German or the U.S. bond at the bond values calculated in
      part (c). She knows that she will need to sell any bonds she buys after one
      year to realize her investment.

      Given the investor’s expectations about future yields, what are the rates of
      return she should expect from investing in either of the two bonds for one
      year? Explain your solution method and any similarities and differences in the
      rates of return of the two bonds.

                                                 Question 12 continued on next page

                                    Page 7 of 10

Question 12 continued

   In your calculations, assume that:

      •   any investment is undertaken immediately given current yields to maturity
          of 5 percent as in part (c)
      •   prices of bonds equal their present values; current prices are as calculated
          in part (c)
      •   the USD-EUR exchange rate will remain unchanged over the coming year
      •   any coupon payments received by the investor during the year are
          invested at a zero rate of return
      •   there are no transaction costs arising from trading bonds or currencies.

                                                                            (7 marks)

                                                    (Total 35 marks for this question)


                                    Page 8 of 10

                                         SECTION C (35 marks)

                                         Answer ONE question


      a) Describe the European call option contract and derive the payoff at maturity.
                                                                            (6 marks)
      b) Currently the stock XYZ has a price of £55. What are the payoffs at maturity
         (T) of the derivative contract defined below and why would an investor be
         interested in buying such a derivative?

         You have the right but not the obligation to either sell the asset XYZ at a price
         of £50 at time T, or to buy the asset XYZ at a price of £60 at time T.
                                                                              (10 marks)

      c) Explain how you could generate the following payoff function at time T:





                                     0         50             100         150
                                              Final Stock price (T)

         where call and put options are available at all maturities and strikes, and the
         risk-free rate is 5 percent per annum (annual compounding rate), and T = 1
         year from today.                                                     (10 marks)

      d) Currently the stock ABC has a price of £50. After one period it will either be
         worth either £60 or £40 with equal probability. A derivative written on stock
         ABC has a payoff of £5 if stock ABC rises in value, and a payoff of zero if
         stock ABC falls in value. The risk-free rate is 5% per period (discrete
         compounding rate). Can the derivative payoff be replicated by a portfolio of
         stock and risk-free bonds? If so how many units of ABC’s stock are required?
                                                                             (9 marks)

                                                               (Total 35 marks for this question)

                                             Page 9 of 10


      a) Describe the assumptions of Lintner’s model.                          (6 marks)

      b) Describe the three valuation steps for warrants.                      (8 marks)

      c) Explain the “imputation” and “split rate” tax systems. What is the effect of
         these different tax systems to dividend policy?                   (6 marks)

      d) ABC Corp. has £100 million invested in short-term Treasury bonds paying a
         7% annual coupon, and it pays out the interest payments on these bonds as a
         dividend. The board is considering selling the bonds and paying out the
         proceeds as a one-time dividend payment. If you assume that capital markets
         are perfect:

         i.    If the board went ahead with this plan, what would happen to the value of
               the company stock upon the announcement of a change in policy? What
               would happen to the stock on the ex-dividend date of the one-time
               dividend?                                                      (6 marks)

         ii.   If we now assume that ABC Corp. pays a corporate tax rate of 35%, and
               investors pay no taxes, what is the answer to question (i)?
                                                                            (9 marks)

                                                        (Total 35 marks for this question)

                             END OF EXAMINATION PAPER

                                      Page 10 of 10

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