ACF214 PRINCIPLES OF FINANCE

SECTION A

SECTION A CONSISTS OF QUESTIONS 1 AND 2.

ANSWER ONLY ONE QUESTION FROM SECTION A (EITHER QUESTION 1 OR QUESTION 2).

QUESTION 1

ANSWER ALL PARTS OF THIS QUESTION

a. Regarding capital budgeting, which of the following statements is FALSE?

[3 marks]

A. Many projects use resources that the company already owns, which still should be counted as expenses of these projects.

B. In capital budgeting, project externalities are direct effects of the project that may increase or decrease the profits of the business activities of other firms.

C. Only include as incremental expenses in your capital budgeting analysis if the additional overhead expenses arise because of the decision to take on the project.

D. As a practical matter, to derive the forecasted cash flows of a project, financial managers often begin by forecasting earnings.

b. A firm is considering a project that requires £6 million to build a new product line, which will last for 3 years. Its annual free cash flows are £2 million, £5 million, and £3 million in Year 1, 2, and 3, respectively. Assume the annual discount rate is 12%. The NPV of this project is closest to:

[4 marks]

A. £1.11 million

B. £1.91 million

C. £2.51 million

D. £2.91 million

c. Regarding deferring a project, which of the following statements is FALSE?

[4 marks]

A. By delaying an investment, we can base our decision on additional information.

B. The smaller the cost of waiting, the less attractive the option to delay becomes.

C. Given the option to wait, an investment that currently has a negative NPV can have a positive value.

D. If there is a lot of uncertainty, the benefit of waiting is large.

d. You are considering some new projects but have concerns about the limited warehouse space of your company. The space requirements (in square feet) and NPVs of these projects are listed below.

Your company only has 10,000 square feet available. To maximize your profit, which projects should you choose?

[4 marks]

A. 1 and 4.

B. 1, 2, and 3.

C. 2, 4, and 5.

D. 3, 4, and 5.

a. As the CEO of your company, you are considering a new project that requires £600,000 capital expenditure. The project will last for 6 years and the relevant equipment will be depreciated straight line over the project period. The salvage value will be zero.

Based on the investigation by your marketing team, you believe the product can be sold 4,000 units per year at a price £200 per unit. The cost per unit is £100. The firm is in the 20% tax bracket and its cost of capital is 10%.

REQUIRED:

i. Please calculate the NPV of this project based on the information given above.

[6 marks]

ii. The new product from this project will affect the sales of other existing products of your company. Specifically, during the period of this project, you expect this project will increase the sales of Product A by £300,000 per year but reduce the sales of Product B by £100,000. Based on this consideration, do you need to adjust your NPV calculation above? If you need to adjust it, please update your NPV calculation. If you do not need to adjust it, please explain the reasons.

[9 marks]

iii. In practice, the situation in product market varies quickly and there is uncertainty about the demand for the new product. For example, the sale price in reality may be different from the value given above. To understand how sensitive the NPV calculation in Part i is to the sale price, please calculate the elasticity of the NPV with respect to sale price.

[9 marks]

iv. You also have an alternative project that will last for 3 years only. The initial investment will be lower, which is only £200,000. The equipment will be depreciated straight line over the project period and the salvage value will be zero. 3,500 units of the product can be sold per year at a price £180 per unit. The cost per unit is £80. Due to the capital constraints, you can only carry one project. If you prefer a larger annual benefit, should you choose this project lasting for 3 years or the project described in Part i? Please justify your decision.

[11 marks]

TOTAL 50 MARKS

QUESTION 2

ANSWER ALL PARTS OF THIS QUESTION

1. Suppose an investment is equally likely to have a 30% return or a -15% return. The variance on the return for this investment is closest to:

[3 marks]

A. 3.06%

B. 4.06%

C. 5.06%

D. 6.06%

b. Which of the following statements is FALSE?

[3 marks]

A. Because investors are risk averse, they will demand a risk premium to hold unsystematic risk.

B. Over any given period, the risk of holding a stock is that the dividends plus the final stock price will be higher or lower than expected, which makes the realized return risky.

C. The risk premium for diversifiable risk is zero, so investors are not compensated for holding firm-specific risk.

D. Because investors can eliminate firm-specific risk "for free" by diversifying their portfolios, they will not require a reward or risk premium for holding it.

c. Which of the following is not consistent with the CAPM and efficient capital markets?

[3 marks]

A. A security with a beta of 1 has a return last year of 8% when the market has a return of 8%.

B. A small stock with a beta of 1.5 is expected to have the same return as that of a large stock with a beta of 1.5.

C. A security with only diversifiable risk has an expected return that exceeds the risk-free interest rate.

D. A security with only systematic risk has an expected return that exceeds the risk-free interest rate.

d. You are considering 3 stocks, X, Y, and Z for investment purpose. The covariance matrix of their returns is listed below.

If you decide to hold a portfolio of X and Y with weights 20% and 80%, respectively, the variance of this portfolio is closest to:

[3 marks]

A. 0.124

B. 0.156

C. 0.194

D. 0.246

a. Which of the following statements is FALSE?

[3 marks]

A. We say a portfolio is an efficient portfolio when it is not possible to find another portfolio that is better in terms of both expected return and volatility.

B. When making investment decisions, we can rule out inefficient portfolios because they represent inferior investment choices.

C. The volatility of a portfolio depends on the correlation between the securities in the portfolio.

D. The expected return of a portfolio depends on the expected returns of the securities in the portfolio and the correlations between them.

b. The economy is now in a recession. As the CEO of your company, you are considering a project in a new field. Your company has bond outstanding with yield to maturity of 5% and a rating of BBB. The expected loss rate of the bond is 50%. The tax rate of your company is 20%. Please round your results to the second digit to the right of the decimal point in your following calculations.

REQUIRED:

i. Please calculate the cost of debt for your company.

[8 marks]

ii.Your company did not have business in this new field before. So you decide to consider three comparable firms with business only in this field. T

What are the unleveraged equity betas of these comparable firms?

[12 marks]

iii. The stock price of your company is £60 and there are 10 million shares outstanding. The total debt of your company has the market value of £300 million. Please calculate the levered equity beta of your company based on the information of the comparable firms.

[8 marks]

iv.The risk free rate is 2% and the market risk premium is 5%. Please calculate the project’s weighted average of cost of capital (WACC).

[7 marks]

TOTAL 50 MARKS

SECTION B

SECTION B CONSISTS OF QUESTIONS 3 AND 4.

ANSWER ONLY ONE QUESTION FROM SECTION B (EITHER QUESTION 3 OR QUESTION 4).

QUESTION 3

ANSWER ALL PARTS OF THIS QUESTION

1. The Grant Corporation is considering permanently adding $500 million of debt to its capital structure. Grant's corporate tax rate is 35% and investors pay a tax rate of 40% on their interest income and 20% on their income from capital gains and dividends. Using Miller’s (1977) model calculate the present value of the interest tax shield provided by this new debt. Please around your answer to the nearest 0.01.

[5 marks]

A. 33.33 million

B. 50.00 million

C. 66.67 million

D. 80 million

E. None of the above

b. The balance sheet for Price Cut, Inc. is shown below in market value terms. There are 28,000 shares of stock outstanding.

Instead of a dividend of $1.60, the company has announced it is going to repurchase $44,800 worth of stock. What effect will this transaction have on the market value balance sheet of the firm?

[5 marks]

A. Cash deceases by $44,800, but equity increases by $44,800

B. Cash and equity both decrease by $44,800

C. Cash increases by $44,800, but equity decreases by $44,800

D. Cash and equity both increase by $44,800

E. None of the above

a. Flagstaff Enterprises is expected to have a free cash flow next year of £8 million, and this free cash flow is expected to grow at a rate of 3% per year thereafter. Flagstaff has an equity cost of capital of 13%, a debt cost of capital of 7%, and it is in the 35% corporate tax bracket. If Flagstaff currently maintains a 0.8 debt to equity ratio, then calculate the value of Flagstaff's interest tax shield. Please around your answer to the nearest 0.01.

[5 marks]

A. 18.00 million

B. 19.02 million

C. 20.05 million

D. 21.07 million

E. None of the above

b. MJ Enterprises has 50 million shares outstanding with a market price of £25 per share and no debt. MJ has had consistently stable earnings, and pays a 35% tax rate. Management plans to borrow £500 million on a permanent basis through a leveraged recapitalization in which they would use the borrowed funds to repurchase outstanding shares. Calculate MJ's share price following announcement of the recapitalization plan.

[10 marks]

c. Empirical research has found that there have been significant increases in stock price on the day of an initial dividend (i.e. the first time a firm pays a cash dividend is announced). What does this finding imply about the information content of initial dividends?

[5 marks]

d. “High dividend payouts reduce agency costs”. Discuss why this might be true and provide other arguments and/or theories for why firms might have a policy of paying high dividends.

[20 marks]

TOTAL 50 MARKS

QUESTION 4 ANSWER ALL PARTS OF THIS QUESTION

T.R.E. Industries is currently trading for £27 per share. The stock pays no dividends. A one-year European put option on T.R.E. with a strike price of £30 is currently trading for £2.60. If the risk-free interest rate is 6% per year, what is the price of a one-year European call option on T.R.E. with a strike price of £30?

[5 marks] A. 1.10 B. 1.20 C. 1.30 D. 1.40 E. None of the above

Suppose that Lakedistrict Leisure plc (LL) is currently trading for £9.5 per share. The stock pays no dividends. A one-year European put option on LL’s stock with a strike price of £10.2 is currently trading for £1.50. The risk-free interest rate is 2% per year. Calculate the fair price of a one-year European call option on Lakedistrict Leisure with a strike price of £10.2.

[5 marks] A. £0.50 B. £1.00 C. £1.50 D. £2.00 E. None of the above

A trader enters into a short cotton futures contract when the price is 50 cents per pound. The contract is for the delivery of 50,000 pounds. How much does the trader gain if the cotton prices at the end of the contract are 48.20 cents per pound and 51.30 cents per pound, respectively?

[5 marks] A. 900, 650 B. 900, -650 C. 650, -900 D. 650, 900 E. None of the above

Illustrate what is meant by a protective put and outline its main application.

[10 marks] A one-year European call option on a non-dividend-paying stock is currently selling for £5. The stock price is £64, the strike price is £60. The risk-free interest rate is 12% per annum for all maturities. What opportunities are there for an arbitrageur? [15 marks] Explain how an option holder gains from an increase in the volatility of the underlying stock price. [10 marks] TOTAL 50 MARKS