Section A: Non-numerical Questions

Q1.

Suppose there are two streams of cash flows A and B you can choose to receive. The discount rate is the same for both. Which ONE of the following statements is FALSE?

1. Assuming that both cash flows accrue over 5 years. If the future value of A in 5 years’ time is higher than that of B in 5 years’ time, you prefer A.

2. If the present value of A is higher than that of B, you prefer A.

3. If the present value of A and B are the same, by investing the amount of money equal to the present value of A today, you can generate the same cash flows as B.

4. If you receive A over 5 years and B over 10 years, you always prefer A.

5. (Tick here if you think that none of the statements is false.)

Q2.

Consider  the  following  statements  describing  the  advantages  and  disadvantages  of  the Internal Rate of Return (IRR) approach.

i. The IRR approach is related to Net Present Value and always leading to identical decisions.

ii. The IRR approach is related to Net Present Value and often leading to identical decisions but may result in multiple answers with non-conventional cash flows.

iii. The IRR approach is related to Net Present Value and often leading to identical decisions but may lead to incorrect decisions in comparison of mutually exclusive investments.

Which of the three statements above are correct?

1. i only.

2. ii only.

3. ii and iii.

4. iii only.

5. (Tick here if you think that none of the three statements above is correct .)

Q3.

Which ONE of the following statements about a bond with call provision is CORRECT?

1.  If an  investor  holds a  bond with  call  provision, she  has the  right to  buy the  bond  at predetermined price in the future.

2.  If  an  investor  holds  a  bond with  call  provision,  she  has the  right to  sell the  bond  at predetermined price in the future.

3. If a company issues a bond with call provision, it has the obligation to buy the bond at predetermined price in the future.

4. If a company issues a bond with call provision, it has the obligation to sell the bond at predetermined price in the future.

5. (Tick here if you think that none of the statements is correct.)

Q4.

If the market is weak-form efficient, which ONE of the following is TRUE?

1. Investors could not earn abnormal returns regardless of the information they possessed .

2. Prices reflect all information, including public and private .

3. Investors cannot earn abnormal returns by trading on market information .

4. Prices reflect all publicly available information e.g. trading information, annual reports, and press releases.

5. (Tick here if you think that none of the above is true.)

Q5.

Which ONE of the following is the correct description of the Security Market Line (SML)?

1. The reward-to-risk ratio must be the same for all the assets in the market.

2. The slope of the SML is the beta.

3. The intercept of the SML is the beta.

4. The reward-to-risk ratio must be higher for riskier assets.

5. (Tick here if you think that none of the descriptions is correct.)

Q6.

Consider the suitability of the following models for estimating the cost of equity:

•   Dividend Growth Model (DGM)

•   Security Market Line (SML)

•   Weighted Average Cost of Capital (WACC)

Which ONE of the following statements is correct?

1. Both the SML and WACC approaches can be used to estimate the cost of equity.

2. Both the DGM and SML approaches can be used to estimate the cost of equity.

3. Both the DGM and WACC approaches can be used to estimate the cost of equity.

4. All three approaches can be used to estimate the cost of equity.

5. None of the approaches can be used to estimate the cost of equity.

Q7.

The proposition that the value of the firm is independent of the firm’s capital structure is known as which ONE of the following?

1. WACC

2. Efficient Market Hypothesis (EMH)

3. M&M Proposition I

4. M&M Proposition II

5. (Tick here if you think that none of the terms listed is the correct answer.)

Q8.

Which ONE of the following is a measure of either short-term or long-term solvency?

1. Quick ratio

2. Total asset turnover

3. Days’ sales in inventory

4. Profit margin

5. (Tick here if you think that none of the measures listed is the correct solution.)

Q9.

Which ONE of the following statements about derivatives is FALSE?

1. A call option contract is an agreement that gives the owner the right, but not the obligation, to buy a specific asset at a specific price for a set period of time.

2. A put option contract is an agreement that gives the seller the right, but not the obligation, to sell a specific asset at a specific price for a set period of time.

3. An investor can replicate the payoffs at option expiry to a call-option holder by buying a forward contract and buying a put option.

4. In general, given any two of the three instruments (forward, put and call), the third can be synthesized.

5. (Tick here if you think that none of the statements listed is false.)

Q10.

Which ONE of the following is NOT a possible reason for the apparent underpricing of initial public offerings (IPOs)?

1. If uninformed investors face the winner’s curse, IPOs need to be underpriced to allow uninformed investors to break even.

2. Issuers underprice shares at the IPO to ensure the long-term post-IPO success of the share issue as underpriced IPOs are found to outperform the shares of other companies in the stock market during the subsequent 2-3 years after the IPO.

3. Underpricing is a way to reward institutional investors for truthfully revealing what they think the share issue is worth.

4.  Underpricing  is  a  kind  of  insurance to  protect  underwriters  against  legal  action from disappointed IPO investors.

5. (Tick here if you think that all of the statements give possible reasons for underpricing.)

Section B: Numerical Questions

Q11.

Two companies, Unlever PLC and Lever PLC, have the same earnings before interest and tax (EBIT). Their EBIT is £100,000 per year, and this is assumed to continue unchanged forever. Lever PLC has debt with a market value D = £80,000 and an interest rate RD  = 10 percent.

Unlever PLC has no debt, and its cost of capital RU is 20 percent. The tax rate TC is 21 percent. Which ONE of the following statements is FALSE?

1. After-tax, Unlever’s net income every year is £79,000

2. Unlever’s firm value is £395,000

3. Lever’s firm value is £411,800

4. The present value of Lever’s interest tax shield is £1,680

5. (Tick this option if you think that none of the listed statements is false.)

Q12.

Suppose you hold an option on oil with a strike (or exercise) price of $40, which you bought for a premium of $3. Which ONE of the following statements is FALSE?

1. If the option is a call option and the oil price is $50, you can exercise the call option and achieve a payoff of $10 (ignoring the option premium).

2. If the option is a call option and the oil price is $45, you can exercise the call option and achieve a profit of $2 after deducting the premium.

3. If the option is a call option and the oil price is $35, you will not exercise the option.

4. If the option is a put option and the oil price is $45, you will not exercise the option.

5. (Tick this option if you think that none of the statements listed is false.)

Q13.

Assume the following information for projects that last for 1 year:

Consider the following statements:

A.   IRR of X is 12.5%

B.   IRR of Y is 2.5%

C.   IRR of X is 10%

D.   IRR of Y is 5%

Which ONE of the following identifies correctly all of the statements above that are TRUE?

1.   A and B

2.   C and D

3.   A and D

4.   B and C

5.   (Tick here if you think that none of the other options correctly identifies the true statements.)

Q14.

Your company has just suffered a loss of £78 million, when someone offers you the following gamble that gives you the chance to recover your company’s loss and break even. If entered, the gamble would give your  company  a  20%  chance  of  recovering the  £78  million  loss. However, there is an 80% chance that the loss will grow from the original £78 million to £100

million (i.e., by an additional £22 million).

Which of the following statements is FALSE?

1. Without the gamble, your company makes a loss of £78 million for sure.

2. The expected loss is £80 million with the gamble (including the original loss of £78 million).

3. The gamble has a positive expected payoff.

4. Decision makers who take this gamble may suffer from loss aversion.

5. (Tick here if you think that none of the statements listed is false.)

Q15.

A stock has an expected return of 14.4 percent and a beta of 1.35. The risk-free rate is 4.2 percent. What is the slope of the security market line?

1. 4.62 percent

2. 5.67 percent

3. 6.03 percent

4. 7.56 percent

5. (Tick here if you think that none of the numbers shown is the correct answer.)

Q16.

Given the following information, what is the expected return of a portfolio that is invested 35 percent in both stocks A and C, and 30 percent in stock B?

1. 8.98 percent

2. 9.47 percent

3. 10.41 percent

4. 10.83 percent

5. (Tick here if you think that none of the numbers shown is the correct answer.)

Q17.

Suppose you have estimated your company’s beta as 1.1 . You expect the market risk premium to be 4%, and the risk-free rate is 1%. The company’s market value of equity is £200 million, and the market value of its debt is £100 million . The company’s pre-tax cost of debt is 4% and the corporate tax rate is 30% .

Which ONE of the following statements is FALSE?

1. Using the Security Market Line, the company’s cost of equity is 5.4%.

2. We can calculate the weighted average cost of capital (WACC) as 2/3 of the cost of equity plus 1/3 of the after-tax cost of debt.

3. The after-tax cost of debt is 2.8%.

4. The company’s after-tax WACC is 5.1%

5. (Tick this option if you think that none of the statements is false.)

Q18.

The annual returns of three stocks over a 3-year period are given below:

The weights of Stocks A, B, and C in a portfolio is given below:

What is the standard deviation of the portfolio ABC?

1.   0.0094

2.   0.0457

3.   0.0971

4.   0.1357

5.   (Tick here if you think that none of results shown is correct.)

Q19.

The Johnston Company will pay an annual dividend of $2.05 next year. The company has increased its dividend by 3.5 percent a year for the past twenty years and expects to continue doing so. What will a share of this stock be worth three years from now if the   required return is 14 percent?

1.   $20.21

2.   $20.91

3.   $21.65

4.   $22.41

5.   (Tick here if you think that none of the figures shown is correct.)

Q20.

Taylor's Men's Wear has a debt-equity ratio of 42 percent, sales of £749,000, net income of £41,300, and total debt of £198,400.  Which ONE of the following is FALSE?

1. Equity multiplier = 1.586.

2. Total equity = £472,381.

3. Total assets = £670,781.

4. ROE = 8.74%.

5. (Tick this option if you think that none of the figures listed is false.)