ECON 20191 CORPORATE FINANCE EXAMINATION PAPER 1

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ECON 20191 WE01

CORPORATE FINANCE

EXAMINATION PAPER

SECTION A – Answer ALL questions. Each question has only ONE correct answer. Each question carries equal weight.

1.  In which of the following situations would you get the largest reduction in risk by spreading your investment across two stocks?

A.  The two stocks are perfectly correlated

B.  There is no correlation

C. There is modest negative correlation

D. There is perfect negative correlation

2.  Which of the following is an advantage of ownership of a corporation over that of a sole proprietorship?

I.   The owner of the corporation has unlimited liability for the firm’s debts.

II.  It is the simplest to start.

III. The corporation has an unlimited life.

IV. Dividends received by the corporation’s shareholders are tax-exempt.

a.   I only

b.   II only

c.    III only

d.   III and IV only

3.  Which of the following statements are TRUE?

I.   If stocks were perfectly negatively correlated, diversification would not reduce risk.

II.  Diversification over a large number of assets can eliminate unsystematic risk.

III. Diversification works only when assets are uncorrelated.

IV. A well-diversified portfolio with a beta of 2.0 is twice as risky as the market portfolio.

a.   I and II only

b.   I and III only

c.   II and III only

d.   II and IV only

4.  Consider the following probability distribution for stocks X and Y:

State of Economy

Probability

Return on

Stock X

Return on

Stock Y

Recession

0.30

11%

5%

Normal

0.30

13%

7%

Boom

0.40

15%

8%

The standard deviations of stocks X and Y are approximately:

a.  1.78%, 1.11%

b.  12.20%, 6.40%

c.  3.16%, 1.24%

d.  None of the above

5.  Which of the following statements are FALSE?

I.   The Security Market Line (SML) displays the relationship between expected return on investment and standard deviation of return. If a security plots below the SML, it is offering too little return to justify its risk.

II.  If a stock lies below the SML, it is overpriced and it presents a selling opportunity.

III. The expected return on an investment with a beta of 2.0 is twice as high as the expected return on the market.

IV. The CAPM implies that if you could find an investment with a negative beta, its expected return would be less than the risk-free rate of return.

a.  I and II only

b.  I and III only

c.  II and IV only

d.  I, II, III and IV

6.  Which of the following statements are TRUE?

I.   If the markets are efficient in the weak form, technical analysis is worthless.

II.  The semi-strong form of the efficient markets hypothesis states that prices reflect all publicly available information.

III. In efficient markets only professional money managers will be able to earn profits.

IV. If the stock market is semi-strong efficient, you cannot expect to find underpriced or overpriced stocks even if you have inside information .

a.  I and II only

b.  II and III only

c.  II, III and IV only

d.  I, II, III and IV

7.  A company issued £100 million in perpetual debt (at par) with an annual coupon of 7%. It will pay interest only on this debt. The company’s marginal tax rate is expected to be 40% for the foreseeable future. The company’s annual interest tax shield is closest to:

a.  £2.8 million

b.  £4.2 million

c.  £7.0 million

d.  £40 million

8.  If dividends are taxed more heavily than capital gains, investors:

a.  Should pay more for stocks with low dividend yields

b.  Should pay more for stocks with high dividend yields

c.  Should pay the same for stocks regardless of the dividend yields

d.  Cannot be predicted as stock prices fluctuate randomly

9.  Firm Alpha has a value of £300 million and Firm Beta has a value of £200 million. Merging the two companies would allow cost savings with a present value of £50 million. If Firm Alpha purchases Firm Beta for £220 million, how much do the shareholders of firm Alpha gain from this merger:

a.  £20 million

b.  £30 million

c.  £40 million

d.  £50 million

10.Which of the following is/are example(s) of different types of real options?

a.  You will defer the start of a project to gain more additional information regarding the value of the investment.

b.  You want to shut down three projects or sell them to other companies to reduce the scale of your investment.

c.  You will enhance the flexibility into the firm’s production facilities so that the firm can use cheapest raw materials or produce the most valuable set of outputs.

d.  All of the above

SECTION B – Answer ONE question

11.

a)  Explain what financial economists mean  by the Capital Asset  Pricing  Model  (CAPM). Illustrate your answer with relevant equation and diagram. (20 marks)

b)  The following table gives the percentage returns on two risky assets A and B, the market portfolio, and the risk-free rate for three equally likely states of the economy.

State of the economy

Recession

Normal

Boom

Asset A

-22

35

32

Asset B

-9

30

-3

Market

-5

10

25

Risk free

5

5

5

i.    Calculate the correlation coefficient between risky assets A and B and comment on your results. Calculate and comment upon the expected return and risk associated with a portfolio that comprises equal proportions of assets A and B . (40 marks)

ii.     Calculate the beta values for assets A and B and comment on whether the observed returns are consistent with the CAPM. (40 marks)

12.

a)  Define and discuss the unsystematic and systematic risk of an asset. Is there a way to eliminate them? Illustrate your answer with relevant examples. (30 marks)

b)  A stock has a beta of 1.4 and an expected return of 8 percent. A risk-free asset currently earns 2.5 percent.

i.     What is the expected return on a portfolio that is equally invested in the two assets? (10 marks)

ii.    If a portfolio of the two assets has a beta of 0.6, what are the portfolio weights?   (20 marks)

iii.    If a portfolio of the two assets has an expected return of 7 percent, what is its beta? (20 marks)

iv.    If a portfolio of the two assets has a beta of 2.1, what are the portfolio weights? How do you interpret the weights for the two assets in this case? (20 marks)

13.

a)  Luna Corporation has a beta of 1.5, £10 billion in equity, and £5 billion in debt with an interest rate of 4%. Assume a risk-free rate of 0.5% and a market risk premium of 6%. Calculate the WACC without tax.  (30 marks)

b)  Queen Corporation has a debt-to-equity ratio of 1.8. If it had no debt, its cost of equity would be 16%. Its current cost of debt is 10%. What is the cost of equity for the firm if the corporate tax rate is 35%? (20 marks)

c)  Discuss the impact of corporate taxes on the optimal capital structure of the firm in an otherwise perfect capital market. (50 marks)

SECTION C – Answer ONE question

14.

“The CAPM is an absurd model because its assumptions and its predictions/conclusions have no basis in the real world. The use of CAPM is also a source of litigation:  many professors,  lawyers…get  nice fees  because  many  professionals  use  CAPM  instead  of common sense to calculate the required return to equity.” (Pablo Fernandez (2014), p.1) Critically assess Fernandez’s view of the CAPM.

15.

a)  “From March 2008 through March 2009, the stock market declined by almost 50%...For many observers, the collapse of 2008-09 and the subsequent world financial crisis sounded the death knell for the efficient market hypothesis” (Malkiel, 2015, p.284). Critically evaluate this statement. (80 marks)

b)  Some studies of the stock market have concluded that a ‘January Effect’ exists. These studies found that, on average, the stock prices tend to increase during January, relative to other months of the year. Is this a violation of the concept of efficient markets? Explain. (20 marks)

16. What do you understand by ‘the dividend puzzle’? Critically evaluate theoretical arguments developed to explain the reasons why firms pay dividends.

17.

a) ‘There is evidence that roughly two-thirds of public merger and acquisition transactions destroy shareholder value for the acquiring companies. ’ Critically discuss. (50 marks)

b)  Critically discuss the five anti-takeover devices which are commonly available to the target firm’s management to use as defence mechanisms. (50 marks)

2023-05-23