Calculator instructions:

You are only allowed to use a nonprogrammable calculator from the following list of approved models in this exam:

· Casio fx-82, fx-83, fx-85, fx-350

· Sharp EL-531 series

Dictionary instructions:

You are not allowed to use your own dictionary in this exam. A basic English language dictionary is available to use if required.

Exam information:

· A formula sheet is attached on pages XX and YY.

· Tables are provided on pages ZZ to ZZ.

· A LUBS MCQ answer sheet is provided.

· There will be 2 hours to complete this exam.

· There are 3 sections to this exam: Section A, Section B and Section C.

· Section A is worth 40 marks and is worth 40% of the overall marks available for this exam paper. Answer all questions from Section A on the MCQ answer sheet provided. There are 16 questions in section A. Questions 1-12 are worth two marks each. Questions 13-16 are worth four marks each.

· Section B is worth 30 marks and is worth 30% of the overall marks available for this exam paper. Answer one question from Section B in the first script book provided.

· Section C is worth 30 marks and is worth 30% of the overall marks available for this exam paper. Answer one question from Section C in the second script book provided.

· Answer different questions in separate script books.

· Answer all questions from Section A on the LUBS MCQ Answer sheet provided.

Please do not remove this paper from the exam venue.

MCQ Instructions:

Read the following instructions carefully before answering Section A.  Please remember – if there is any ambiguity regarding what answer you have given, the question will be marked wrong.

Write your name in the Name field on the answer sheet.

You must write your 9-digit student number in the ID field.

Write the examination room and your seat number in the Venue & Seat No. field.

Write the module code in the Module Code field.

Apart from writing in the information as indicated above, and blackening the cells to indicate your answers, do not write on or mark the answer sheet in any way.

Do not write on the back of the answer sheet.

Do not fold, crease or pierce the answer sheet.

You must record your answers using the answer sheet provided.  Do not write your answers in an exam booklet.

Each question has one correct answer.  You must mark the one answer you think is correct. No marks are deducted for incorrect answers.

Indicate your answer on the answer sheet provided by completely blackening the appropriate cell.  Do not use ticks or crosses.

Use only pencil on the answer sheet.  If you wish to change an answer, do so by completely erasing the mark you wish to change with an eraser before blackening the new cell.  Do not use correcting fluid (such as “Tipp-Ex”) anywhere on the answer sheet.

The script book provided is for rough work only and will not be sent for marking.

Please see the below example of how you should mark your answer sheet:

 

Section A (40 marks)

Answer all questions on the MCQ answer sheet provided.

Questions 1-12 are worth two marks each. Questions 13-16 are worth four marks each.

In all cases select one answer from a, b, c, d and e.

1) Which of the following cash flows should not be treated as relevant incremental flows when deciding whether to go ahead with production of a new model of mobile phone?

I. The resulting reduction in the sales of the company’s existing models

II. Falls in sales of phones made by competitors

III. Additional sales of related items such as phone covers and electric leads

IV. The cost of market research undertaken during the past five years

V. Changes in working capital arising from proceeding with the new phone

a. I and II only

b. II and IV only

c. II and III only

d. I and V only

e. All five should be treated as relevant cash flows.

2) Holmes plc is appraising an investment which has an initial cost of £750,000 and a salvage value of £250,000 after 6 years. What is the average accounting rate of return (to the nearest 0.01%) for the investment which has the following estimated accounting profits:

a. 9.25%

b. 11.5%

c. 12.75%

d. 15.5%

e. None of the above

3) McGilvray’s Foods currently pays no dividends. You overhear the CEO tell the finance director that the plan is to begin paying dividends in 3 years. The first dividend will be £1 and dividends are expected to grow at 5% thereafter. Given a required return of 15% what would you pay for the stock today?

a. £7.1

b. £7.56

c. £8.29

d. £10

e. £4.3

4) Consider a series of cash flows as follows: £1,250 received two years from now, £1,600 received five years from now, and £1,900 received eight years from now. If the discount rate is 8%, to the nearest £1 what is the (i) present value of the cash flows and (ii) the future value in fifteen years of the cash flows?

a. (i) £3,187 and (ii) £10,110

b. (i) £3,187 and (ii) £8,110

c. (i) £2,557 and (ii) £10,110

d. (i) £2,557 and (ii) £8,110

e. None of the above

5) You are asked to put a value on a bond which promises five annual coupon payments of £4.50 and will repay its face value of £100 at the end of five years. Determine how much this bond is worth (to the nearest £0.10) if the yield to maturity on similar bonds is (i) 3% and (ii) 6%.

a. (i) £106.90 and (ii) £93.70

b. (i) £103.60 and (ii) £93.70

c. (i) £106.90 and (ii) £95.90

d. (i) £103.60 and (ii) £95.90

e. None of the above

6) A company with a share price of £5.50 and 500,000 shares plans to undertake an investment project which will change expectations about the future growth of dividends. As a result of the project next year’s dividends are expected to be 25p and they are then expected to grow at 7% per annum. The firm’s required rate of return is 11%. Assume that the share price is determined using the dividend valuation model and that prices adjust as soon as an investment decision is made. For the situation where the company decides to go ahead with the project. What is (i) the new share price and (ii) the net present value of the project?

a. (i) £6.25 and (ii) £250,000

b. (i) £6.25 and (ii) £375,000

c. (i) £6.00 and (ii) £250,000

d. (i) £6.00 and (ii) £375,000

e. None of the above

7) Stock A is fairly priced by the market. Given that the risk free rate is 3.5%, the beta of stock A is 1.2, the beta of stock B is 0.8, the expected return on A is 6.5% and on B is 5.5% which of the following is correct given that betas of stocks A and B are correct?

a. Stock B is also fairly priced

b. The expected return on stock B is too high

c. The expected return on stock A is too high

d. The price of stock B is too high

e. The price of stock A is too high.

8) Which of the following would likely have the greatest amount of systematic risk?

a. A portfolio of the ordinary shares of 100 randomly selected companies

b. The market portfolio

c. A portfolio half invested in the market portfolio and half invested in treasury bills

d. A portfolio half invested in the market portfolio and half invested in stocks with betas greater than 1.5

e. A portfolio made up entirely of treasury bills.

9) In relation to the efficient markets hypothesis, consider the following observations:

I. Mutual fund managers do not on average make superior returns.

II. In any year approximately 50 percent of all pension funds outperform the market.

III. It is possible to make superior returns by buying or selling stocks after the announcement of an abnormal rise in earnings.

IV. Managers who trade in their own stocks make superior returns.

Which of the following statements is true?

a. I does not provide evidence against semi-strong form efficiency, but II does provide evidence against semi-strong form efficiency.

b. II does not provide evidence against semi-strong form efficiency, but I does provide evidence against semi-strong form efficiency.

c. Both I and II provide evidence against the semi-strong form of market efficiency

d. III provides evidence against semi-strong form efficiency and IV provides evidence against strong form efficiency.

e. III and IV provide evidence against semi-strong form efficiency.

10) What is the beta for the following portfolio?

Stock 1 2 3 4 5

Investment £’s 25 10 15 40 35

Beta . .75 .95 1.25 1.5 0

a. 0.73

b. 0.81

c. 0.86

d. 0.94

e. 1.07

11) One of the major advantages of common stock financing is:

I. equity capital requires a lower rate of return than debt capital in the same firm

II. no fixed dividend obligation exists

III. it is relatively cheaper issuing new common stock than issuing new debt capital

IV. common stocks holders receive a zero rate of return

a. I only

b. II only

c. II and III only

d. I and III only

e. I, III and IV only

12) Consider the following statements:

The interest tax shield for a firm:

I. Is the tax benefit a firm derives from paying interest

II. Will decrease as the corporate income tax rate is increased

III. Is the yield to maturity on a firm’s bonds multiplied by the market value of the bonds outstanding

Which of the statements is true?

a. I only

b. II only

c. III

d. I, II and II only

e. None of the above

13) You have the choice between two mutually exclusive investments, A and B. Both investments cost £80000, but investment A pays £35000 a year for 4 years and investment B pays £30000 a year for five years. Your required return is 13%. Consider the following statements:

I. Project A has a higher net present value (NPV) than project B

II. Project A has a higher internal rate of return (IRR) than project B

III. Project B has a higher NPV than project A

IV. Project B has a higher IRR than project A

Which of the following is correct?

a. I and II are both correct and you should choose project A

b. I and IV are both correct and you should choose project B

c. II and III are both correct and you should choose project A

d. II and III are both correct and you should choose project B

e. III and IV are both correct and you should choose project B (4 marks)

14) Philips plc has just paid a dividend of 10p per share. Next year’s dividend is expected to be 30% higher and thereafter dividends are expected to grow at a rate of 5% per annum. The cost of capital for Philips is 9%. The management of the company is faced with an investment opportunity which will require dividends to be reduced to 5p next year and then thereafter dividends will be as follows:

10p at the end of year 2

10p at the end of year 3

10p at the end of year 4;

23p at the end of year 5;

Dividends will then grow at 7% per annum.

However, the market believes that the new investment increases the riskiness of Philips plc with the result that the cost of equity capital rises to 12%. Assume that the market is strong form efficient. Consider the following statements.

I. If a decision is taken now to go ahead with the investment the current share price and the share price after 4 years will both be lower.

II. If a decision is taken now to go ahead with the investment the current share price will be higher and the share price after 4 years will be lower.

III. If a decision is taken now to go ahead with the investment the current share price will be lower and the share price after 4 years will be higher.

Which of the following is correct?

a) I is correct and the company should not go ahead with the investment

b) II is correct and the company should go ahead with the investment

c) II is correct and the company should not go ahead with the investment

d) III is correct and the company should go ahead with the investment

e) III is correct and the company should not go ahead with the investment (4 marks)

15) Smith Manufacturing is currently all equity financed, had EBIT of £2 million, and is in the 34% tax bracket. John, the company's founder, is the lone shareholder. Assume that all earnings are paid out as dividends. Now consider the fact that John must pay personal tax on the dividends he will receive. John pays taxes on interest at a rate of 33%, but pays taxes on dividends at a rate of 28%.  If the firm were to convert £4 million of equity into debt at an interest rate of 10% and John holds all the debt, calculate the total cash flow to John after he pays personal taxes. Compare this to John’s total cash flow after personal taxes if the firm remains unlevered. What is the change in John’s cash flows after personal taxes if the firm becomes levered?

a. -£190,080

b. £77,920

c. £150,220

d. £0

e. None of the above (4 marks)

16) The Risky-Bet firm has promised payments to its bondholders that total £100. The company believes that there is an 85% chance that the cash flow will be sufficient to meet these claims. However, there is a 15% chance that cash flows will fall short, in which case total earnings are expected to be £65. If that happens, then the firm will go bankrupt. If the bonds sell in the market for £84, what is (i) an estimate of the bankruptcy costs for Risky-Bet and (ii) the impact of bankruptcy costs on the price of the bond?

a. (i) £14.35 and (ii) -£1.68

b. (i) £14.35 and (ii) -£2.14

c. (i) £15.67 and (ii) -£1.68

d. (i) £15.67 and (ii) -£2.14

e. None of the above (4 marks)

Section B (30 marks)

Answer one question in the first script book provided. 

Section B and Section C should be answered in separate script books.

Each question is worth 30 marks.

Question 1

“Corporate finance theory suggests that corporations should take decisions with the aim of maximising shareholder wealth. However, corporations typically delegate management of day to day activities to professional managers. Such delegation can lead to conflicts arising between the owners and the managers” Discuss this statement and discuss the factors which limit the freedom of managers to deviate from the wishes of shareholders. Total 30 marks

Question 2:

“The dividend share valuation model is based on the view that the share price at any given time is simply the discounted value of all future dividends.” Explain this statement and discuss the extent to which the model is a useful guide to value in practice. Total 30 marks

Outline answers:

Question 1:

Answers should be presented in essay form and not in bullet point form or simply listing points. Answers should be well structured, answer the specific question set and be of appropriate length given the question accounts for 30% of a two-hour exam. The dividend share valuation model should be set out and explained. The principles underlying discounting all future dividends should be discussed. The limitations of the dividend share valuation model should be discussed. In particular, attention could be paid to uncertainty about future dividends and the need to forecast them for many years into the future and assumptions about the appropriate discount rate and growth rate of dividends. Good answers will also discuss problems in valuing newly listed firms, including negative earnings (growth rates and negative earnings, implications for tax computations and the going concern assumption), absence of historical data and absence of comparables and the impact on risk estimates, forecasts, etc.

Question 2:

Answers should be presented in essay form and not in bullet point form or simply listing points. Answers should be well structured, answer the specific question set and be of appropriate length given the question accounts for 30% of a two-hour exam. Answers could explain why shareholder wealth maximisation is the goal. They should then explain the nature of the principal-agent relationship. The separation of ownership and control in modern corporations creates the potential for a conflict of interest between managers (the agents) and shareholders (the principals). Answers should then discuss the factors which can limit the scope for managers to deviate from the wishes of the owners: incentive packages, market for corporate control, managerial labour market, managers’ interest for independence and access to funds from capital markets. In addition, the role of linking managers’ rewards to the (suitable) financial performance measure for the firm should be discussed.

Section C (30 marks)

Answer one question in the second script book provided. 

Section B and Section C should be answered in separate script books. 

Each question is worth 30 marks. 

Question 3: 

In answering question 1, treat sections (a), (b), and (c) as independent to each other

Gamestart is a videogame retailer that operates mainly in the US. The company has issued common stock equity, partly owned by institutional investors, and bonds to finance its operations. Those are its only sources of capital. The company’s shares are publicly traded in the New York Stock Exchange (NYSE). Gamestart has a new management team that is currently implementing a significant restructuring plan. Some of the most important changes are the following:

(a) 

· Gamestart is selling the properties that used to house its brick and mortar stores, as it will rely mostly rely on home delivery for its products in the future. As a result, the company’s ratio of fixed to total assets will drop significantly.

· Gamestart announced a big investment plan that will allow the company to expand its operations to the streaming services sector. The new investment involves the launch of a new streaming platform for movies, series, and documentaries. After the announcement, Gamestart stock price skyrocketed, reflecting the news. As a result, the stock of Gamestart is now trading at a much higher trailing price-to-earnings ratio compared to the stocks of its peers, and is expected to remain so for the near future.

· Gamestart managed to penetrate successfully the Canadian market, and now more than one third of its revenues comes from its operations in Canada.

Discuss how each one of the three aforementioned changes will affect the theoretically optimal leverage ratio of Gamestart, relating you discussion to the trade-off theory of capital structure. (9 marks)

(b) Gamestart announced its intention to issue new shares via a seasoned equity offering (SEO). Upon the announcement, the market price of its stock dropped by 3%. Discuss the potential reasons for this drop in the context of the pecking order theory of capital structure. Discuss whether the drop would have been higher or lower if, ceteris paribus, (i) the number of financial analysts following the firm was lower, (ii) the company’s debt was not rated, or (iii) the company had no institutional investor ownership. (9 marks)

(c) The US economy is experiencing high growth rates driven mainly by consumers’ pent-up demand, which was unleashed after the end of lockdowns. As a result, several changes can occur in the US economy and financial markets. Discuss the potential impact of each one of the following hypothetic changes on the weighted average cost of capital (WACC) of Gamestart. When discussing the impact of each one of these changes, assume that everything else remains constant.

i. The US Federal Reserve Bank raises the reference interest rate in order to prevent the outbreak of inflationary pressures.

ii. The annual expected return for the S&P 500, the benchmark index for the US stock market, is revised upwards.

iii. The credit rating agencies upgrade the credit rating of the bonds that have been issued by Gamestart.

iv. The US government lowers the US corporate tax rate. (12 marks)

Total 30 marks

Question 4:  

(a) 

(i) Explain the benefits of portfolio diversification for investing and discuss how diversification benefits are affected by the correlation between the securities in a portfolio. (8 marks)

(ii) Suppose that you are holding a portfolio consisting of stocks of companies based and operating in countries A and B. Discuss whether the diversification benefits will be mitigated or reinforced if each one of the following changes occur, relating your discussion to the potential change in the correlation between the securities in your portfolio:

a. There is a dangerous virus outbreak affecting the whole region where the two countries are located.

b. After the adoption of a regional trade agreement, the two countries lower the trade tariffs on imported goods.

c. The number of cross-border mergers & acquisitions between the firms from the two countries has recently increased.

d. Exchange rate volatility between the currencies of the two countries is expected to increase substantially over the next 5 years.  (8 marks)

(b) Summarizing the numerous event studies conducted in US stock markets, Eckbo et al. (Eckbo, B. & Masulis, Ronald & Norli, Oyvind. 2007. Security Offerings. Handbook of Corporate Finance: Empirical Corporate Finance) report that announcements of equity issues result in significant negative stock price reaction, which is -2.22% on average, while announcements of straight bond issues have no effect on the stock price. Discuss the reaction of investors to equity and bond issues relating your discussion to the pecking order theory of capital structure. (14 marks)

Outline answers:

Question 3

Answers should be presented in essay form and not in bullet point form or simply listing points. Answers should be well structured, answer the specific question set and be of appropriate length given the question accounts for 30% of a two-hour exam.

a. Good answers should link each one of the three aforementioned changes with a firm-specific characteristic, i.e. (i) tangibility, (ii) growth opportunities, and (iii) size and level of diversification, respectively. Then, answers should explain why changes in these characteristics affect the optimal leverage ratio in a trade-off theory context.

b. Good answers should explain why the stock price drop is an implication of the information asymmetry between corporate insiders and outside investors. Good answers should also explain why each one of the three conditions imply a higher level of asymmetric information, and thus an even larger drop in the stock price.

c. Good answers should identify the specific component of the WACC formula that is affected by each one of these hypothetic changes and then explain the overall effect on WACC.

Question 4

Answers should be presented in essay form and not in bullet point form or simply listing points. Answers should be well structured, answer the specific question set and be of appropriate length given the question accounts for 30% of a two-hour exam.

a. 

(i) Good answers should discuss the two different types of risk (systematic vs unsystematic risk) and then explain how diversification can eliminate unsystematic risk. They also need to discuss why diversification benefits are a function of the correlation between the securities in a portfolio

(ii) Good answers should discuss whether each one of these changes would make the economies of the two countries more or less synchronized, and thus their stock markets more or less correlated. For example, a virus outbreak is a negative exogenous shock affecting the economies of the two countries simultaneously. As a result, the stock markets in both counties would go down at the same time to reflect the economic shock, and thus the correlation between them would increase.  

b. Good answers should explain why the stock price drop is an implication of the information asymmetry between corporate insiders and outside investors. Then, the differences between the effect of information asymmetry on stocks and the effect on bonds should be discussed.