Faculty of Economics and Business

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Examination: Finance 203BE

Date and time of the examination: December 18 Duration examination: 2 hours
You must identify yourself with the UvA-identification card or your UvA student card and passport or driver' licence or any other valid proof of identification for students containing a photograph. If you did not register for this examination, your exam will not be marked. If you believe that your examination should be marked despite this omission, you can write a letter to the Director of the Teaching Institute specifying arguments and containing proof of your claims.

Write your name and student number on every sheet of paper you hand in.
Warning against cheating: Do not cheat! In the case if cheating the maximum punishment from exclusion to all examinations for one year. Your mobile phone should be switched off and should be put in your briefcase. Your briefcase should be closed and placed on the floor to the left <right> of your desk. During the examination you are not allowed to go to the toilet unless the co-ordinating invigilator gives you permission to do so. Tools allowed: pencil, pen, eraser, non-programmable calculator Specific information on this examination: There are 10 questions The result of this examination will be published within 15 working days after the date of the examination. If the re-sit is scheduled within 6 weeks of this examination, the results will be published within 12 days.

Reviewing the examination: A date and location will be announced on blackboard

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Question 1 (Repurchasing shares/Dividend policy, 15 points) ABC Corporation is an all-equity financed firm with 20,000 shares outstanding and a 100% payout policy. Current net income (at t=0) is $60,000. The expected value of the firm one-year hence (that is at t=1) is $1,650,000. The appropriate discount rate for ABC is 10%. a) What is the current cum-dividend share price (at t=0)? b) What is the ex-dividend price of ABC stock (at t=0) if the board follows its current policy? c) At the dividend declaration meeting, several board members claimed that the current dividend is too low and is probably depressing the share price of the company. They proposed that ABC sell enough new shares to finance at t=0 a $5 dividend per share. The new shares will be sold ex-dividend.If the proposal is adopted, at what price will the new shares sell and how many will be sold? Question 2 (Capital budgeting with taxes, 20 points) Suppose Goodyear Tire and Rubber company is considering divesting one of its manufacturing plants. The plant is expected to generate free cash flows (FCF) of 3 million per year one year from now, than growing at a rate of 3% per year forever. Goodyear has an equity cost of capital of 9%, a marginal corporate tax rate of 40% and a debt/equity ratio of 2. Its cost of debt is 6%. To set the price of its plant, Goodyears treasurer considers calculating the present value of the FCFs using the company WACC. a) Name two conditions under which the treasurer may proceed using the WACC. b) What price will the treasurer set? Magna, an automotive manufacturing company considers setting up a new stand alone tyre plant. Magna management estimates that the market risk of the tyre plant is similar to the market risk of Goodyear. Magna plans to finance the new plant with 30% debt financing and faces a marginal corporate tax rate of 45%. c) Estimate the unlevered cost of capital for the new tire plant. d) Derive the equity cost of capital for the new tire plant under the proposed financing structure with 30% debt. e) Derive the WACC for the new tire plant. f) Explain, intuitively, why the unlevered cost of capital is less than the equity cost of capital and higher than the WACC. Question 3 (Options, 15 points) The share price of the newly listed start-up company FreshFood.com is currently 100. Assume that the stock price can either half or double over the next 6 months. The risk free interest rate is 3% for a six-month period. There will be no dividends paid on this share over the coming six months.

a. An investor holds FreshFood shares in her portfolio. To protect against the risk of a decline in the value of FreshFood, the investor considers using options for the next six months. Should she use a call option or a put option to be protected against such a risk? Motivate your answer using a payoff diagram. b. Using the binomial approach, calculate the value of a European call option on the share of FreshFood with a six-month maturity and a strike price equal to 100. c. Suppose now that there are call options traded for shares of FreshFood.com (next to its common shares, of course) but no put options. Construct a portfolio (i.e., combination of different securities) that perfectly replicates a put option on that stock (hint: use the Put-Call Parity) and calculate the value of the put option.

Question 4 (Capital Structure, 15 points) The Mapple company has two mutually exclusive projects: A and B. Mapple has no other cash-flows than those generated by the chosen project. Mapple is heavily financed with debt. An amount of $ 200,000 is due to the debt-holders at the end of next year. The interest rate is 0%. Each project requires an initial investment of $ 50,000. Mapple has this amount in cash and does not need to raise any additional capital. The two projects offer the following cash-flows in one year. Good state 0.5 CF CF 300,000 360,000 Bad state 0.5 220,000 120,000

Probability Project A Project B

a) If managers are acting in the interest of risk-neutral shareholders, which project will they choose? Motivate your answer with a calculation. b) Who will seemingly benefit from such behavior and who will suffer? Who will ultimately bear the costs? c) Describe in a general way how these conflicts of interest can be mitigated.

Short questions

Question 5 (CAPM, 10 points) Suppose the risk free rate is 2.6% and the market portfolio has an expected rate of return of 11.8 % and a volatility of 16.5%. JJ stock has a 18.9% volatility and a correlation with the market of 0.065 a. What is JJs beta with respect to the market? b. Under the CAPM assumptions what is the expected rate of return of JJs stock

Question 6 (CAPM, 5 points) Assume the CAPM is correct. Why an empirical test of the CAPM might indicate that the model does not work- that is, that stocks have alphas that are statistically significantly different from 0: a. b. c. d. Expected returns are measured with error The proxy portfolio for the market portfolio is not correct Beta is measured with error All of the above

Question 7 (CAPM, 5 points) There are two public-listed companies, X and Y. The equity betas for X and Y are 0.8 and 1.2, respectively. The market portfolio return is 12% and the risk-free rate is 4%. Assume that CAPM holds. Which of the following portfolios has the same beta as the market portfolio beta? (1) (2) (3) (4) Invest 33% in X, 67% in Y Lend 40% at the risk free rate and invest 60% in Y Borrow 20% at the risk free rate and invest 120% in X Invest 50% in X, 50% in Y

Question 8 (Pecking Order Theory, 5 points) According to the pecking order theory: (1) (2) (3) (4) New debt is preferable to new equity New equity is preferable to internally generated funds New debt is preferable to internally generated funds New equity is always preferable to other sources of capital

Question 9 (Valuation, 5 points) Suppose a firm makes an investment in a risky project financed entirely with a riskless debt. The T-Bill rate is 2.5%. The discount rate of the project is then: (1) equal to the riskless rate of 2.5% since the discount rate depends on the source of funds (2) cannot be determined (3) the firms cost of capital since the project is undertaken by the firm (4) the firms cost of debt since the project is entirely financed with debt

Question 10 (Efficient Markets, 5 points) If the market is efficient, buying equity is a transaction with: (1) Zero NPV and investors do not receive a fair compensation for their investment. (2) Positive NPV and investors receive a fair compensation for their investment. (3) Zero NPV and investors receive a fair compensation for their investment (4) Negative NPV transaction

SOLUTION Question 1 (15 points:5,5,5) b. Value (cum dividend): 60000 + (1650000/1.1) = 1560000, Price per share: 1560000/20000 = 78 c. P ex- dividend: subtract dividend: 78-3= 75 d. Need to raise 40000 (2 $ extra dividend per share, 20000 shares) by issuing equity. At which price can you issue equity? We know that: PxN = 40000 And: (20000+N)P = 1500000 (where N is the number of new shares and 1,500,000 right after the firm payed its dividend). From these two equations we can calculate that: P=73, N=548 Question 2 (20 points) a. Treasurer may use WACC provided that (I) Goodyear maintains constant debt equity ration and (ii) market risk of investment is similar to market risk of Goodyear b. First calculate the appropriate WACC after taxes. This is 5.4%; D/V ratio is 2/3, E/V is 1/3 cost of equity, cost of debt and tax rate have been given. To calculate the price: calculate the value of the investment. Perpetual growth of 3% hence: V= C/(r-g) = 3/(0,054-0,03) = 125 million. c. Since the risk of the investment is similar to the risk of the Tyre industry, we cannot use the unlevered cost of capital of Magna, but we should use the unlevered cost of equity for Goodyear instead. This is equal to the WACC before taxes for Goodyear. Unlevered cost of equity: 7% d. Using MM proposition 2 we can calculate the Cost of equity with 30% debt: 7,42 % (7% + 0,3/0,7(7-6)) e. WACC= 7,42*0,7 + 6* 0,3*0,55 = 6,184 f. Cost of equity: shareholders want compensation for business risk and financial risk (due to additional leverage); cost of levered equity is always higher than unlevered cost of capital. Due to tax benefit of debt financing the WACC is always equal or lower than the unlevered cost of capital. Question 3 (15; 3,6,6) a. put, sketch payoff graph (3 points, -1 if no graph used) b. delta = 2/3, B = -32.36, C = 34.3 (6 points, -3 if minor mistake in calculation, 1 if interest rate is compounded semi-annually) c. C = S + P - PV(K); P = 31.39 (6 points, 2 points given for parity condition)

Question 4 (15 points, 5,5,5) a. Calculate the value of the equity holders of the two investments after debt has been repayed. For project A the expected pay off will be: 0.5 * [300000200000] + 0.5 * [220000-200000] = 60000

For project B it is: 0.5 * [ 360000-200000] + 0.5* [ 120000 120000] = 80000. Hence, shareholders will chose project B. In the bad state of project B only 120000 of 200000 debt outstanding is repayed! b. Shareholders seemingly benefit, debtholders suffer. Ultimately the existing shareholders bear all cost; ex ante they will be able to attract less debt, more covenants will be added, shorter maturity, more collateral, higher costs of funding. c. Adding collateral, reducing debt maturity, adding covenants to the debt contract.

Question 5 (10 points: 5,5) Simply using CAPM a. 3.28% b. 0.074 Question 6 (5 points) Answer d: all of the above Question 7 (5 points) Answer (4): 0.8 * 0.5 + 1.2 * 0.5 = 1 Question 8 (5points) Answer (1): New debt is preferable to new equity Question 9 (5points) Answer (2): cannot be determined

Question 10 (5 points) Answer (c): Zero NPV and investors receive a fair compensation for their investment