Faculty of Economics and Business

On this first page, you will find important information about the examination.
Before starting with the examination you should read this information!

Examination: Financiering basisvak 6003

Date of the examination: January, 2011
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.
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Write your name and student number on your answer sheet.

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 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.

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

Good luck!

Question 1 (Capital budgeting; 15 points)

The management of firm ABC considers starting a new project. The project requires
an initial investment equal to $ 3,000,000,-. The project is in line with the firms
current activities in terms of market risk. The project will generate an annual free cash
flow (after taxes) equal to $300,000 to perpetuity (at the end of each year).
The firms balance sheet (market values) prior to the investment is as follows:
Existing Assets
Cash

$18,000,000
2,000,000
__________
$20,000,000

Equity
Debt

$ 16,000,000
4,000,000
__________
$ 20,000,000

The beta of the firms stock is equal to 1.5. Debt is riskless. The risk-free rate is equal
to 2% and the expected market risk premium is 4%. The corporate tax rate is 25%.
You may assume that corporate taxes are the only market imperfection and that the
firms debt-equity ratio is constant.
a. Calculate the firms Weighted Average Cost of Capital that is appropriate for
calculating the value of the project.
b. Calculate the value of the project using the WACC method.
c. Calculate the unlevered value of the project (that is the value of the project
without leverage)
Question 2 (Portfolio theory; 15 points)
Assume that there are only three future states of the World: a good state, a bad state
and an intermediate state. Each state is equally likely. In these three states an investor
expects the following rates of return on an investment in a stock A in each state:
State:

Return in state:

Good

20%

Intermediate

5%

Bad

-10%

a. What is the expected rate of return on this investment?

b. What is the standard deviation of the return?
Assume that the investor combines this security in a portfolio with an investment in
the risk free rate, where you invest for 40% in the risk free security and for 60% in the
risky stock A. The risk free security has a rate of return equal to 2%.
c. Calculate the expected rate of return and the standard deviation of this
portfolio. [Hint: use info from answer under a. and b.]

Suppose that the firm issuing stock A faces the risk of a strike that possibly will
reduce its expected profits.
d. Is the risk that a strike will affect the expected profits of a firm, firm specific
or systematic risk? What is the implication in a valuation framework?
Question 3 (Lectures: P/E ratio; 15 points)
a. Show using a numerical example how growth opportunities and growth (for
example through value takeovers) affect the Price Earnings (P/E) ratio.
b. Explain under what conditions intended takeovers do contribute to a higher
P/E ratio and under what conditions they do not contribute.
c. What could possibly go wrong when you as a management steer your firm too
much on the basis of your P/E ratio?
d. As an investor , you have the choice to invest in a firm with high and low
growth expectations. Which one would you choose and why?
Question 4 (options; 15 points)
Assume that you know that there will be a court ruling in two months which will
determine whether TNT is allowed to reduce their labor force or not. You do not know
what the court ruling will be, and what the effect on the stock price will be, but you
expect a strong change in the stock price upon announcement of the court ruling,
which can go either up or down.
The stock price of TNT is currently 20.
a. Is there any strategy you could use to take advantage from this expected shock
to the stock price, even if you dont know which direction this will go? If yes,
explain carefully what position you should take.
Now assume that you are holding 100 shares of TNT already and you are afraid of the
potential down-side shock that the court ruling might have.
b. What option should you use to protect the downside risk? (Describe carefully:
call or put; maturity, long or short, European or American).
c. Show graphically that you have protected the downside risk of your original
position with the option described under b) using a payoff diagram at the end
of maturity (be as precise as possible).
Assume that the (annual) risk free interest rate is 4% and that TNTs share price can
only either go up to 30 or decrease to 12 upon the court ruling.
d. Calculate the value of a call option on TNTs shares with an exercise price
equal to 20 per share and a maturity of two months using the binomial option
pricing model.

Question 5 (Capital Structure; 15 points)

The Ben-and-Jerry Company expects a free cash-flow of $50,000 forever, starting one
year from now. The company is fully equity financed and its cost of equity is 20%.
Suppose that there are no taxes initially.
a. What is the value of the firm?
b. Suppose now that Ben-and-Jerry borrows money and fixes its current debt to
equity ratio (D/E) equal to 1 and keeps it constant forever. Assume that there are
no taxes and the cost of debt is 9%. Does the new capital structure affect the
equity cost of capital? Motivate your answer with a calculation.
c. How much value is created by the change in capital structure if the firm has to
pay taxes and the tax rate is equal to 35%?
d. Consider two types of firms: low-growth mature firms and R&D intensive
firms. Which type should have higher leverage based on the trade-off theory of
capital structure and the agency theory of debt. (maximum 10 lines)
Short questions (25 points; 5 points each):
Question 6
According to the agency theory of capital structure debt overhang arises when in a
firm which is highly levered:
a. Shareholders decide not to finance new positive NPV investments
because most of the profits will go to debtholders.
b. Shareholders decide not to finance new positive NPV investments,
because they are too risky for shareholders.
c. Shareholders decide to finance negative NPV investments, benefiting
from taking low risk investments, which can be costly to debtholders.
d. None of the statements a-c is true.
Question 7
Your firm is planning to invest in a new power generation system. Galt Industries is
an all equity firm that specializes in this business. Suppose Galt's equity beta is 0.75,
the risk-free rate is 3%, and the market risk premium is 6%. If your firm's project is
all equity financed, then your estimate of your cost of capital is closest to:
A) 5.25%
B) 6.00%
C) 6.75%
D) 7.50%

Use the following information to answer questions 8 plus 9 below.

Wyatt Oil has assets with a market value of $600 million, $70 million of which are

cash. It has debt of $250 million, and 20 million shares outstanding. Assume perfect
capital markets.
Question 8
Wyatt Oil's current stock price is closest to:
A) $11.00
B) $12.50
C) $14.00
D) $17.50
Question 9
If Wyatt Oil distributes the $70 million as a dividend, then its stock price after the
dividend will be closest to:
A) $12.50
B) $14.00
C) $17.50
D) $26.50
Question 10
Which of the following statements is false?
A) Securities that tend to move more than the market have betas between 0 and 1.
B) Securities whose returns tend to move in tandem with the market on average have
a beta of 1.
C) Beta corresponds to the slope of the best-fitting line in the plot of the securities
excess returns versus the market excess return.
D) The statistical technique that identifies the best-fitting line through a set of points
is called linear regression.

NPV

Perpetuity
Growing perpetuity

Annuity

Expected return of a
portfolio
Variance and standard
deviation of a stock

Historical variance

Covariance of two
stocks
Historical covariance
Correlation coefficient

Variance of a portfolio
of two stocks

Variance of a portfolio
of many stocks

Formula Sheet Finance Exam

T
FCFt
NPV
Initial cos t
t
t 1 (1 r )
PV0

Cash Flow
r

PV0

CF1
rg
1
1

r r 1 r t

PV0 CF

E RP i xi E Ri , where xi

value of investment i
total value of portfolio

Sharpe ratio

CAPM

E ( Ri ) ri rf iMkt (E ( RMkt ) rf )

Beta

iMkt

Unlevered beta without

taxes
Pre-tax WACC:

A U

rE rU

Put-Call Parity
One-period Binomial
Tree model

Risk neutral
probabilities model

E
D
D
rE
1 c rD rU c rD
E D
E D
V

Dt d Vt L
C S P PV ( K ) PV ( Div )

Su + (1 rf )B Cu
S d (1 rf )B Cd

E
D
rE
rD
E D
E D

D
( rU rD )
E

after tax rwacc

Debt capacity

Black-Scholes

E
D
E
D
E D
E D

rU rA pre tax rwacc

Levered return on
equity
After-tax
WACC

SD(Ri ) Corr (Ri ,RMkt )

Cov(Ri ,RMkt )

SD(RMkt )
Var (RMkt )