This paper is not to be removed from the Examination Halls

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1 This pper is not to be remove from the Exmintion Hlls UNIVESITY OF LONON FN3092 ZB ( ) BSc egrees n iploms for Grutes in Economics, Mngement, Finnce n the Socil Sciences, the iploms in Economics n Socil Sciences n Access oute Corporte Finnce Thursy, 10 My 2012 : 10.00m to 1.00pm Cnites shoul nswer FOU of the following EIGHT questions: ONE from Section A, ONE from Section B n TWO further questions from either section. All questions crry equl mrks. A list of formuls is given t the en of the pper. A clcultor my be use when nswering questions on this pper n it must comply in ll respects with the specifiction given with your Amission Notice. The mke n type of mchine must be clerly stte on the front cover of the nswer book. University of Lonon 2012 Pge 1 of 5 PLEASE TUN OVE

2 SECTION A Answer ONE question from this section n not more thn further two questions. (You re remine tht four questions in totl re to be ttempte with t lest one from Section B.) 1. () Explin the free rier problem in the context of tkeovers s in Grossmn n Hrt (1980). Wht re the implictions for returns to i. the bier? ii. the cquire firm? Suppose some number of shres cn be ccumulte in secret. Explin why this my prtilly resolve the free-rier problem. Grossmn n Hrt (1980) suggeste ilution mechnism to get roun the free-rier problem. Explin how ilution mechnism my work. 2. () The Moiglini n Miller proposition sttes tht in the bsence of txes n other frictions pyout policy is irrelevnt. Explin. Suppose tht the corporte tx rte is τ C, the cpitl gins tx rte is τ CG, n the personl income tx rte is τ P. Consier tx coe where cpitl gins re txe t ifferent rte thn iviens n interest, tht is τ CG τ P. Explin how this chnges the Moiglini n Miller proposition. How woul you expect firms to rect if the cpitl gins tx ws suenly reuce? Wht is the reltionship between cpitl gins, interest, n ivien txes in typicl tx coes roun the worl (for exmple the U.S.). Suppose tht only corporte profits re txe t rte τ C but interest is tx euctible. iscuss the implictions for optiml cpitl structure. 3. () Accoring to Linter (1958)'s chrcteriztion of firm ivien behviour, if firm's ernings increse by 0.1/shre, the firm's iviens re likely to increse by less thn 0.1, 0.1, or more thn 0.1? Explin your nswer. Explin why some firms my choose to issue iviens s signl to investors. Explin the tx clientele theory for the existence of iviens. 4. () Wht oes it men for mrkets to be efficient? iscuss the ifferences between types of mrket efficiency. Suppose you fin tht the stock price of compny X typiclly flls severl ys fter ys in which your neighbour hs lou rgument with his wife. Explin wht forms of efficiency this violtes. Suppose you observe tht n estimte of voltility whose vlue is known toy (for exmple the VIX inex) forecsts future stock returns, is this necessrily violtion of the Efficient Mrket Hypothesis? Explin. Briefly review evience on the forecstbility of stock returns. Pge 2 of 5

3 SECTION B Answer ONE question from this section n not more thn further two questions. (You re remine tht four questions in totl re to be ttempte with t lest one from Section A.) 5. The risk free rte is 3%, the expecte stock mrket return is 8%, n the stnr evition of the stock mrket return is 16%. All firms consiere in this question re 100% equity owne. () Firm Jelly PLC hs mrket cpitliztion of 120 million n n expecte stock return of 14%. Clculte its bet if the CAPM hols for this firm. () Firm Penut PLC hs mrket cpitliztion of 40 million. Using historicl t over the pst 15 yers, you fin tht its return covrince with tht of the mrket ws n its verge historicl return ws 7%. Hs Penut outperforme the CAPM over this perio? Wht is its lph? Firm Butter PLC opertes in the sme inustry s firm Jelly n its prouctive ssets hve similr risk to firm Jelly. However, in ition to these ssets, Butter hols 40 million in risk free U.S. tresuries (essentilly csh). Butter's mrket cp is 120 million. Wht is Butter's bet? Butter uses its csh to purchse Penut. Assume Penut is bought for its mrket price n Butter oes not py tkeover premium. Wht is the bet of the conglomerte PenutButter? Wht is the vlue of the conglomerte PenutButter? Compre the risk of Butter n PenutButter n explin ny ifferences. 6. Pre LLC is consiering one of two potentil projects. Ech project requires n initil investment I= 50. Ech project s csh flows re relize in one yer n there re no subsequent csh flows. Project Bunt will py 80 in the goo stte (probbility 0.3) n 50 in the b stte (probbility 0.7). Project Homerun will py 320 in the goo stte (probbility 0.1) n 0 in the b stte (probbility 0.9). The initil investment must be me toy n ll pyoffs occur one yer from toy. The iscount rte is 6% n ll investors re risk neutrl. The firm will finnce the initil investment with one yer lon. () Clculte the NPV of ech project. Which project is better? (5 mrks) () Suppose tht investors believe tht project Bunt will be tken. It is fully finnce by the lon, clculte the fce vlue of the lon. Clculte the pyoff to the firm's owners uner the lon contrct in if they choose project Bunt. o the sme for Homerun. Which project will they choose? Will the investors belief be s in? iscuss the risk-shifting (sset substitution) problem in the context of the bove clcultion. Wht re potentil solutions to this problem? (5 mrks) Pge 3 of 5

4 7. A shre of MSFT is tring t $30. In 6 months it will either go up by $10 or own by $8. In the following 6 months it will gin either go up by $10 or own by $8. uring this perio MSFT will py no iviens. The 6 month interest rte on Tresuries is 1.5% n will sty tht wy for the full yer. () Vlue Europen put option on MSFT with strike price of $35. Vlue n Americn put option on MSFT with strike price of $35. Comment on the itionl option vlue n Americn option provies. o ll Americn options provie itionl vlue? Briefly iscuss how n why cll option vlue chnges with voltility n time to expirtion. 8. epening on the option of shle gs extrction technology in Poln n Ukrine, worl nturl gs prices will be either high or low in ech of the yers If they re high, prices will be $0.2 per cubic meter in 2013 n grow t 5% ech yer. If they re low, prices will be $0.1 per cubic meter in 2013 n grow t 5% ech yer. The probbility of prices being high is 40%. Toy (2012) you re consiering purchsing license from the ussin government to extrct nturl gs from reserves in Siberi. These reserves cn yiel 10 billion cubic meters per yer for t lest 10 yers, however the license will expire fter The vrible costs (extrction) re $0.08 per cubic meter. In ition to the vrible costs, you nee to instll pipeline to trnsport nturl gs from your plce of extrction to the buyers. This pipeline will cost $3 billion n the instlltion must begin toy (2012) in orer to finish it in time to extrct gs in At the en of 2016 you estimte tht you will be ble to sell this pipeline to the ussin government for $2 billion. The ussin government llows you to use stright line eprecition on this pipeline. The corporte tx rte is 30% n your verge cost of cpitl is 11%. () Wht is the mximum you re willing to py for this license? (10 mrks) Suppose you were ble to convince ussin Minister to sell you the license for $1 million. Wht is this project's I? Suppose you coul wit for yer to see whether Poln n Ukrine re successful in opting shle gs extrction technology. You woul still nee to buy the license toy, but you coul choose to buil or not buil the gs pipeline next yer (2013). If you choose to buil it next yer, you woul only strt extrcting gs the following yer (2014). The cost n resle price of pipeline remins s before. How woul your nswer to () chnge? Pge 4 of 5

5 Blck-Scholes Option Pricing Formul C = S[N( 1 )] - X[N( 2 )]e -rt 1 ( S X ) ln / 1 = + σ σ t 2 n = σ t 2 1 t Cpitl Assets Pricing Moel (CAPM) E [ ] ( ) = + β E( ) i f Moiglini n Miller Proposition I (no tx): V = V i m Proposition II (no tx): ( ) E L e f U = + Proposition I (with corporte tx): VL = VU + Tc Proposition II (with corporte tx): ( )( ) E e = + 1 T c Miller (1977) V L = V U ( 1 T )( 1 T ) c e T EN OF PAPE Pge 5 of 5

This paper is not to be removed from the Examination Halls

This paper is not to be removed from the Examination Halls This pper is not to be remove from the Exmintion Hlls UNIVESITY OF LONON FN3092 ZA (279 0092) BSc egrees n iploms for Grutes in Economics, Mngement, Finnce n the Socil Sciences, the iploms in Economics