ECONOMICS OF CORPORATE FINANCE AND FINANCIAL MARKETS. Answer ALL questions in Section A and Section B. Answer TWO questions from Section C.

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1 UNIVERSITY OF EAST ANGLIA School of Economics Main Series UG Examination ECONOMICS OF CORPORATE FINANCE AND FINANCIAL MARKETS ECO-6004Y Time allowed: 3 hours Answer ALL questions in Section A and Section B. Answer TWO questions from Section C. Notes are not permitted in this examination. Do not turn over until you are told to do so by the Invigilator. ECO-6004Y Module Contacts: Dr Alasdair Brown, ECO Copyright of the University of East Anglia Version 1

2 Page 2 SECTION A (Answer ALL questions in this section) 1 Milton Ltd. has excess cash of 10 million, debt with a current market value of 100 million, and 2 million shares outstanding. Analysts forecast that Milton will generate 20 million of free cash flow per year in perpetuity. a) If Milton has a weighted average cost of capital of 10%, estimate its share price. [10 Marks] b) Name a ratio used in financial statement analysis that uses enterprise value as one of its variables. Why do analysts prefer to use the ratio, rather than just enterprise value on its own, when comparing firms in the same industry? [5 Marks] 2 Staples Ltd. is a supplier of office equipment. Staples has a market value of 800 million and an unlevered cost of capital of 12%. Staples' CEO has heard that he can increase the expected return on equity by issuing debt and buying back shares. Staples decides to issue 200 million of debt, using the proceeds to buy back equity. The debt has an expected return of 6%. a) Assuming perfect capital markets, what is the new cost of equity? [8 Marks] b) Is this restructuring good news for equity holders? Justify your answer with reference to Modigliani and Miller Proposition I. c) Describe two departures from the assumption of perfect capital markets that lead to the concept of an optimal capital structure. ECO-6004Y Version 1

3 Page 3 3 Easy Fit has just paid a dividend of 10. Analysts expect the dividend to grow by 10% in year 1; 8% in year 2 and 5% thereafter. a) If Easy Fit's cost of equity is 6% and it has 1 million shares outstanding, what is its share price according to the dividend discount model? [9 Marks] b) What is a better modelling framework for valuing shares? Justify your answer by providing two reasons. SECTION B (Answer ALL questions in this section) 4 Suppose you have 100,000 in cash, and you decide to borrow another 25,000 at a 3% interest rate to invest in the stock market. You invest the entire 125,000 in a portfolio J with a 20% expected return and a 25% volatility. a) What is the expected return and volatility (standard deviation) of your investment? b) What is your realized return if J goes up 40% over the year? [2 Marks] c) What return do you realize if J falls by 10% over the year? [2 Marks] 5 The current price of stock X is 6. In each of the next two years, this stock price can either go up by 2.50 or go down by 2. The stock pays no dividends. The one-year risk-free interest rate is 3% and will remain constant. Using the Binomial Model, calculate the price of a two-year call option on stock X with a strike price of 7. [10 Marks] TURN OVER ECO-6004Y Version 1

4 Page 4 SECTION C (Answer TWO questions in this section) 6 Describe the performance of the Capital Asset Pricing Model (CAPM) as a model of stock returns. 7 Describe the effect of the media on stock prices. 8 What is the equity premium puzzle? 9 Describe the differences and similarities between the binomial and Black-Scholes models of option pricing. END OF PAPER ECO-6004Y Version 1

5 Exam Feedback Module: ECO-6004Y Economics of Corporate Finance and Financial Markets, 2017/18 Structure of the exam: The exam had 5 compulsory technical questions in sections A and B, worth 70 marks. In section C there was a choice of essay questions (2 from 4), worth 15 marks each. Marks distribution: This summary is based on provisional marks. No. of scripts: 207; Mean: 68.48; Median: 71; Standard Deviation: 15.43; Max: 96 Feedback Q.1 This question was on cost of capital and financial statements analysis, and carried 15 marks. Many achieved full marks for this question. The average from a (random) sample of 93 papers was Q.2 This question was on the weighted average cost of capital and Modigliani Miller Proposition I, and carried 20 marks. Performance was more middling for this question, with an average of (based on sample). Marks were often lost for the essay parts (b) and (c). Q.3. This question was on the dividend discount model, and carried 15 marks. Performance was also middling for this question, with an average of 8.52 (based on sample). Q.4. This question was on leveraged portfolio returns, and carried 10 marks. Many students got full marks, and the average for the sample was Q.5. This question was on the binomial model, and carried 10 marks. Some got full marks, but many had forgotten how to solve this model. The sample average was 7.6. Q.6 This question was on the CAPM. This was a popular question, and many answered it comprehensively. Focus needed to be on anomalies (size/value/momentum). Q.7 This question was on the effect of the media on stock prices. This was a slightly left-field question, and only a few that answered it performed well. Q.8 This question was on the equity premium puzzle. This was answered very comprehensively by some students, though others seemed to misunderstand the question (difference in returns between stock and bond portfolios) Q.9 This question was on the binomial and Black-Scholes option models.

6 A popular question, and in general answered well.