This paper is not to be removed from the Examination Halls

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Donna Whitehead
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1 This pper is not to be remove from the Exmintion Hlls UNIVESITY OF LONON FN3092 ZA ( ) 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. () The Moiglini n Miller proposition sttes tht in the bsence of txes n other frictions cpitl structure is irrelevnt. Explin. Consier tx coe where corporte profits re txe but interest is tx euctble. Explin how this chnges the Moiglini n Miller proposition. How woul you expect firms to rect if the tx coe suenly chnge from not llowing interest to be euctble to llowing interest to be euctble? In the presence of personl txes tht re ifferent for equity n ebt income the conclusion you reche in my look ifferent. Explin. 2. () Explin the ifferent forms of mrket efficiency n how they relte to one nother. Suppose you fin tht stock returns for ll firms whose nme strts with A re positively correlte t 5 minute frequency. Explin wht forms of efficiency this violtes. Suppose you observe tht toy s price-to-ivien rtio forecsts future stock returns, is this necessrily violtion of the Efficient Mrket Hypothesis? Explin. Briefly review evience on the forecstbility of stock returns. 3. () 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? Grossmn n Hrt (1980) suggeste ilution mechnism to get roun the free-rier problem. Explin how ilution mechnism my work. Suppose some number of shres cn be ccumulte in secret. Explin why this my prtilly resolve the free-rier problem. 4. () Suppose you selecte 10 firms who receive very negtive ernings shock n nother 10 who receive smll negtive ernings shock. Bse on Linter (1958) wht o you think will hppen to these firms ivien pyments? Explin the tx clientele theory for the existence of iviens. Explin how n why ebt my be use s signl to investors s in oss (1977). 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. A shre of IBM is tring t $200. In 6 months it will either go up by $50 or own by $50. In the following 6 months it will gin either go up by $50 or own by $50. uring this perio IBM will py no iviens. The 6 month interest rte on Tresuries is 1% n will sty tht wy for the full yer. () Vlue Europen put option on IBM with strike price of $225. Vlue n Americn put option on IBM with strike price of $225. 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. 6. The risk free rte is 2%, the expecte stock mrket return is 9%, n the stnr evition of the stock mrket return is 15%. All firms consiere in this question re 100% equity owne. () () Firm Scottyog hs mrket cpitliztion of $100 million n n expecte stock return of 15%. Clculte its bet if the CAPM hols for this firm. (6 mrks) Firm Highlner hs mrket cpitliztion of $50 million. Using historicl t over the pst 10 yers, you fin tht its return covrince with tht of the mrket ws n its verge historicl return ws 5%. Hs Highlner outperforme the CAPM over this perio? Wht is its lph? (6 mrks) Firm Helix opertes in the sme inustry s firm Scottyog n its prouctive ssets hve similr risk to firm Scottyog. However, in ition to these ssets, Helix hols $50 million in risk free U.S. tresuries (essentilly csh). Helix's mrket cp is $300 million. Wht is Helix's bet? Helix uses its csh to purchse Highlner. Assume Highlner is bought for its mrket price n Helix oes not py tkeover premium. Wht is the bet of the conglomerte Helix Highlner? Wht is the vlue of the conglomerte Helix Highlner? Compre the risk of Helix n Helix Highlner n explin ny ifferences. (6 mrks) Pge 3 of 5

4 7. epening on the outcome of the US nucler ispute with Irn, worl oil prices will be either high or low in ech of the yers If they re high, prices will be $150/brrel in 2013 n grow t 5% ech yer. If they re low, prices will be $50/brrel in 2013 n grow t 5% ech yer. The probbility of oil prices being high is 30%. Toy (2012) you re consiering purchsing license from the US government to extrct oil from reserves in the Gulf of Mexico. These reserves cn yiel 6 million brrels per yer for t lest 10 yers, however the license will expire fter The vrible costs (extrction n trnsporttion) re $30/brrel. In ition to the vrible costs, you nee to purchse 10 oil rigs t cost of $100 million per oil rig. These must be purchse in 2012 in orer to instll them in time to extrct in At the en of 2016 you estimte tht you will be ble to sell the use oil rigs for $60 million per oil rig. The US government llows you to use stright line eprecition on this equipment. The corporte tx rte is 35% n your verge cost of cpitl is 10%. () Wht is the mximum you re willing to py for this license? (10 mrks) Suppose you were ble to negotite iscount n the license only cost you $1 million. Wht is this project's I? Suppose you coul wit for yer to see how the US versus Irn conflict gets resolve. You woul still nee to buy the license toy, but you coul choose to buy or not buy the oil rigs next yer (2013). If you choose to buy them next yer, you woul only strt extrcting oil the following yer (2014). The purchse n resle prices of the oil rigs remin s before. How woul your nswer to () chnge? 8. Chrger 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 Thunerbolt will py 100 in the goo stte (probbility 0.5) n 40 in the b stte (probbility 0.5). Project Lightning will py 150 in the goo stte (probbility 0.4) n 0 in the b stte (probbility 0.6) The initil investment must be me toy n ll pyoffs occur one yer from toy. The iscount rte is 5% 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 Thunerbolt 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 Thunerbolt. o the sme for Lightning. 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 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 ZB (279 0092) BSc egrees n iploms for Grutes in Economics, Mngement, Finnce n the Socil Sciences, the iploms in Economics