This paper is not to be removed from the Examination Halls UNIVERSITY OF LONDON

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Oliver Morris
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1 ~~FN3092 ZA 0 his pper is not to be remove from the Exmintion Hlls UNIESIY OF LONDON FN3092 ZA BSc egrees n Diploms for Grutes in Economics, Mngement, Finnce n the Socil Sciences, the Diploms in Economics n Socil Sciences n Access oute Corporte Finnce uesy, 4 My 203 : 2.30pm to 5.30pm Cnites shoul nswer FOU of the following EIGH questions: ONE from Section A, ONE from Section B n WO 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. he mke n type of mchine must be clerly stte on the front cover of the nswer book. PLEASE UN OE UL3/0057 Pge of 6

2 SECION A Answer one question n no more thn two further questions from this section.. () Briefly explin the concept of risk shifting n wht implictions it hs for optiml cpitl structure. (9 mrks) Personl txes result in the Moiglini n Miller st proposition being violte. Briefly explin why. Briefly explin the Moiglini n Miller st proposition n iscuss some of the other resons (not incluing () n ) which my cuse it to be violte. 2. () Explin pecking orer theory. Accoring to pecking orer theory, how o b firms ten to finnce investment? How o goo firms ten to finnce investment? (9 mrks) A recent reserch stuy foun tht firms run by CEOs who hve fmily problems (such s seriously sick chil) ten to unerperform. You re wre tht your cousin, who is mrrie to the CEO of NONE LLC, is likely to file for ivorce. As result you expect NONE s stock price to fll n you short it. Which kin of efficiency must be violte for your expecttions to be correct? Explin your resoning. Suppose tht strting next yer you will receive csh flow D, which will grow t rte g per yer. he pproprite iscount rte is r. Derive the Goron Growth Moel for the present vlue of this csh flow. (9 mrks) 3. () How oes the price of Europen put option chnge if the time to mturity rises? If the price of the unerlying rises? If the voltility of the unerlying rises? If the exercise price rises? Explin. (9 mrks) Wht re the ifferences between the NP n I pproches to project evlution? Is one of the pproches superior to the other? Describe the stylize fcts bout ivien pyments which were liste in Linter (958). 4. () How oes the empiricl security mrket line compre to the one preicte by the CAPM? Discuss possible explntions for the ifferences between the empiricl line n the one preicte by theory. (0 mrks) Suppose the CAPM oes not hol, is this evience of the violtion of mrket efficiency? UL3/0057 Pge 2 of 6

3 SECION B Answer one question n no more thn two further questions from this section. 5. For this question ssume tht ebt crries no tx vntge over equity. he verge return on the stock mrket is 8% per yer, n the verge risk free rte is 2% per yer. () Cyberyne Systems is robot mnufcturer. It is n ll equity firm whose historic verge nnul return is 3%. Suppose the CAPM hols, clculte Cyberyne's bet. (5 mrks) Union Aerospce Corportion (UAC) hs M shres of equity outstning with price of $00 per shre n historic nnul return of 5%, it lso hs $50M of long term ebt with n interest rte of 4%. Clculte UAC's weighte verge cost of cpitl. UAC consists of two ivisions. he first ivision mnufctures robots n competes irectly with Cyberyne. It is very similr to Cyberyne in terms of its risk chrcteristics. he nnul free csh flows (FCF) of this ivision re $8M n its expecte growth rte is 6% per yer. UAC hs secon ivision which prouces toy eroplnes n its nnul free csh flows (FCF) re $6M. he expecte growth rte of the toy eroplne ivision is zero. UAC is consiering ivesting n selling off the toy eroplne ivision. Use informtion from (A) n (B) to compute the fir vlue of this ivision n the rte of return on stn lone firm tht prouces toy eroplnes. Hint: Apply the Goron Growth Moel () Suppose UAC ws ble to sell this ivision for the price you compute in, n it then use ll of the procees to repy s much of its outstning ebt s it coul. Wht is the vlue of the remining ebt? Wht is UAC's expecte cost of equity? Briefly explin why the return on equity is ifferent from before. UL3/0057 Pge 3 of 6

4 6. here re two types of firms. Ech firm hs project whose qulity is known by the firm s CEO but not by outsiers (except for in ). ype G re goo, their project is worth $30 million. ype B re b, their project is worth $8 million. It is publiclly known tht goo firms re 40% of the totl popultion of firms, with the reminer being b. hese firms cn lso finnce n itionl project. his new project requires n initil investment of $20 million n next yer will py $24 million with 75% probbility or $8 million with 25% probbility. Assume risk neutrlity n iscount rte of zero. () Wht is the NP of the project? If the mrket oes not know which firm is of which type n therefore vlues ll firms eqully (not incluing the project), wht is firm s mrket vlue? (3 mrks) Suppose the outsie mrket knows ech firm s type. Wht is the pyoff to ech firm s originl owners if they o not invest in this project? Wht is the pyoff to ech firm s originl owners if ech firm finnces the new project with equity? Wht frction of equity must ech type of firm offer to outsiers? Which firms finnce the project n which o not? (5 mrks) Now consier worl of symmetric informtion where the CEO knows her own firm type but the outsie mrket oes not. Suppose outsie investors believe tht ll firms finnce these projects with equity. Wht frction of equity will outsie equity investors sk for? Wht will be the totl vlue of firm G? Wht will be the totl vlue of firm B? () Compute the benefit to the originl shreholers of ech firm from following the strtegy in n compre it to the strtegy of not investing in this project. Wht will ech type o? hus, wht will the mrket believe bout firms who rise equity? (e) If the mrket rects rtionlly to the ssume strtegies in (), wht oes the mrket ssume bout ny firm tht rises equity? Wht frction of equity oes the mrket sk for? Wht is the mrket vlue of ny firm tht rises equity? How oes it compre to the originl stock price in ()? (5 mrks) UL3/0057 Pge 4 of 6

5 7. Hotel Cliforni, lovely plce long the 0 Highwy, lst unerwent n upgre in 969. As result of its ilpite conitions it hs plenty of extr rooms. It is consiering mjor renovtion. he construction costs of the renovtion re estimte to be $ million, pyble t the en of construction. If the construction strts toy, it will lst one yer. During the renovtion, the hotel will be close to guests (however ssume tht ll of the hotel s expenses, such s pying stff, re unchnge ue to long term contrcts). Hotel Cliforni s cpcity is 40 rooms n, on verge, 60% of the rooms re vcnt on ny single y. he ily profit per occupie room is $90. he corporte tx rte is 20%, the pproprite iscount rte is 9%, n renovtion cn be eprecite t 33.3% per yer. () Compute the verge profit per occupie room yer. hen compute the verge profit for the hotel s whole. Assume 365 ys per yer. (4 mrks) Suppose Hotel Cliforni ecies to begin renovtion toy. Assume tht fter renovtion, the vcncy rte will fll to 25%. Suppose tht the hotel will be sol exctly 3 yers fter the renovtion is complete. Ignore the sles price n everything tht hppens fter the sle n compute the NP of renovtion for csh flows from now until the sle (excluing the sle). Do not forget eprecition n corporte txes. Assume tht Hotel Cliforni hs enough txble profit to tke vntge of ny itionl tx breks ue to this construction. Assume no itionl cpitl expenitures re me between the en of renovtion n the sle of the hotel. (4 mrks) Explin how you woul clculte the price t which the hotel is sol n how you woul use this number to ugment the NP clcultion. 8. You currently hve $50,000 in csh. You hve ccess to project which requires n initil investment of $50,000. One yer from now this project will py either $40,000 with probbility 50% or $00,000 with probbility 50%. After this, there re no further csh flows. Assume risk neutrlity n n nnul iscount rte of 0%. his is lso the risk free rte. () Wht is the NP of this project? (4 mrks) () (e) Suppose you ecie to finnce this project with your own csh. How much money o you expect to hve one yer from now? You hve foun investors who will fun the full cost of the project through equity. You will invest your csh t the risk free rte. Wht is the shre of equity they will sk for? How much money o you expect to hve one yer from now? You hve foun investors who will give you lon for the full cost of the project. You will invest your csh t the risk free rte. Assume in cse of efult, these investors cn clim ll of the project s csh flows, but cnnot clim the csh you hve investe outsie of the project. Wht is the fce vlue of the lon n the interest rte? How much money o you expect to hve one yer from now? In light of your numericl nswers bove, iscuss Moiglini n Miller s st proposition. (3 mrks) UL3/0057 Pge 5 of 6

6 UL3/0057 Pge 6 of 6 Blck-Scholes Option Pricing Formul C = S[N( )] - X[N( 2 )]e -rt Cpitl Assets Pricing Moel (CAPM) f m i f i E E Moiglini n Miller Proposition I (no tx): U L Proposition II (no tx): E D e Proposition I (with corporte tx): D c U L Proposition II (with corporte tx): E D c e Miller (977) e c U L D END OF PAPE 2 ln / 2 S X t t n t

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