This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON 279 0092 ZA

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route for
External Students

Corporate Finance

Wednesday, 11 May 2011 : 10.00am to 1.00pm

Candidates should answer FOUR of the following EIGHT questions: ONE from Section A,
ONE from Section B and TWO further questions from either section. All questions carry
equal marks.

A list of formulas and extracts from Present Value and Annuity Discount tables, are given at
the end of the paper.

A calculator may be used when answering questions on this paper and it must comply in all
respects with the specification given with your Admission Notice. The make and type of
machine must be clearly stated on the front cover of the answer book.

© University of London 2011

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SECTION A

Answer one question from this section and not more than a further two questions. (You are reminded
that four questions in total are to be attempted with at least one from Section B.)

1 (a) Derive the risk of a N-asset portfolio in terms of the average variance of the N assets and
the average covariance across all assets. Discuss the implication(s) of the number of assets
(N) in portfolio management and diversification of risk. (10 marks)

(b) Critically assess the validity of the Capital Asset Pricing Model in light of Roll’s critique
and other anomalies. (15 marks)

2 (a) Explain clearly why it is impossible to successfully takeover a company according to

Grossman and Hart (1980). (10 marks)

(b) Outline the arguments for the agency cost of debt. Explain how the use of convertible
bonds might mitigate the agency conflict between equity-holders and debt-holders in
financially distressed firms with high debt to equity ratios. (15 marks)

3 (a) Explain clearly the 3 main conditions for debt to act effectively as a signal of a firm’s
value. (9 marks)

(b) Critically assess the empirical evidence for the semi-strong form of market efficiency.
(10 marks)

(c) Explain why Net Present Value is a better investment appraisal technique than Internal
Rate of Return. (6 marks)

4 (a) Explain, with the aid of a diagram, why a firm’s dividend policy is independent from its
investment policy in a perfect and complete market. You should include a discussion of
Fisher’s Separation Theorem in your answer. (10 marks)

(b) Using the arguments for the signalling and tax clientele effects of dividends, to what extent
would you conclude that dividend policy is relevant to corporate value? (15 marks)

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SECTION B

Answer one question from this section and not more than a further two questions. (You are reminded
that four questions in total are to be attempted with at least one from Section A.)

5. (a) Tiger plc has the following projects:

Projects Initial Investment, £ NPV (after tax), £

A 100,000 10,000
B 150,000 25,000
C 75,000 5,000
D 50,000 6,000

The company has only £250,000 available at year 0. There is no other investment
opportunity for the firm with any spare cash which is not invested in the above 4 projects.

i. Assume that all projects above are infinitely divisible. Explain, with supporting
calculations, which projects the company should choose to maximise its value? What
is the optimal NPV of the investment plan? (3 marks)

ii. Would your advice to the management be different if these projects are not infinitely
divisible? What would be the NPV of the revised investment plan? (2 marks)

(b) CM Ltd has been presented with the following project:

A new machine for £100,000 is required at the beginning of the first year. The machine
will last for 4 years and thereafter can be disposed of for £20,000. The company’s policy
is to depreciate this type of machine over its economic life on a straight-line basis.

The demand for the product CF depends on the states of the economy in the future. In the
good state, CM Ltd expects to sell 12,000 units per year for the next 4 years. If the
economy is bad, sales will fall to 8,000 units per year. Each state of the economy has an
equal probability to materialise.

Each unit of product CF will be priced at £30. Total variable costs per unit are expected to
be £25 for the first year and rise by 10% per year thereafter.

The cost of capital (after tax) is 10%. For the purposes of tax, the machine is available for
capital allowance relief at 25% per annum on the written down value at the beginning of
each year. Any unrelieved capital allowance will be given at the end of the project’s life.
Corporate tax at 30% of the taxable profit after capital allowances is payable in the same
year as the profit to which the tax is related.

The net cash flows (before tax) for the project are assumed to be the taxable profit before
capital allowances. All cash flows are assumed to arise at the end of the year except the
purchase of the new machine.

Question continues on following page.

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 Required

i. Calculate the Net Present Value of the project. (12 marks)

ii. Suppose the state of the economy will be known for sure in one year’s time. Advise
CM Ltd whether the production of CF should be deferred by a year. Assume that the
first year cash flow will be lost but the state of the economy will remain the same
once it has materialised. (8 marks)

6. (a) The last 5 years returns on Vjay plc and on the broad market index are as follows:

Year Vjay, % Market, %

2010 -2 -5
2009 0 -2
2008 10 7
2007 13 10
2006 14 15

If the risk free rate is expected to be 3% per annum in the foreseeable future, estimate
Vjay’s beta using the covariance method and its expected return according to the Capital
Asset Pricing Model (CAPM). (10 marks)

(b) Suppose the returns on Stocks x, y and z are determined by the following two-factor
model:
rx  0.2  2 F1  F2  5%
ry  0.16  4 F1  2 F2  7%
rz  0.1  1F1  F2  9%

i. Determine the portfolio weights you need to place on x, y and z in order to replicate
the portfolio returns on F1 and F2 respectively. (10 marks)

ii. The return on Stock M is known to follow the factor model below

rm  0.5  F1  1.5F2

It is currently traded with a return of 10%. Explain if any arbitrage opportunity arises
in this case. (5 marks)

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7. Blue Shark plc, a quoted company in the UK, is considering a takeover of Black Seal Ltd. Both
companies are 100% equity financed. The following information is available for these two
companies:

Blue Shark Black Seal

Number of shares 10,000,000 1,000,000
Share price £10 Not available
Dividend per share (latest) £1 £0.8

You discover the following additional information:

(1) Black Seal Ltd. has been paying a constant dividend for the last 5 years to its shareholders.

(2) The Directors of Black Seal have been using a discount rate of 15% to appraise its
projects.

(3) It is believed that if the takeover is successful, Black Seal’s dividend per share will grow at
10% per year.

Required
(a) What is the value of Black Seal Ltd. before it is taken over? (2 marks)

(b) What is the value of Black Seal Ltd. under the management of Blue Shark after it is taken
over? (3 marks)

(c) Suppose Blue Shark has the following options to finance the takeover:

i. Pays £15,000,000 to acquire 100% of Black Seal’s shares; or

ii. Issues 1,000,000 new shares to Black Seal’s shareholders in exchange for the control
of the company.

Calculate the gain, net gain, cost and net cost of acquisition in each case. Discuss the
advantages and disadvantages of each option to Blue Shark and Black Seal.
(20 marks)

8. (a) Mojito plc’s share price, S, can either go up to SH or down to SL in the next period. Derive
the price of a call option written on S in terms of a position in the stock and a risk free
asset. (7 marks)
(b) Mojito plc’s shares are currently traded at £10 each. Its share price is expected to go up to
£13 or down to £8 in three months’ time. The effective interest rate for the next three
months is 2%. What is the price of a call option on Mojito’s share with an exercise price of
£10? (5 marks)
(c) Explain clearly why the price of a call option does not depend on the investor’s risk
preference and the probabilities of the future states of the economy. Determine the risk
neutral probabilities of the two states of the economy in (b). (13 marks)

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Black-Scholes’ Option Pricing Formula

C = S[N(d1)] - X[N(d2)]e-rt

ln  S / X   1
d1  t
 t 2
and
d 2  d1   t

Capital Assets Pricing Model (CAPM)


E Ri   R f   i E Rm   R f 
Modigliani and Miller

Proposition I (no tax): VL  VU

Proposition II (no tax): Re  Ra  Ra  Rd 

D
E

Proposition I (with corporate tax): VL  VU  Tc D

Proposition II (with corporate tax): Re  Ra  Ra  Rd 1  Tc 

D
E

Miller (1977)

 1  Tc 1  Te 
VL  VU  1  D
 1  Td 

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Table 1: Present value of £1 to be invested at the end of the nth periods
Interest Rate
Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386

Periods 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162

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Table 2: Annuity of £1 to be received for n periods
Interest Rate
Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145

Periods 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192

END OF PAPER

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