Business Management Master 1

STUDENT N°:

20_M1_LI_BM_CCO_FIN_644

CORPORATE FINANCE
CORRECTION

FINAL EXAM – DECEMBER 2019

Professor/Lecturer: Philippe Cogneau – Serge Macé – Pascal Vanwynendaele -

Milos Vulanovic (course coordinator)

DURATION: 2H

INSTRUCTIONS:
DOCUMENT NOT ALLOWED
NON-PROGRAMMABLE CALCULATOR ALLOWED

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Note: The exam has been checked several times so as to avoid any errors or ambiguity. If in doubt, do
not disturb the invigilators. Please wait to see the solution that will be made available on Blackboard
after the exam. If any problem appears, it will be taken into account in the grading process.

Formulas which may be useful or not for this exam:

C 1 
▪ Present value of an ordinary annuity = 1  
r  (1  r )T 

C  (1  g )T 
▪ Present value of an ordinary growing annuity  1  
r  g  (1  r )T 

(1  r )T  1
▪ Future value of an ordinary annuity =C
r

PART 1: MULTIPLE CHOICES QUESTIONS (2 points)

Circle the correct answer. 1 answer only is correct for each question. Good answer = 0.5 point ; bad
answer = -0.25 ; no answer = 0 point.

1) Each of two stocks A and B are expected to pay a dividend of 3€ in the upcoming year. The expected
growth rate of dividends is 5% for both stocks. You require a rate of return of 10% on stock A and a
return of 17% on stock B. The estimated value for stock A ...
a. will be greater than the estimated value of stock B.
b. will be the same as the estimated value of stock B
c. will be less than the estimated value of stock B
d. cannot be calculated without knowing the market rate of return

2) Considering an increase in the discount rate, which one of the following statements is false:
a. It reduces the present value of future cash flows.
b. It reduces the profitability index.
c. It increases the internal rate of return.
d. It increases the discounted payback period.

3) According to the Capital Asset Pricing Model (CAPM), which one of the following statements is false:
a. The expected rate of return on a security decreases in direct proportion to a decrease in
the risk-free rate
b. The expected rate of return on a security increases as its beta increases.
c. At the equilibrium, all securities lie on the security market line.
d. The higher the beta of a security, the greater the unavoidable risk of that security

4) Modigliani and Miller's Proposition I states that:

a. the market value of any firm is dependent of its capital structure
b. the market value of a firm's debt is independent of its capital structure
c. the market value of a firm's common stock is independent of its capital structure
d. none of the above options

PART II: EXERCISES (18 points)

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Note: Always give the details of your answers and computations in the dedicated space. Answers with
no proper explanations or computations will not be taken into account.

1) A company plans to acquire a first machine and to use it over the next 12 years. You are given the
following information:

- Initial payment: €50,000 to be paid now

- Maintenance costs of €5,000 in exactly 4 years, 8 years and 12 years.
- The machine will be sold for €10,000 in exactly 12 years.

In 12 years, the company will have to purchase a new machine at the same price, bear the same costs
and timing of maintenance and will be able to sell it at the same price (€10,000) 12 years later (that is
in 24 years). The company uses a 7% annual discount rate. What is the equivalent annual cost of a
machine over a 24-year period? (2 points)

Your answer: __________________ 6,862.22

Calculation details:
The PV of the total net costs of the first machine is given by:

5, 000 5, 000 5, 000 10, 000

50, 000      54,504.46
1.07 4 1.078 1.0712 1.0712

The equivalent annual cost of the first machine (EAC) satisfies:

EAC EAC EAC EAC  1 

€54, 504.46    ..   1
1.07 1.07 2
1.0712 
0.07  1.0712 

€54, 504.46  0.07

EAC   6, 862.22
1
1
1.0712

The equivalent annual cost of the second machine being the same, the equivalent annual cost of a
machine over a 24-year period is unchanged.

2) What is the present value of the following stream of cash-flows:

€5,000 every year over the next 10 years (first payment in one year)
+ €10,000 every year over the following 10 years

The annual interest rate remains at 3% over the next 5 years and will be equal to 7% in the following
next 15 years. (3 points)

To reduce your calculations, you can pick the relevant values in the following table:

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 Your answer: __________________ €83,779.88

Calculation details:

5, 000 5, 000 5, 000

PV   2
 ... 
1.03 1.03 1.035
1  5, 000 5, 000 5, 000 
 5 
  ...  
1.03  1.07 1.07 2
1.075 
1  10, 000 10, 000 10, 000 
 5 
  ...  
1.03 1.07  1.07
5
1.07 2
1.0710 

5, 000  1  1 5, 000  1  1 10, 000  1 

PV  1  5 
 1  5 
 1  
0.03  1.03  1.03 0.07  1.07  1.03 1.07 0.07  1.0710 
5 5 5

22,898.54 20,500.99 70,235.82

 22,898.54  17,684.33  43,197  83,779.88

3) A project has an Internal rate of Return of 12%. The initial investment is €12,450.5 and made now.
The cash flows are the following:

Year 1 = €5,000
Year 2 = €6,000
Year 3 = unknown

a) What is the cash-flow of year 3? (1 point)

Your answer: C3 = 4,500

5, 000 6, 000 C
12, 450.5   2
 33 0  C3  4,500
1.12 1.12 1.12
NPV

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b) Is it possible to determine the profitability index? (1 point)

Your answer:

● Yes and the profitability index is ________________

● No, because we do not know the discount rate

Details:
NPV
To compute the Profitability index equal to  1  , we need the discount rate. But we just
C0
have the internal rate of return.

4) You build a portfolio with 3 assets 1, 2 and 3. You have the following information:

Asset 1 risk-free and offers a 5% interest rate.

Expected return standard deviation

Asset 2 10% 0.3
Asset 3 8% 0.5

You want to put 20% of your money in asset 1 and the remaining in asset 2 and 3 to target an expected
return of 8.4%. What is the standard deviation of your portfolio P given that the correlation coefficient
between the returns of asset 2 and 3 is 0.6?

Your answer : Standard deviation = 26.83%

Details: The weights of your portfolio must satisfy:

0.2(5%)  w2 (10%)  (1  w2  0.2)(8%)  8.4%

1%  w2 (10%)  8%  w2 (8%) 1.6%  8.4%
1%
w2   0.5
2%
And so w3  1  0.5  0.2  0.3

Because asset 1 is riskless, we have 1  0 and the variance of the portfolio is given by:

 P 2  w2 2 2 2  w32 32  2w2 w3 23   2 . 3

 23

 P  0.5 0.3  0.3 0.5  2  0.5  0.3  0.6  0.3  0.5  0.072
2 2 2 2 2

 23

 P  0.043228  26.83%

5) Consider a simplified case in which a stock A offers 50% chance of get a 0% return and 50% chance
to get a 8% return. Stock B has exactly the same characteristics. Suppose that the covariance between

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the returns of both stocks is -0.0016. Build a portfolio which minimizes risk. What is this level of risks?
(3 points)

Your answer: wA  0.5 (1 point) wB  0.5 (1 point) P  0

Details:
 A   B  0.5(0  4%)2  0.5(8%  4%)2  0.0016  4%
 AB 0.0016
 AB    1
 B   B 0.04  0.04

Because there is a perfect negative linear correlation between both return, it is possible to build a
riskless portfolio. The general expression of the risk of the portfolio with  AB  1 is given by :

 P 2  wA2 0.042  wB 2 0.042  2  wA  wB  0.04  0.04   wA 0.04  wB 0.04 = 0

2

To obtain a riskless portfolio, we just have to take wA  wB  0.5

6) Consider the following variance covariance matrix of returns about the risky assets 1 and 2 and the
market portfolio M

1 2 market
1 0.25 0.05 0.18
2 0.05 0.16 0.07
market 0.18 0.07 0.15

What is the proportion of diversifiable risk in asset 1? (2 points)

Your answer: 36.88%

Details:
0.18
1   1.2
0.15

If we decompose the variance of the return of asset 1, we have:

0.25  1.22  0.15  Var ( i )  Var ( i )  0.034

0.216 unsystematic risk unsystematic risk

 0.034
i
  36.88%
 i
0.25

7) Your firm has a debt-equity ratio of .60. Your cost of equity is 11% and your after-tax cost of debt is
7%.
a) What will your cost of equity be if the target capital structure becomes a 50/50 mix of debt and
equity assuming that the risk on debt is unchanged? (1 point)

Your answer : cost of equity = 12%

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Details:
D DE E 1
 0.6   1.6    0.625
E E E  D 1.6

WACC  0.625(11%)  0.375(7%)  9.5%

The WACC being constant, the change in the capital structure implies that rE satistfies

0.5(rE )  0.5(7%)  9.5%

6%
 rE   12%
0.5

b) If we consider a change in the risk of debt, does the previous answer over-estimate or under-
estimate the true cost of equity? (1 point)

● It overestimates it ● It underestimates it

Brief explanation in one sentence: If there is a change in the risk of debt following the increase in the
D/E ratio (from 0.6 to 1), this change will be positive. As a result, rD would go up, and rE would be
lower than 12%. As a result, the previous answer would overestimate the true cost of equity.

8) An investment is available that pays a tax-free 7%. The corporate tax rate is 40%. Ignoring risk,
what is the pre-tax return on taxable bonds? (1 point)

Your answer: 16.67%

Details
7%
rb (1  t )  7% and so rb   11.67%
1  0.4

9) EDHEC Company has a cost of equity of 11.9 percent and a pre-tax cost of debt of 9 percent. The
weighted average cost of capital is 11 percent. What is the firm's debt-equity ratio based on Modigliani-
Miller second proposition in the absence of taxes? (1 point)

Your answer: Debt-Equity ratio = 0.45

Details: The debt-equity ratio D/E satisfies:

D D
0.119  0.11  (0.11  0.09)   0.45
E E

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