Foundations of Finance Exam - University of Manchester

BMAN23000A / BMAN23000B Page 1 of 6 THE UNIVERSITY OF MANCHESTER FOUNDATIONS OF FINAN CE 21 st May 2021 You should already have answered SECTION A (MCQ) on Blackboard Answer ONE question from SECTION B and Answer ONE question from SECTION C As this is an open book , timed exam, you should not directly quote from lecture materials, internet sources or other material. Every answer must be written in your own words to avoid plagiarism. In addition, please note: 1. All textual answers must be typed and not hand -written. 2. Any part of the exam that requires equations, mathematical workings or diagrams may be completed either by: a) Using your software of choice, such as the Equation editor of Word or Powerpoint. OR b) Alternatively, in the form of photographs of your handwritten work . It is your responsibility to ensure that such information is clearly discernible, in English (r the images are of a high quality) , and appropriately integrated into a single final documen t. Where mathematical workings are required, you must provide a textual explanation of each step, indicating what the equations are demonstrating and why they are performing that step. Electronic calculators may be used in accordance with the University regulations © The University of Manchester, 2021. PTO BMAN23000A / BMAN23000B Page 2 of 6 Answer ONE question from SECTION B (35 marks) Question 11 (answer all parts). The prices of a set of zero -coupon government bonds with a face value of £100 and a time -to -maturity of 1, 2, 3, 4 and 5 years are, respectively, £95.24, £91.57, £88.90, £87.14 and £86.26. These bonds can be assumed to be risk -free. You also observe the prices of a set of zero -coupon corporate bonds, just issued by Manchester plc, each of which has a credit rating of BBB. Ea ch bond has a face value of £100. The prices of the bonds with time -to -maturity of 1, 2, 3, 4 and 5 years are, respectively, £88.50, £78.31, £69.31, £61.33 and £54.28 . a) Using the prices of the zero -coupon government bonds, calculate the price of a coupon -bearing government bond with a face value of £10,000, a coupon rate of 5% per annum, and 5 years till maturity. Coupon payments are made at the end of each year only. (5 marks) b) Using the prices of the zero -coupon government bonds, calculate the yield -to - maturity for each of these five maturities. (5 marks) c) Comment on the shape of the yield curve. What does this yield curve i ndicate about the market’s prediction of future economic con ditions? Explain your answer. (4 marks) d) Consider the zero coupon government bond with a maturity of 5 years mentioned at the start of the question. Describe how the Dirty Price of this bond wi ll change through time, until maturity. Assume that its Yield to Maturity stays constant at all times. (3 marks) e) Calculate the default risk premium between the BBB yield curve and the government bond yield curve, for each m aturity from 1 to 5 years. (10 marks) f) What would happen to the prices of the zero coupon corporate bonds issued by Manchester plc, if all the corporate bonds’ credit ratings were downgraded to CCC from BBB? Assume the yield to maturity of all the zero -coupon government bonds remain the same. (3 marks) Question 11 continued overleaf PTO BMAN23000A / BMAN23000B Page 3 of 6 Question 11 continued g) Liverpool plc today issues a coupon bond with a time to maturity of 5 years, a face value of £10,000, and which pays a semi -annual coupon. Its c oupon rate is 6% in annualized terms, and its yield to maturity is 6% in annualized terms. What is its current price? (5 marks) (TOTAL 35 MARKS) Question 12 (answer all parts). As financial adviser, you have access to very detailed forecasts about a number of assets. In particular, as the table below shows, you have predictions about future returns in different possible scenarios for a treasury bill, the market portfolio, a utili ty company (Water&Co), a high -tech company (HP -Technology), and a counter -cyclical company (CounterMarket & Co). Your line -manager asks you to use those forecasts to do some analysis of the performance of those stocks and compute risk and return of two possible portfolios. You assume that the CAPM assumptions hold. Expected Rate of Return Scenario Probability Treasury Bill Market Portfolio Water&Co HP - Technology CounterMarket & Co Recession 30% 2% -6% 4% -15% 13% Near Recession 20% 2% 4% 5% 3% 10% Normal 20% 2% 13% 7% 20% 9% Near Boom 10% 2% 19% 10% 32% -1% Boom 20% 2% 28% 12% 47% -5% a) Calculate expected returns and volatilities of the assets in the table. (4 marks) Question 1 2 continued overleaf PTO BMAN23000A / BMAN23000B Page 4 of 6 Question 1 2 continued b) Please comment on the relation between risk and return of the individual stocks that you calculated in part a). (7 marks) c) Using the results in part a), calculate the beta for the assets in the above table and provide the interpretation of beta for the th ree stocks. (4 marks) d) Indicate which stocks are undervalued and which are overvalued and provide the reason why you reach that conclusion. (7 marks) e) Construct an equally -weighted portfolio composed of HP -Technology and CounterMarket & Co. stocks. Using t he information provided in the above table, calculate the expected return and volatility of this portfolio. Comment on the results and the possible ways to diversify a portfolio. (6 marks) f) Now construct a new portfolio composed of 70% of HP -Technology stoc k and 30% of Market Portfolio. Calculate expected return and volatility of this portfolio. Compare this combination with the portfolio in part e) and explain which one is better . (7 marks) (TOTAL 35 MARKS) PTO for Section C Questions BMAN23000A / BMAN23000B Page 5 of 6 Answer ONE question from SECTION C (35 marks) Question 13 ( answer all parts ) Burberry Group PLC is a British fashion clothing company. It is considering the replacement of one of its existing machines with a new model. The existing machine can be sold now for £10,000. The new machine costs £60,000 and will generate free cash flows of £12,560 p.a. over the next 5 years. The corporate tax rate is 30%. The new machine has average risk. Burberry’s debt -equity ratio is 0.4 and it plans to maintain a constant debt -eq uity ratio. Burberry ’s cost of debt is 6.30% and its cost of equity is 14.25%. a) Compute Burberry’s weighted average cost of capital. (5 marks) b) What is the NPV of the new machine and should Burberry replace the old machine with the new one? (5 marks) c) The average debt -to -value ratio in the fashion clothing industry is 20%. What would Burberry’s cost of equity be if it took on the average amount of debt of its industry at a cost of debt of 5%? Do this calculation assuming the company does not pay taxes. (5 marks) d) Given the capital structure change in question c), Modigliani and Miller would argue that according to their theory, Burberry’s WACC should decline because its cost of equity capital has declined. Discuss. (10 marks) e) How could the capital structure change in question c) be explained based on what we know from the trade -off theory of capital structure? Assume the debt -to -value ratio of 20% is the new optimal capital structure for Burberry. (10 marks) (TOTAL 35 marks) PTO BMAN23000A / BMAN23000B Page 6 of 6 Question 14 ( answer all parts ) a) Explain what a convertible bond is. Describe how a convertible bond is priced on the market before its expiration, also using a graph. (6 marks) b) What is a timing real option? Why should financial managers take such option into account when it is embedded in a project and which decision rule should the manager follow? In the context of the Black -Scholes model, what are the variables that affect the value of a timing real option? (6 marks) c) Briefly describe t he different sources of equity financing for private firms. Which one is preferable? Why? (6 marks) d) Discuss and demonstrate in detail how in a perfect capital market, dividend policy of a firm has no effe ct on its stock price. (17 marks) (TOTAL 35 MARKS) END OF EXAMINATION PAPER