333-201 Business Finance

Suggested Answers to Sample Final Exam 1

Section A
A1.

False. The CML can only be used to price efficient portfolios, that is, portfolios
perfectly positively correlated with the market portfolio. The SML can be used to
price individual assets or portfolios based on their level of systematic risk.

A2.

True. Calls Max[ST X, 0], Puts Max[X ST, 0]

A3.

False. Arbitragers identify mispricing and obtain risk free profits, or speculators take
a position in the market and profit is the market moves in accordance with their
expectations.

A4.

False. The market value of a company is defined as the market value of debt plus the
market value of equity. i.e. V = DMV + EMV

A5.

True. The value of a company is independent of its capital structure. A company can
be viewed as a collection of assets that generate cash flow, and its value does remains
the same regardless of how these cash flows are divided between different classes of
investors.

A6.

True. It is always possible for some investors/traders to beat the market some of the
time. In an efficient market, it should not be possible for them to beat the market
consistently over time after transactions (and other) costs.

A7.

False. Under a pure residual dividend policy, dividends are paid from profits that
cannot be profitably invested.

A8.

True. Method is biased in favour of projects that recover initial cash outlays quickly.

A9.

False. Short refer to short dated of long dated. Else short hedge means selling
and long hedge refers to a buying hedge.

A10.

False. The APT does not say anything about which factors are priced in the market.
Empirical research has found four main factors, and the market portfolio is not one of
them.

e)

(iii)

IRR gives a consistent 18.2%, A exceeds both B and C. Conflict with

NPV is due to 9% and 11% falling on different sides of the Fisher
point of intersection (the cross over point)

(i)

A:3 years, 270 + 20 / 70 = 3.29

B: 4 years, 220 +70 / 80 = 4.88
C: 4 years, 440 + 110 / 160 = 4.88

(ii)

B3.

a)

Pay back period is an alternative project selection criteria. It is not a

measure of project profitability. If short pay back period assets were
more profitable, then current assets would be the higher yielding
assets. Merely recovering the initial outlay, yields no profit at all. This
highlights a major weakness with the payback methodology, in that it
ignores the timing and magnitude of cash flows.

Debt
k d = 13%
MVd =
#=

11
111
+
= 9.7345 + 86.9293 = $96.6638
1.13 (1.13)2

3,000,000
= 30,000
100

Preference

Int = $2 7% = 0.14
MV = $1.50
$1.50 =

0.14
kp

0.14
= 0.0933 = 9.33%
1.50
1,000,000
#=
= 500,000
2

kp =

Ordinary shares
MV = $2.10
ke = 8 + 1.2(18 8) = 20%

D
P
E

WACC
$96.6638 x 30,000
$1.50 x 500,000
$2.10 x 4,000,000

(b)

2,899,914
750,000
8,400,000
12,049,914

0.2407
0.0622
0.6971
1.0000

0.130
0.093
0.200

0.0313
0.0058
0.1394
0.1765

See class notes.

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Section C
C1.

a)

i)

Company has a given investment plan - not affected by changes in

dividend policy. Removes the capital budgeting decision from the
question at hand.
Perfectly competitive capital market - no transaction costs, flotation
costs or information costs. Enables payment of dividend, raising of
new funds without costs, and removes the information content of
dividends.
No taxes - investors are indifferent between receiving dividends and
capital gains. Importance is obvious from second part of statement.

ii)

Dividend policy is a trade off between:

C2.

retaining profits, and

paying a dividend and making a new share issue to replace the
cash paid out.

b)

One reason for the relevance of dividends is that certain shareholders may
require their shares to provide current income. A retired person may require
dividend income to support their consumption pattern. But MM argue that an
investor requiring income could simply sell their shares. In other words,
investors can create home made dividends by selling their shares. Yes, MM
are correct, but any investors following this policy would incur stamp duty and
brokerage costs. They may also incur capital gains tax, plus there is a gradual
erosion of voting power as the portfolio is liquidated.

a)

The time line is as follows:

Hedging period

11

14

Borrowing period

Step 1: Enter the futures market at t0 and sell 90 BAB futures contracts (to the
face value of $1,000,000) expiring at t5, t8, and t11. This assumes that these
dates are actual expiry dates. Else select the nearest futures expiry date after
these times.
Step 2: At t5 Physical - draw down bills in spot market, receive discounted
proceeds. Enter futures market and buy BAB90 futures expiring at t5. If this is
an expiry date, then spot and futures should converge, else we are faced with
basis risk
Step 3: At t8 Physical - draw down bills in spot market, use funds to repay
retired bill from t5. Enter futures market and buy BAB90 futures expiring at t8.
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