THELONDON SCHOOL

OFECONOMICS AND
POLITICAL SCIENCE ■

Mock Exam 1

FM2.13
Principles of Finance

Suitable for all candidates

Instructions to candidates
This paper contains four questions: two in Section A and two in Section 8. Answer all questions from
Section A and all questions from Section B. All questions will be given equal weight (25%).

Time Allowed Reading Time: None

Writing Time: 3 hours

You are supplied with: No additional materials

You may also use: No additional materials

Calculators: Calculators are allowed in this examination

© LSE ST 2019/FM213 Page 1

 Section A: Answer two questions from this section and another two from Section B

Question 1

Give all answers to 1 decimal place.

a) Bond A is a 6-year bond with face value $100 and is selling at a price of $95. Its yield to maturity is
5%. What is its coupon rate? Assume that coupons are paid annually. (5 marks).
b) Bond B also pays annual coupons. It has two years to maturity, a coupon rate of 8% and a face
value of $100. If the one-year spot rate is 2.6% and the bond's yield to maturity Is 6.1%, what is the
two-year spot rate? (5 marks)
c) Using the data from part (b), compute the forward rate of interest for the period beginning one year
from today and ending two years from todc;1y. Give a brief Interpretation of your result. (3 marks)
d) Bonds C and D both pay annual coupons, both have face values of £100 and both have two years to
maturity. Bond C has a coupon rate of 5% and bond D a coupon rate of 2%. Bond C's price is
£ 101.93 and bond D's price is £96.25. Use absence of arbitrage to infer the price of a zero coupon
bond with 1 year to maturity and face value £ 100. (5 marks)
e) A bond's duration can be used to infer how the bond's price will react to a change in yield to maturity.
Give a brief overview of how the duration measure is derived and thus why it is informative about the
relationship between prices and yields. What are its shortcomings as a measure of the sensitivity of
prices to yields? (7 marks)

Question 2

a) A portfolio manager has been able to beat the market over the last 5 years (i.e. her portfolio has a
mean return over the last 5 years that exceeds the market's mean return over the same period).
Does this provide evidence against the efficient markets hypothesis? Discuss. (5 marks)
b) Today, the 2-year spot interest rate in the UK is 0.1%. The 2-year spot interest rate in the US is
1.16%. The spot FX market tells me that £1 is worth exactly $1'.25 today. If the market two-year
forward exchange rate of Sterling for US Dollars is $1.29 per £1, demonstrate whether an arbitrage
is available and, if so, demonstrate how to exploit it. (5 marks)
c) Prove that the premium on a European put option must always be below the present value of its
exercise price. Demonstrate that if this condition does not hold, an arbitrage profit is possible. (5
marks)
d) Today, you have taken out a 10-year loan to buy a car. The car cost $25,000 and you paid this
amount today with the proceeds of your loan. Loan repayments are made on a quarterly basis and
the stated annual interest-rate, with quarterly compounding, is 8%. After 5 years have elapsed, how
much of the loan amount remains outstanding, assuming no changes to interest rates in the
economy? (5 marks)
e) Two companies, X and Y, are entirely financed by equity and analysts expect that neither of them
wilf experience any growth in dividends. The ratio of X's most recent dividend to its ex-dividend price
is two and a half times the value of the same ratio for Y. If X's required rate of return is 10%,
estimate Y's. If the risk-free interest rate is 1 %, estimate the ratio of the beta of X to that of Y? (5
marks)

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Section B: Answer two questions from this section and another two from Section A

1) Mergers, Acquisitions, and Capital Structure

Suppose company Alpha is considering a takeover of company Beta that is deeply burdened with debt
and is on the verge of bankruptcy. Alpha generates perpetual free cash flow of £1OM per year and the
required return on equity is 5%. In addition to the free Cf1Sh flow, Alpha has £50M cash inside the
company. Alpha is all equity financed, with 1 OM shares. Beta t:tas 90% market leverage ratio and 1M
shares currently traded at £15 per share. The takeover will improve the value of Beta's assets by 10%.
Assume that shareholders of Alpha and Beta will equally share the ·gain in this takeover.

a. What is the market value of Beta's assets without a takeover? What is the price that Alpha pays
for Beta's total equity? (6 marks)

b. Suppose Alpha uses cash in the corporate account to take over Beta's existing shares. How much
should Alpha pay for each share of Beta? What is the capital structure (debt equity composition) of
the merged company? What is the share price of the post-takeover Alpha? (6 marks)

c. Suppose Alpha issues equity to compensate. Beta's shareholders. How many shares of Alpha per
one share of Beta should be issued to Beta's shareholders? (Hint: the shares that Beta's
shareholders receive are equity claims on the merged company.) What is the ownership structure
and capital structure of the merged company? (Hint: ownership structure means percentage
ownership of the merged company by Alpha's and Beta's original shareholders respectively) (8
marks)

d. Calculate the leverage ratios in b. and c. Explain why they are the same or different? Can you say
something about how payment methods in takeover affect the size of the merged company? (5
marks)

2) Payout Policy

Suppose company XYZ's free cash flows grow at 5% per year. This growth is not affected by the firm's
payout policy. The first free cash flow per share in the next year (year 1) will be $3. The discount rate is
15%. XYZ is considering two potential payout policies.

Policy A: Pay out all free cash flows as dividend. The first dividend will be paid in year 1. Questions a.
and b. are based on policy A.

a. Recall that share price is the discounted value of all future dividends. What is the· share price
today? (2 marks)
b. What will the cum-dividend and ex-dividend price be in year 1 and year 2? (6 marks)

Policy B: XYZ uses year 1 free cash flow to repurchase shares. After the repurchase, the firm will pay out
all future free cash flows as dividends starting from year 2. Questions c. and d. are based on policy B.

c. What fraction of total shares can be repurchased in year 1? What is the dividend per share in year
2 and year 3? (8 marks)
d. Based on c., what is the ex-dividend price and cum-dividend price in year 2? (4 marks)

e. Compared your answers in b. and d., does your result confirm or contradict Miller-Modigliani
dividend policy irrelevance theorem? Why? (5 marks)

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