me LONDON SCHOOL oF ECONOMICS an POLITICAL SCIENCE m ‘Summer 2016 examination FM212/FM492 Principles of Finance Suitable for all candidates Instructions to candidates This paper contains six questions: three in Section A and three in Section B. ‘Answer two questions from Section A and two 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: Hand Calculators are allowed in this examination © LSE ST 2016/FM212/FM492 Page 1 of 5Section A: Answer two questions from this section and another two from Section B 1 a. Consider two firms with identical required returns of 10%. Firm A has expected earnings of £5 per share over the next year and for every subsequent year and commits to paying out all of those earnings as dividends. Firm B has identical expected earings to firm A in the next financial year but commits to a policy whereby it always ploughs back 10% of earnings into investment projects. The remaining earnings are paid out as dividends. Its return on equity is 20% i. Compute the market values of the two firms and the implied present value of growth opportunities for firm B. (4 marks) ji. Explain the source of the difference in the values of the two firms with reference to the underlying data. (2 marks) b. An investor has access to a set of N securities (where N is large). Each of them has an annual retum variance of 0.25 and the correlation between every pair of the N assets is 0.5. The investor wants to build an equally weighted portfolio of a subset of these N assets that has a return variance of 0.18 or smaller. What is the smallest number of assets that his portfolio should contain? (6 marks) ©. Consider a 3-year government bond with an annual coupon rate of 5%. Assume that the yield to maturity on this bond is 3%. Also assume that coupons are paid annually. Compute and interpret the price of the bond and the duration of the bond. (4 marks) 4. The current set of spot interest rates with one, two, three and four years to maturity are 4%, 6%, 7% and 7.5% respectively. From these data, estimate what the one, two and three year spot rates will be in one year’s time. (5 marks) . “The efficient markets hypothesis implies that the expected future return on any portfolio of assets must be zero, otherwise every investor would end up buying portfolios with positive expected returns and selling those with negative expected returns.” Is this statement true or false? Justify your response. (4 marks) 2) a. A particular economy contains only two risky assets, X and Y, plus a risk-free asset. Asset prices in this economy satisfy the CAPM. Data on the two assets are given below. The correlation between retums on the two assets is exactly one third ee ee ee x 50 20 o2t o.1s y 80 250.15 ___0.09 i, Compute the market portfolio weights, the expected return on the market and the standard deviation of the market return. (5 marks) ji. Compute the beta on both assets, Comment on their absolute and relative magnitudes. (5 marks) iii, Calculate the risk-free rate in this economy. (2 marks) iv. Compute Sharpe ratios for X and Y and for the market portfolio. Comment on their relative magnitudes and, in particular, on the size of the market Sharpe ratio relative to those on X and Y. (3 marks) © LSE ST 2016/FM212/F M492 Page 2 of 5b. Briefly describe how one would test whether the CAPM is empirically valid. Proceed to discuss the evidence on the CAPM's validity and to suggest alternative asset pricing models that fit the data better. (10 marks) 3) Derivatives a. Consider a forward contract written on @ physical commodity. Define the notion of net convenience yield in this context and describe the factors that contribute to this net convenience yield. (3 marks) b. Starting from an equation that links spot and forward prices under the assumption of zero net convenience yields, show and explain how the introduction of a net convenience yield affects the relationship between spot and forward prices. In particular how does the forward price minus the spot price change as you vary the net convenience yield? (3 marks) ©. Consider a European call option, with price ¢, and a European put option, priced at p, with the same strike prices (X) and written on the same underlying stock. The current stock price is S. Both options have one period to expiry. If the one period interest rate is r and the stock will pay a dividend of D just before the end of the period, derive a put-call parity condition that holds for these options. (7 marks) d. Assume a one-period binomial setting for stock Z. The stock currently sells for £20. Over the next period its price will either rise to £26 or fall to £16. The one period interest rate is 10%. A one-period call option with strike price £23 exists. It is currently selling in the market for £1.50. i. Show that this call option is mis-priced. Compute the size of the mis-pricing, (6 marks) ji, Devise and explain in detail an arbitrage strategy that generates risk-less profits from this, mis-pricing. Compute the instantaneous profits from the arbitrage strategy. (6 marks) © LSE ST 2016/FM212/F M492 Page 3 of 5Section B: Answer two questions from this section and another two from Section A 4) M&A and Payment Methods Your company has eamings per share of £4. It has 1 million shares outstanding, each of which has a price of £40. You are thinking of buying DeltaCo, which has earnings per share of £2, 1 million shares outstanding, and a price per share £25. You will pay for DeltaCo by issuing new shares. The synergy as a result of this acquisition will increase your original company’s EPS and share price both by 25%. a. Ifyou pay no premium to buy DeltaCo, what will your earnings per share be after the acquisition? (4 marks) Starting from this point, suppose you pay a 20% premium to buy DeltaCo. What will your earnings per share be after the acquisition? (6 marks) ©. Are you better off with this acquisition? What is the maximum percentage premium you are willing to pay before DeltaCo becomes too expensive to acquire? (7 marks) d. Instead of using pure equity to pay for the deal, now assume you pay the deal with 50% cash coming from your old company and 50% newly issued shares. What is the number of shares issued? (8 marks) 5) Conflict between Debt and Equity Holders and Security Design a. Briefly explain the risk-shifting problem. (2 marks) Consider a risk neutral entrepreneur who has two investment opportunities. Both require an investment of £100 upfront with the following payoffs in the next year: A pays: £200 with probability 0.4 and £0 with probability 0.6 B pays: £120 for sure. The risk free rate is normalized to 0 for your computational convenience. b. If the entrepreneur has £100 in cash to fund the investment, which project will he choose? Show your calculations, (2 marks) c. Now, suppose the entrepreneur has no cash and must issue straight debt with one year maturity to raise the required investment of £100. If the entrepreneur can commit to take project B, what is the required face value of debt such that the market value of debt is £100? After the debt is in place, which project will the entrepreneur choose? Show your calculations. (4 marks) d. Ifyou were a sophisticated bank, expecting the entrepreneur's choice of investment after taking the loan, would you make the loan at any face value? If not, why? If so, at what face value can you break even? (2 marks) Now consider an alternative world in which the entrepreneur issues convertible debt (one year maturity). Suppose the company has 10 shares outstanding at the time of debt issuance. The convertible debt has a face value of £100. It can be converted into 40 shares at maturity if the debt investor wishes. © LSE ST 2016/FM212/FM42 Page 4 of 5e. Should the investor convert if project A is taken and £200 is realized? Should the investor convert if Bis taken and £120 is realized? (5 marks) {Given the conversion decision in e), what is the entrepreneur's expected pay-off with project A? How about the pay-off with project B? Which project will the entrepreneur choose under convertible debt financing? (5 marks) g. Compare your findings in c) and d) with e) and f). What can you say about straight debt financing and convertible debt financing under conflict of interest between debt and equity? (5 marks) 6) Real Option and IPO Market Timing Every point in time mentioned in this problem is at the beginning of each year. It is now 2016. Gravitational Waves (GW) Company is a start-up, founded in 2015 with a potentially profitable idea. GW has already spent its £7M endowment over the past year on developing this idea and now the company has a reasonable outlook for it. The idea stil requires £10M and one more year to refine before one can definitively see its potential. Unfortunately GW has run out of money and therefore approaches a VC and asks for a £10M equity contribution. In 2017, GW's idea will be either a complete failure with 0 value or a great success generating annual earnings of £20M forever starting from 2018. The probability of success is 0.1, and the appropriate discount rate is 20%. Earnings will be paid out as dividends. a. What's the fair valuation of the company at 2017 after the idea proves to be successful? (2 marks) Now assume that GW goes public in 2017 if the idea tums out to be successful and raises an additional £100M. Post-IPO the company has 10M shares. Assume that the VC cashes out immediately after IPO. b. What is the share price after IPO at 2017? How many shares are sold to the public? (4 marks) ofthe c. Will the VC contribute the £10M capital in 2016? If so, what is the VC's percentage owners! company after the contribution in 2016? (4 marks) Unfortunately markets rarely give a fair valuation. This mis-valuation gives GW the option to choose the ideal timing to go public (so-called “market timing"). Suppose GW can choose to conduct the IPO in 2017, 2018 or 2019 at prices of £22, £32, and £34 per share respectively. Continue assuming that GW raises an additional £100M at IPO and post-IPO the company has 10M shares. d. When should GW go public in order to maximize its pre-IPO expected valuation in 2017? (6 marks) e. Given the possibility to “time the market’, redo question c). (5 marks) f. Compare what you find in c) and e). Is IPO market timing good or bad for efficient project selection? (4 marks) © LSE ST 2016/FM212/FM492 Page 5 of 5