LSE Summer 2014 examination FM212/FM492 Principles of Finance 2013/2014 syllabus and 2011/2012 and 2012/2013resit candidates Instructions to candidates Time allowed: 3 hours 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%). Hand calculators only are allowed in this examination. © LSE 2014/FM212/FM492 Page 1 of 6Section A: Answer two questions from this Section and another two from Section B 4 8) ©) o) (c) (0) Answer all of the following questions giving appropriate justifications for your answers where necessary. Your answer will be judged on the quality of your explanation. True/False answers with no explanation will receive a mark of zero. The notion of efficient markets requires stock prices to be completely random and thus they cannot be related in any systematic way to fundamental company information. True or false? [5 marks] You know that two stocks, X and Y, will pay identical dividends next year but they currently sell in the market for different prices. X is substantially cheaper than Y. Using the Gordon Growth model as your stock pricing framework, explain the ways in which the stocks could differ so as to justify their different market prices. [5 marks] At the current time, the yield to maturity on two-year zero-coupon government bonds is 5%. The yield to maturity on three-year zero-coupon government bonds is 4%. Given these data, at which rate of interest would you be willing to make a one-period risk-free loan starting at the end of period 2? Give the intuition for your calculations. [5 marks] ‘A bond with three years to maturity pays annual coupons at a rate of 8%. Its yield to maturity is 12%. Calculate the price of this bond, its duration and its modified duration assuming a face value of £1000. What do the duration and modified duration tell you about the interest rate sensitivity of this bond? [10 marks] Portfolio Theory ‘Two stocks X and Y have (annual) expected retums equal to 6% and 10% respectively and (annual) return standard deviations of 25% and 40% respectively. Their return correlation is -0.4. Compute the mean retumn and return standard deviation of an equally weighted portfolio of X and Y. [5 marks] An investor with mean-variance preferences is offered a menu of three investments. The first has ‘mean retum and return standard deviation identical to those of X above, the second has mean retum and return standard deviation the same as Y and the third has return properties identical to those of the equally weighted portfolio of X and Y. Can one immediately identify which of the three options the investor will choose or can one identify any investments that will definitely not be chosen? [3 marks] Assume that the CAPM holds. A portfolio P that combines the risk-free asset and the market portfolio has an expected return of 14% and a retum standard deviation of 18%. The risk-free rate is 5%, and the expected return on the market portfolio is 17%. Consider a security Z. What expected rate of return would you expect Z to earn if it had a 0.40 correlation with the market portfolio and a standard deviation of 36%? Comment on the market risk associated with security Z. [8 marks] A key result of the CAPM is that it implies a unique market portfolio of risky assets and that every investor, regardless of risk preferences, agrees on this portfolio's composition. Explain, and show graphically, the implications of this result for the optimal investment portfolios of different investors and discuss the implications for the mutual fund industry. Also comment on the assumptions that underlie this result. [9 marks] © LSE 2014/FM212/FM492 Page 2 of 63 Derivatives @) iividend paying stock has current price equal to £20. In each of the next two periods it could in price by 30% or fall in price by 20%. The one-period (simple) interest rate is 10%. A derivative exists that promises a payoff of £1 if, in two periods time, the price of the stock is above £16 and zero otherwise. Compute the possible price paths of the stock and the possible payoffs of the derivative and proceed to price the derivative using the risk-neutral method. [10 marks] (8) Price an at the money European straddle with two periods to maturity on the stock in part (a). Describe, analytically and graphically, the set of stock prices for which this straddle position generates a profit two periods from now (where profit is defined as the payoff on the option portfolio. in two periods less the premia paid today). [7 marks] (©) Mexico is a substantial producer of cil. In recent years, worried about the effects of global ‘macroeconomic shocks on the price of oil, Mexico has invested heavily in put options on oil. Explain what Mexico might be hoping to achieve with this strategy and lay out the implications of the strategy under various hypothetical scenarios for the future oil price. Use diagrams to aid your explanation. [8 marks] © LSE 2014/FM212/FM492 Page 3 of 6Section B: Answer two questions from this Section and another two from Section A 4 A 8) ) 0) (&) Capital Structure In parts (A)-(D), please answer whether the specific statement is true or false. Your answer will judged based on the quality of your explanation. True/False answers without any explanation will Teceive zero marks. Investors prefer diversified companies because they are less risky. True or False? Explain. [4 marks] Apple ended 2013 with nearly $160 billion in cash. The company is leaving money on the table by having such a large cash balance well below their firm’s cost of capital. True or False? Explain. [4 marks] Firms should obviously finance their investment with as much debt as possible because equity has a higher expected retum than debt. True or False? Explain. [4 marks] Since shareholders are risk averse, public corporations can raise their value and make their shareholders better off by hedging their exposure to risks such as oil prices, commodity prices, and interest rates. True or False? Explain. [4 marks] Jabari Inc. is an all-equity firm with 60,000 shares outstanding. On 1 May 2014, Jabari issued 20,000 five-year PERCS (Preferred Exchangeable Redemption Cumulative Securities). PERCS are a form of preferred equity. They pay a fixed dividend and have priority higher than common stock. At the end of the five-year period, the PERCS convert into common equity. Unlike a convertible bond, this Conversion is not an option for the equityholders—it always occurs. The number of shares each PERCS converts into is a function of the common stock price on that day. The number of shares each PERCS issued by Jabari converts into is: Psa sock Draw the total gross payoff diagram to the old equityholders as a function of firm assets, as of 1 May, 2019. Label the diagram clearly and thoroughly, detailing any necessary calculations. When answering this question, state any additional assumptions you may need to make, [9 marks] © LSE 2014/FM212/FM492 Page 4 of 65 Nikola Batteries develops rechargeable batteries for electric vehicles, including an industry-leading lithium-ion product in production. Nikola is also pursuing a project to develop a long-lasting lithium- sulfur version of their product. Though lithium-sulfur batteries hold four times more energy per mass than lithium-ion batteries, current lithium-sulfur batteries have relatively shorter lifespans because they cannot be charged as many times as lithium-ion batteries. Nikola requires an injection of £80 milion of outside equity capital to invest in the project as no bank will finance such a risky project. The following table on the next page details the outcomes linked to the four possible states of the world relevant to Nikola’s prospects. Values in millions State 1 State 2 State 3 State 4 Probabilities 25% 25% 25% 25% Lithium-Ion Assets £200 £200 £1160 £1160 (Assets in Place) Investment Cost £80 £80 £80 £80 NPV fithium-sulfur] £10 £30 £20 £100 When answering this question, state any additional assumptions you may need to make. Show your calculations. (A) __ If Nikola’s managers must issue equity without knowing the state of the world, what percentage of the firm must original equity holders give up in exchange for the capital? [5 marks] (8) Now assume that management knows the true state of the world before the decision to issue and invest is made. If management is maximizing the wealth of old shareholders and can sell equity at the terms described in (A), do they have an incentive to use their inside information when deciding whether to issue equity and invest? Explain. [4 marks] (C) If management knows the true state and announces their intention to issue and invest, what percentage of the firm must original equity holders give up in order to raise the £80 million? (Assume the market believes the managers know the true state even though the state has not been announced to the market.) [4 marks] (©) Calculate the announcement retum for Nikola under the assumptions in part (C) if managers announce their intentions to issue and invest. [7 marks] (E) Discuss in detail possible solutions to the problem that Nikola faces. [5 marks] © LSE 2014/FM212/FM4o2 Page 5 of 6io) (©) ©) (e) (F) Athena Toys’ management is considering building a new plant today (year 0) to exploit innovations in process technology and have forecasted corresponding financial statements for the next six years. ‘Selected items from those forecasts (all numbers in millions of pounds) are as follows: ‘Year 0 | Year 1 | Year2 | Year | Year4 | YearS | Year6 EB) 22 [40 [60 [115 [13.7 [174 Depreciation 19.0 [21.0 [21.0 [463 [481 | 50.0 CAPEX 720 [8.1 [95 [3070 [160 [163 [17.0 ANWC 25 44 [55 [750 [71 [80 |97 ‘Athena’s management expects the project to be a perpetuity growing at 5% in year 7 and after. The risk-free rate is 5.5%. The appropriate project discount rate is 12% ‘When answering this question, state any additional assumptions you may need to make. Show your calculations. ‘Compute the free cash flows in years 0 through 6. [4 marks] Compute the terminal value of the project as of year 6. [4 marks] Compute the NPV of the project. [4 marks] The above forecasts include investment and free cash flow associated with expanding the plant's capacity in year 3 in order to allow Athena Toys to enter a new market. However, this expansion does not necessarily have to be undertaken. Athena's CFO argues that ignoring this flexibility causes the quantitative analysis you have done to be biased. Describe why recognizing this flexibility might be important and how it would qualitatively affect your valuation. [4 marks] The incremental free cash flows associated with expanding the plant in year 3 are detailed in the table below (all numbers in millions of pounds). Year 0 | Year 1 | Year2 | Year3 | Year4 | Year5 | Year6 FOF -366.0 [23.2 [25.4 [28.0 Continue to assume that these free cash flows are a perpetuity growing at 5% in year 7 and beyond. Calculate the NPV of the project with no expansion. Is the expansion option out of the money? [4 marks] The CFO's best guess is that the volatility of the assets associated with the expansion phase of the project is 40% per year. The CFO notes that the expansion of the plant is similar to a call option as Athena has the right but not the obligation to expand the plant. Caloulate the values of the inputs to the Black-Scholes formula (given below) needed to value the expansion phase as a call option. You do not have to calculate the Black-Scholes value of the expansion phase. [5 marks] Black-Scholes formula: C = N(d,) * S —N(d.) * PV(X) with C = Call price, S = Current stock price, X = Exercise price, PV(X) representing the present value of the cash flow X, N(d) = Cumulative normal probabilty density function, d, = In{S/PV(X)] / (oT) + (oT'2)2, d, = dy - (6T"), T = Time to maturity in years, c = Standard deviation of stock retum, and Inf] the natural log function. © LSE 2014/FM212/FM492 Page 6 of 6