BMAN23000A / BMAN23000B FOUNDATIONS OF FINANCE 2021
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BMAN23000A / BMAN23000B
FOUNDATIONS OF FINANCE
2021
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. Each 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 indicate about the market’s prediction of future economic conditions? 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 will 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 maturity 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)
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 coupon 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 utility 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- CounterMarket Technology & Co |
|||
Recession Near Recession Normal Near Boom Boom |
30% 20%
20% 10% 20% |
2% 2%
2% 2% 2% |
-6% 4%
13% 19% 28% |
4% 5%
7% 10% 12% |
-15% 3%
20% 32% 47% |
13% 10%
9% -1% -5% |
a) Calculate expected returns and volatilities of the assets in the table.
(4 marks)
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 three 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 the 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 stock 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)
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-equity 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)
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 the 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 effect on its stock price. (17 marks)
(TOTAL 35 MARKS)
2022-05-23