FN3502016 Outline Solutions
Question 1
a)Answers should define beta and explain systematic risk. Discussion should explore in practice how beta is calculated which will involve a description of the characteristics line. Reference should be made to the use of beta in CAPM to determine and expected return. Firm exposure to systematic risk factors can be explored in explaining the two companies betas.
b)A :ERA = 5% + 0.7(10%-5%) = 8.5% over valued
B:ERB =5% + 1.3 (10%-5%) = 11.5% undervalued
C:ERC = 5% + 0.9 (10%-5%) = 9.5% over valued
c)Discussion should include; APT does not assume that shareholders evaluate decisions within a mean variance framework but assumes return on a share depends partly on macroeconomic risk factors and partly on events specific to the company. Refer to Ross (1976). Specifies return as a function of multiple macro-economic risk factors rather than considering the shares return as a function of one factor, i.e. the return on the market portfolio. APT does not specify the factors. Reference could be made to ongoing research to identify the factors and the work of Fama and French.
d)Total Return=12.5
+(1034 – 1054) x 0.04
+(3.2 – 2) x – 0.5
+(4.5 – 6) x – 0.35
+2.3
=12.5 – 0.8 – 0.6 + 0.525 + 2.3
=13.925%
Question Two
a) Using traditional WACC is problematic where the historic proportions of debt and equity are not to be changed; when the operating risk of the firm will not be changed; and when finance is project specific. Answers should include discussion of these points.
b)
1) Ungear the proxy equity beta:
Asset Beta = 1.5 x (2/(2 +(1(1-0.3))) = 1.11
2) Re gear for Seaside plc using debt capacity of the project:
Equity Beta = 1.11 x ((0.6+0.4(1-0.3)/0.6) = 1.628
3) Use CAPM to find Re
Re = 8 + 1.628 x (12-8) = 14.5%
4) Calculate adjusted WACC:
(14.5 x 0.6) + (8(1-0.3) x 0.4) = 11%
5) Calculate the NPV
-3=-3
+1.6m x 1.11-1=1.44
+1.4m x 1.11-2=1.14
+1.2m x 1.11-3=0.88
NPV = approx. £460,000.
c) Discussion should include; bankruptcy costs, agency costs, tax exhaustion.
Question Three
a)
FixedFloating
Niall Plc400L + 10
Horner Plc250L- 5
------
15015=135
Less payable to broker= 15
-----
120
Gain 60 basis points each.
Niallwill end up receiving Libor + 70
Horner will end up receiving 3.1%
------ ------
3.3%0.15%3.15%
4% Libor -0.05%
---- NiallFIHorner------
------
Libor
Niall’s positionHorner’s position
Receiving from outside4%Libor-0.05%
Receiving from HornerLibor
Paying to Niall(Libor)
Receiving from FI3.15%
Paying to FI(3.3%)
TotalreceiptLibor +0.70%3.1%
b) Two swaps have no value at commencement but over time one will have a positive value and the other negative. If one party defaults, the other party still has to be honoured by the financial institution.
c)
SterlingDollars
Niall500600
Microface400450
------
100 150 = 50 BASIS POINTS
Less payable to FI = 20
------
30
Gain of 15 basis points each.
Niall will end up paying 5.85% for dollars
Microface will end up paying 3.85% for sterling
£500£385
£ 500------------
------NiallFIMicroface ------
------------450 dollars
585 dolllars450 dollars
Check FI position
$ receiving 135
£ paying 115
--
Net receipt 20 basis points as required
Question 4
a) They could do nothing and risk is unlimited
They could take out a forward contract by entering into an OTC contract now and paying nothing now. Outcome certain except for default risk.
They could do a money market hedge by borrowing Nkr so that they have 89m NKr including interest in 6 months time. Risk still of interest rate movements as well as default risk
(They could use futures and mark to market, if they exist, but not in this question)
They could use put options and have upside and default risk.
Pay a premium now, and either walk away or sell at exercise price.
These options would be OTC on krones.
i) Do nothing
T0T1
Receive 89m/8.9 = £10m
(Spot rate best predictor of future spot rate)
Risk: Uncertain
ii)
Take out a forward contract
Receive 89m/9 = £9,888,889
RIsk: Certain but default risk
iii) Money market hedge
NKr86,829,268</1.025< Nkr 89m borrowed
/8.9
£9,756,097 x 1.01 = £9.853,658
Or x 1.06 =£10.341,463
Risk: Interest rate risk
iv) Put options
Premium
89m x .035/8.9 =
£350,000 x 1.015 £355250paid
Minimum exercise
89m/8.95 receipt £9,944,134
Total £9.588,884
But upside risk only
Decision not clear but forward contract or the option and could work out breakeven rate for the option.
9,888,889 = (355,250) +89m/x
10,244,139 = 89m/x
X = 89m/10,244,139 = 8.68Nkr/£ Rate at which option breaks even with Forward. Seems outside foreseen range? Go with forward?
b)
Students would be expected to discuss how the fundamental cash flows of an organisation can be affected by exchange rates because of things such as competition, supply, etc. It occurs because of real exchange rate changes rather than nominal ones. Solutions tend to be operational such as moving economic activity or swapping loans, and because of this can only really be worth managing if they are going to continue over the long term.
Section B
Question 5
Students would be expected to define the EMH and its 3 forms, and discuss the anomalies to the EMH semi-strong form such as magnitude issues, p/e effect, book-to-market ratios, small firms effect etc. They would also be expected to discuss different behavioural theories such as anchoring, overconfidence, framing and regret avoidance, herd behaviour etc Their overall conclusion should be around a lot of evidence for semi strong but there are anomalies that behavioural finance can help explain. Research and outside reading rewarded.
Question 6
Students would be expected to refer briefly to the main traditional theories of dividend policy and how this policy might be relevant to the value of the firm (traditional view, tax, clienteles, signalling.
Then the discussion should move onto share repurchase: the three types (open market, tender and targeted) and a comparison of these with cash dividends for signalling and share price movements.
Stock dividends, splits and spin-offs might also be mentioned
All payout methods should be discussed against retaining cash instead (tax disadvantage of negative gearing and managers more inefficient but do have spare cash for projects)