# Current Issues in Finance

Answer at least ONE question from this section

Question 1

You are considering three investments. The first one is a bond that is currently selling in the bond market at $1,200. The bond has a $1,000 par value, pays interest at 14 percent, and is scheduled to mature in 12 years.

For bonds of this risk class, you believe that a 12 percent rate of return should be required. The second investment that you are considering is a preferred stock ($100 par value) that sells for $80 and pays an annual dividend of $12. Your required rate of return for this stock is 14 percent. The last investment is a common stock ($35 par value) that recently paid a $3 dividend. For this stock, the firm’s earnings per share have increased steadily from $4 to $8 in 10 years, which also reflects the expected growth in dividends per share for the indefinite future. The stock is selling for $25, and you think a reasonable required rate of return for the stock is 20 percent.

Required:

(1) Calculate the value of each security based on your required rate of return. (12 marks)

(2) Which investment(s) should you accept? Why?

(3 marks)

(3) If your required rates of return changed to 14 percent for the bond, 16 percent for the preferred stock, and 18 percent for the common stock, how would your answers to parts (1) and (2) change?

(9 marks)

(4) In the bond market, we can observe that a bond’s price is significantly influenced by the market base interest rate. Briefly discuss: (a) the relationship between the price of a bond and market base interest rates; (b) How you would measure the sensitivity of a bond ‘s price to changes in market interest rates; and (c) the determinants, in theory, of the sensitivity mentioned in (b) above.

(9 marks)

TOTAL 33 marks

Question 2

HUBS is currently an all equity firm with an expected net operating income (NOI) of £25,000 in perpetuity. HUBS has 10,000 shares outstanding. The required annual rate of return on HUBS ordinary share is 18%. The firm’s finance director has recently learnt from modern finance theory that there can be benefits if the company resorts to debt financing to an appropriate degree. He therefore proposes a change in the firm’s capital structure to the board that the firm issues £60,000 of bonds at the cost of 10% per annum and uses the proceeds to repurchase some of its shares. The corporate tax rate is 28%. Required:

(1) Calculate the value and share price of HUBS before and after the capital structure change?

(12 marks)

(2) Calculate the cost of equity capital and weighted average cost of capital of the firm before and after the capital structure change.

(12 marks)

(3) According to Modigliani and Miller’s capital structure theory with corporate tax, businesses should gear up as highly as possible. Discuss the reasons why, in practice, businesses do not gear up as highly as possible. (9 marks)

TOTAL 33 marks

Question 3

(Both parts should be attempted)

Part 1

Murky Oil Ltd. is considering a 5 years investment project to develop a new oil field. The company plans to generate revenues by selling crude oil and to exit in 5 years time by selling the oil field to another company. After doing research, the company estimated the expenditure as follows in all scenarios. expenditure (£m)

all scenarios

Year 1

-4000

Year 2

-4200

Year 3

-4400

Year 4

-4600

Year 5

-4800

The expected cash inflows are subject to the success of the development of the oil field and the project information is as follows:

cash inflows (£m)

success scenario

likely scenario

failure scenario

Year

probability

20%

60%

20%

The expected selling price at the end of year 5 is also subject to the scenario and information is as follows:

Selling price (£m)

success scenario

likely scenario

failure scenario

Year

probability

20%

60%

20%

5

70000

30000

0

The management team agreed that the risk-free return is 6%, market return is 14% and the appropriate beta value for the proposed project is 1.1. Required:

(1) Should Murky Oil Ltd. accept the project? (Support your answer by appropriate calculations)

(11 marks)

(2) Briefly discuss the reasons of why venture capitalists always require relatively high returns, e.g. 60% on their investments. Such high returns cannot be explained as being a reward for systematic risk according to the capital asset pricing model (Timmons, 1999).

(9 marks)

Part 2

The mean and standard deviation of returns on the equity shares of two companies, Hello plc and Goodbye plc, are as follows:

Expected return

Hello plc shares

Goodbye plc shares

0.15

0.17

Standard deviation

0.35

0.45

The correlation coefficient between the returns of the two companies’ shares is 0.3. Assume the risk free rate of return is 6%.

Required:

(1) Compute the expected return and standard deviation of a portfolio which invests 50% in Hello plc and 50% in Goodbye plc.

(7 marks)

(2) Illustrate how using the portfolio an expected return of 15% can be obtained with less risk than by investing wholly in Hello plc. , and calculate the resulting standard deviation of your portfolio. (6 marks)

TOTAL 33 marks

SECTION B

Answer at least ONE question from this section

Question 4

(1)

What are the different forms of an informationally efficient stock market? Explain.

(11 marks)

(2)

Briefly discuss how one can test whether a particular stock market is efficient in semi-strong form.

(11 marks)

(3)

What are the benefits of an efficient market?

(11 marks)

TOTAL 33 marks

Question 5

(1)

In a real world, businesses may be financially constrained for different reasons, being known as ‘capital rationing’. Discuss the key difference between ‘hard’ rationing and ‘soft’ rationing and their implications for investment.

(16 marks)

(2)

Explain why businesses invest in overseas and how to invest overseas. (17 marks)

TOTAL 33 marks

Question 6

(1)

Explain what is meant by the term ‘dividend puzzle’, and discuss the reasons of why many businesses pay dividends to their shareholders. (17 marks)

(2)

Explain what is meant by the term ‘underpricing’ in an IPO event, and discuss the reasons for the underpricing.

(16 marks)

TOTAL 33 marks

END

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