BMAN23000A

Two Hours

Answer Sheet to be provided

Formula Sheet provided
Normal Distribution Table provided

THE UNIVERSITY OF MANCHESTER

FOUNDATIONS OF FINANCE (A)

14 May 2019

14:00 – 16:00

Answer ALL questions from SECTION A on the answer grid provided

and
Answer ONE question from SECTION B
and
Answer ONE question from SECTION C

Answer Section B and Section C in separate answer booklet(s).

(i.e. do not put answers to sections B and C in the same booklet)

THIS QUESTION PAPER MUST NOT BE REMOVED FROM THE EXAMINATION

ROOM

Electronic calculators may be used in accordance with the University regulations

© The University of Manchester, 2019.

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SECTION A (30 marks) - WITHHELD

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SECTION B (35 marks)

Answer ONE question

Question 11 (answer all parts)

John has just turned 20 and his rich relatives are thinking of giving him an investment
while he is young, which will pay for his retirement. They hope that by investing early,
the investment they make for him will grow sufficiently to guarantee him a
comfortable retirement. They therefore approach a financial advisor to help them
make the calculations. The plan is for John to retire on his 70th birthday (i.e., in 50
years’ time). His life expectancy is 85 years. During his retirement (i.e., until his 85 th
birthday), they plan for John to receive £30,000 per year, starting on his 71 st birthday.
The interest rate that applies to his retirement period is 5% per year.

a) Find the amount of money that John would need to have when he is 70, in
order to fund an annuity which would give him the desired cash flows from 71 st
birthday to his 85th birthday. (10 marks)

b) John’s financial advisor suggests investing in a AAA-rated government zero-

coupon bond, which would provide him with enough money upon its maturity,
when he is 70, in order to purchase the annuity in part a). The annualized yield
to maturity of a set of these zero-coupon bonds is observed as follows:

Maturity(years) 20 30 40 50 60
Zero-Coupon YTM 3.60% 3.80% 4.00% 4.20% 4.40%

Calculate how much John would need to invest in a suitable zero-coupon bond
at the age of 20, in order to be able to fund this retirement plan. (5 marks)

c) John’s relatives become concerned that his retirement pension might not be
enough to live on over time due to inflation. They therefore instruct the financial
advisor to present an alternative plan, in which John retires at 70, and receives
a yearly pension which would give him £30,000 on his 71 st birthday, and
afterwards would give him annual payments which grew at a rate of 2% every
year, finishing on his 85th birthday. The interest rate that applies to his
retirement period is 5% per year. They still plan to fund this by investing in a
suitable zero-coupon bond, which would be bought when John is 20, and which
would mature when he is 70. How much would need to be invested in a suitable
zero-coupon bond when John is 20, to pay for this alternative retirement plan?
(10 marks)

Question 11 continued overleaf

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Question 11 continued

d) John likes the scheme in part c). However, he would rather retire earlier, when
he is 60, so that he receives £30,000 on his 61st birthday, and afterwards
receives annual payments which grow at a rate of 2% every year and finish on
his 85th birthday. As before, this annuity would be financed by a suitable zero-
coupon bond, bought when John is 20 and maturing when he is 60. The
interest rate that applies to his retirement period is 5% per year. How much
would need to be invested in a suitable zero-coupon bond when John is 20, to
finance this plan? (10 marks)

(TOTAL 35 MARKS)

Question 12 (answer all parts)

a) Suppose that two stocks, Netflix (NFLX) and Facebook (FB), have the following
characteristics:

Expected
Return Volatility
Netflix (NFLX) 45% 20%
Facebook (FB) 40% 25%

Further, their correlation is equal to 40%. Assume also that the risk free rate is 3%.

i. Calculate the expected return and volatility of a portfolio composed by 70%

of NFLX and the remaining of FB. We will call it Portfolio A.

(4 marks)

ii. Now assume that your available wealth to make investment is equal to
£50,000. You want to have a long position in NFLX of £70,000 and a short
position in FB of £20,000. Calculate the expected return and volatility of this
new portfolio that we will call Portfolio B.
(5 marks)

iii. Briefly explain what “short-selling” means.

(3 marks)

iv. Calculate the Sharpe ratio of Portfolio A and Portfolio B.

(5 marks)

v. Briefly explain what the Sharpe ratio is.

(3 marks)

Question 12 continued overleaf

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Question 12 continued

b) Now suppose that you have invested all your available wealth (£50,000) in Netflix
stock only. You know that the expected return of the market portfolio is equal to
25% and its volatility is equal to 10%. Assume that the characteristics of Netflix
stock and the risk-free rate are the same as in part a). If CAPM assumptions
hold:

i. What alternative portfolio has the lowest possible volatility while having the
same expected return as Netflix? What is the volatility of this new
portfolio? Say if you would borrow money to invest in this alternative
portfolio.
(5 marks)

ii. What investment has the highest possible expected return given that you
want to maintain the same volatility as Facebook? What is the expected
return of this new portfolio? Say if you would borrow money to invest in
this alternative portfolio.
(5 marks)

c) Discuss the ways you know to diversify a portfolio.

(5 marks)

(TOTAL 35 marks)

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SECTION C (35 marks)

Answer ONE question

Question 13 (answer all parts)

GlaxoSmithKline plc is a pharmaceutical company. It is considering the replacement

of one of its existing machines with a new model. The existing machine can be sold
now for £8,000. The new machine costs £50,000 and will generate free cash flows of
£11,416.55 p.a. over the next 6 years. The corporate tax rate is 35%. The new
machine has average risk. GlaxoSmithKline’s debt-equity ratio is 0.5 and it plans to
maintain a constant debt-equity ratio. GlaxoSmithKline’s cost of debt is 5.85% and its
cost of equity is 13.10%.

a) Compute GlaxoSmithKline’s weighted average cost of capital.

(5 marks)

b) What is the NPV of the new machine and should GlaxoSmithKline replace the old
machine with the new one?
(10 marks)

c) The average debt-to-value ratio in the pharmaceutical industry is 20%. What would
GlaxoSmithKline’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.
(10 marks)

d) Given the capital structure change in question c), Modigliani and Miller would
argue that according to their theory, GlaxoSmithKline’s WACC should decline
because its cost of equity capital has declined. Discuss.

(10 marks)

(TOTAL 35 marks)

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Question 14 (answer all parts)

a) Describe the market reactions that are typically generated by cash dividend and
stock repurchase announcements. Why do these reactions exist? Also, what is
dividend smoothing?
(8 marks)

b) Explain the differences between the following IPO mechanisms: best effort, firm
commitment and auction IPO.
(5 marks)

c) Explain the difference between a secured and an unsecured corporate bond.

(5 marks)

d) Tefifza Plc is considering opening a hotel. The project requires an initial capital
investment of £21.5 million. The present value of the expected future cash flows
from the hotel is £20 million. Tefifza Plc is very confident that the project could be
abandoned in 5 years’ time by selling the hotel for £16 million. The variance in the
present value of the cash flows is 0.12. While the opportunity cost of the project is
8%, the (continuously compounded) risk-free rate is 3%.

What is the net present value of the project without the abandonment option?

(2 marks)

Should the project be undertaken? You are required to show all your workings and
to explain each step in your calculations.
(15 marks)

(TOTAL 35 marks)

END OF EXAMINATION PAPER

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