Non-numerical Questions

Q1.

1. Suppose there are two streams of cash flows A and B you can choose to receive. The
discount rate is the same for both. Which ONE of the following statements is FALSE?

1. Assuming that both cash flows accrue over 5 years. If the future value of A in 5 years’ time
is higher than that of B in 5 years’ time, you prefer A.

2. If the present value of A is higher than that of B, you prefer A.

3. If the present value of A and B are the same, by investing the amount of money equal to
the present value of A today, you can generate the same cash flows as B.

4. If you receive A over 5 years and B over 10 years, you always prefer A.

5. (Tick here if you think that none of the statements is false.)

Q2.

Consider the following statements describing the advantages and disadvantages of the
Internal Rate of Return (IRR) approach.

i. The IRR approach is related to Net Present Value and always leading to identical decisions.

ii. The IRR approach is related to Net Present Value and often leading to identical decisions,
but may result in multiple answers with non-conventional cash flows.

iii. The IRR approach is related to Net Present Value and often leading to identical decisions,
but may lead to incorrect decisions in comparison of mutually exclusive investments.

Which of the three statements above are correct?

1. i only.

2. ii only.

3. ii and iii.

4. iii only.

5. (Tick here if you think that none of the three statements above is correct.)

Q3.
Which ONE of the following statements about a bond with call provision is CORRECT?

1. If an investor holds a bond with call provision, she has the right to buy the bond at
predetermined price in the future.

2. If an investor holds a bond with call provision, she has the right to sell the bond at
predetermined price in the future.

3. If a company issues a bond with call provision, it has the obligation to buy the bond at
predetermined price in the future.

4. If a company issues a bond with call provision, it has the obligation to sell the bond at
predetermined price in the future.

5. (Tick here if you think that none of the statements is correct.)

Q4.

If the market is weak-form efficient, which ONE of the following is TRUE?

1. Investors could not earn abnormal returns regardless of the information they possessed.

2. Prices reflect all information, including public and private.

3. Investors cannot earn abnormal returns by trading on market information.

4. Prices reflect all publicly available information e.g. trading information, annual reports,
and press releases.

5. (Tick here if you think that none of the above is true.)

Q5.

Which ONE of the following is the correct description of the Security Market Line (SML)?

1. The reward-to-risk ratio must be the same for all the assets in the market.

2. The slope of the SML is the beta.

3. The intercept of the SML is the beta.

4. The reward-to-risk ratio must be higher for riskier assets.

5. (Tick here if you think that none of the statements is a correct description.)
Q5.

Which ONE of the following is the correct description of the Security Market Line (SML)?

1. The reward-to-risk ratio must be the same for all the assets in the market.

2. The slope of the SML is the beta.

3. The intercept of the SML is the beta.

4. The reward-to-risk ratio must be higher for riskier assets.

5. (Tick here if you think that none of the descriptions is correct.)

Q6.

Consider the suitability of the following models for estimating the cost of equity:

 Dividend Growth Model (DGM)

 Security Market Line (SML)
 Weighted Average Cost of Capital (WACC)

Which ONE of the following statements is correct?

1. Both the SML and WACC approaches can be used to estimate the cost of equity.

2. Both the DGM and SML approaches can be used to estimate the cost of equity.

3. Both the DGM and WACC approaches can be used to estimate the cost of equity.

4. All three approaches can be used to estimate the cost of equity.

5. None of the approaches can be used to estimate the cost of equity.

Q7.

The proposition that the value of the firm is independent of the firm’s capital structure is
known as which ONE of the following?

1. WACC

2. Efficient Market Hypothesis (EMH)

3. M&M Proposition I

4. M&M Proposition II
5. (Tick here if you think that none of the terms listed is the correct answer.)

Q8.

Which ONE of the following is NOT a measure of either short-term or long-term solvency?

1. Quick ratio

2. Price-Earnings (P/E) ratio

3. Current ratio

4. Equity multiplier

5. (Tick here if you think that none of the measures listed is the correct solution.)

Q9.
Which ONE of the following statements about financial engineering is FALSE?
1. If there are only call options and forward contracts available to a company, but no put
options, then the company can replicate the payoffs at option expiry to a put-option holder
by buying a forward and selling a call option.
2. In general, given any two of the instruments (forward, put and call), the third can be
synthesized.
3. If there are only put options and forward contracts available to a company, but no call
options, then the company can replicate the payoffs at option expiry to a call-option holder
by buying the forward and also buying a put option.
4. An investor can replicate the payoffs at option expiry to a put-option holder by selling a
forward contract and buying a call option.
5. (Tick here if you think that none of the statements listed is false.)

Q10.

Which ONE of the following is NOT a possible reason for the apparent underpricing of initial
public offerings (IPOs)?

1. If uninformed investors face the winner’s curse, IPOs need to be underpriced to allow
uninformed investors to break even.

2. Issuers underprice to leave a “good taste” with investors.

3. IPOs may be underpriced due to conflicts of interest between issuers and underwriters.
4. Underwriters favour some investors over others and strategically allocate underpriced
IPOs.

5. (Tick here if you think that all of the statements give possible reasons for underpricing.)

Numerical Questions

Q11.

The company Bruce & Co. expects its earnings before interest and tax (EBIT) to be £100,000
every year forever. The firm can borrow at 10 percent. Bruce & Co. currently has no debt,
and its cost of equity is 20 percent. The tax rate is 21 percent.

Which ONE of the following statements is FALSE?

1. If Bruce & Co. borrows £100,000 and uses the proceeds to back some of its shares, the
present value of interest tax shield is £2,100
2. After-tax, the firm’s net income every year is £79,000
3. The value of the unlevered firm is £395,000
4. If Bruce & Co. borrows £80,000 and uses the proceeds to back some of its shares, the
value of the levered firm is £411,800
5. (Tick this option if you think that none of the listed statements is false.)

Q12.
Suppose you hold a call option on oil with an exercise price of $40, which you bought for a
premium of $3. Which ONE of the following statements is FALSE?

1. If the oil price is $50, you will exercise the call option and achieve a net profit (i.e., payoff
at expiration minus option premium) of $10.
2. If the oil price is $45, you will exercise the call option and achieve a net profit of $2.
3. If the oil price is $35, you will not exercise the call option.
4. If the oil price becomes more volatile, the call option premium will rise.
5. (Tick this option if you think that none of the statements listed is false.)

Q13.
Assume the following information for projects that last for 1 year:

Project Initial Cash flow Discount

Outlay (£) at the end rate (%)
of year 1
(£)
 X 8,000 9,000 10
Y 8,000 8,200 5

Consider the following statements:

A. IRR of X is 12.5%
B. IRR of Y is 2.5%
C. IRR of X is 10%
D. IRR of Y is 5%

Which ONE of the following identifies correctly all of the statements above that are TRUE?

1. A and B
2. C and D
3. A and D
4. B and C
5. (Tick here if you think that none of the other options correctly identifies the true
statements.)

Q14.
Your company has just suffered a loss of £100 million, when someone offers you the
following gamble that gives you the chance to recover your company’s loss and break even.
However, to enter this gamble, you will need to pay an entrance fee of £12 million. Once
entered, the gamble will give you a 10% chance of recovering both your £100 million loss
and the £12 million entrance fee. However, there is also a 90% chance that you will get
nothing (which means losing the £12 million entrance fee and not recovering the original
£100 million loss).

Which of the following statements is FALSE?

1. Without the gamble your company makes a £100 million loss for sure.
2. With the gamble, your company faces an expected loss of £100.8 million.
3. The gamble has a negative expected payoff of -£0.8 million
4. Decision makers who take this gamble may suffer from loss aversion.
5. (Tick here if you think that none of the statements listed is false.)

Q15.

A stock has an expected return of 14.4 percent and a beta of 1.35. The risk-free rate is 4.2
percent. What is the slope of the security market line?

1. 4.62 percent

2. 5.67 percent
3. 6.03 percent

4. 7.56 percent

5. (Tick here if you think that none of the numbers shown is the correct answer.)

Q16.

Given the following information, what is the expected return of a portfolio that is invested
35 percent in both stocks A and C, and 30 percent in stock B?

State of Probability of Rate of Return if State Occurs

Economy State of Economy Stock A Stock B Stock C
Boom .05 .24 .14 .07
Normal .85 .16 .08 .12
Recession .10 -.34 .02 .24

1. 8.98 percent

2. 9.47 percent

3. 10.41 percent

4. 10.83 percent

5. (Tick here if you think that none of the numbers shown is the correct answer.)

Q17.

Suppose you have estimated your company’s beta as 1.1, and you expect the market return
to be 5% and the risk-free rate 1%.

Which ONE of the following statements is FALSE?

1. Using the Securities Market Line, the company’s cost of equity is 6.5%.

2. If the company’s market value of equity is £200 million, and the market value of its debt is
£100 million, we calculate the weighted average cost of capital (WACC) as 2/3 of the cost of
equity plus 1/3 of the after-tax cost of debt.
3. If the pre-tax cost of debt is 4% and the corporate tax rate is 30%, the after-tax cost of
debt is 2.8%.

4. The company’s after-tax WACC is 4.53%

5. (Tick this option if you think that none of the statements is false.)

Q18.
The annual returns of three stocks over a 3-year period are given below:

Year Stock A Stock B Stock C

2017 7% -2% 6%
2018 -7% -10% 8%
2029 24% 15% -10%

The weights of Stocks A, B, and C in a portfolio is given below:

Portfolio Stock A Stock B Stock C

ABC 50% 30% 20%

What is the standard deviation of the portfolio ABC?

1. 0.0094
2. 0.0457
3. 0.0971
4. 0.1357
5. (Tick here if you think that none of results shown is correct.)

Q19.

The Johnston Company will pay an annual dividend of $2.05 next year. The company has
increased its dividend by 3.5 percent a year for the past twenty years and expects to
continue doing so. What will a share of this stock be worth three years from now if the
required return is 14 percent?

1. $20.21

2. $20.91

3. $21.65

4. $22.41
5. (Tick here if you think that none of the figures shown is correct.)

Q20.

Your company is conducting an IPO. It has sold 8 million shares at $55 each to an
underwriter, and the underwriter sells the shares at $59 each to investors. At the close of
the first day’s trading, your company’s stock price is $58. Besides the spread to the
underwriter, your company incurred a total of $1.5 million in other IPO-related costs. Which
ONE of the following statements is TRUE?

1. The percentage spread (relative to IPO proceeds to your company) is 7.5%.

2. The spread and underpricing of your IPO are broadly in line with those of the average US
IPO.
3. The company incurs an indirect cost due to IPO underpricing of $8 million.
4. The sum of the direct costs of the IPO plus the indirect cost to your company due to IPO
underpricing amount to $25.5 million.
5. (Tick this option if you think that none of the statements is true.)