PART A - 30 points

Question 1. [4 points]
What can you say about the CAPM-Beta of an insurance policy?

Question 2. [5 points]
1PERIOD corporation is a simple company that will only exist for one year. The value of total assets
in 1 year is expected to be £215. Out of the £215, 110 will be paid out to equity holders and 105 will
be paid out the debt holders. The cost of equity is 10% and the cost of debt is 5%. The tax rate is 0%.
What is the WACC (today) of 1PERIOD?

Question 3. [4 points]
Assume the only financial friction is that debt has tax benefits. Then, firms find it optimal to lever up
to 100% market leverage. Explain!

Question 4. [4 points]
Why should stockholders, who only own equity, care about maximizing the market value of the firm?

Question 5. [5 points]
Briefly discuss 4 major difficulties that one needs to overcome when valuing a company.
Question 6. [4 points]
Using multiples to conduct company valuation might result in very accurate or very inaccurate num-
bers. What defines a promising valuation multiple?

Question 7. [4 points]
The zero-coupon yield curve is flat at 3%. A bond has just paid its most recent coupon, has a face value
of 100, and its coupon rate is 3%. Then, this bond is traded at 100. True or False?

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 PART B - 48 points

Question 8. [20 points]

Part (i) [10 points]
The Coromandel Yarn Factory (CYF) has a target debt-to-equity ratio of 0.55. Its current opportunity
cost of equity is 14% and its current opportunity cost of debt is 7%. If the tax rate is 35%, what is
CYF’s weighted average cost of capital?

Part (ii) [10 points]

Ripping Yarns Inc has the same asset mix (it is in the same business) as CYF. Its target debt-to-equity
ratio is 0.05, and its current debt is deemed riskless, because its operating cash flow will always
exceed its debt service obligation. The risk-free rate is 3%, and Ripping is also in the 35% tax bracket.
Compute Ripping’s opportunity cost of equity. To receive full credit state and justify any assumption
you make.

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Question 9. [12 points] You have the following information on an M&A deal, between two all equity
firms that operate in the same industry. The cost of equity for both firms is the same and equal to
10%. For each of the firms, capital expenditures are equal to depreciation and net working capital is
expected to remain constant forever. The EBIT of the acquirer is a constant perpetuity equal to £30
million per year, and the EBIT of the target is constant perpetuity of £3 million per year, both of which
start in one-year time. The corporate tax rate is 20%.

Part (i) [6 points]

Obtain the stand alone values of the acquirer and the target. At what multiple of EBIT should these
companies trade?

Part (ii) [6 points]

The acquirer decided to make a cash offer for the target. The acquirer believes that it will be able to
generate synergies from the deal that will lead to an increase in the annual EBIT of the target equal
to 2 million pounds. The EBIT of the acquirer remains unchanged. What is the acquisition multiple if
the price paid for the target is £38 million? Is this a good deal for the acquirer? Briefly explain your
answer.

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Question 10. [8 points]
Let C(X) (P(X)) denote a call (put) option with a strike price X. Draw the final payoff of the following
portfolio: C(100) - 3C(200) + 2C(250).

Solution.

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Question 11. [8 points]

Part (i) [4 points]

The payoff at maturity in the above picture can be replicated using put options. Describe how (specify
clearly number of options, strike price, type of option, etc)

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Part (ii) [4 points]

Construct a portfolio of European put options with the payoff at maturity as in the picture above. The
portfolio can include both long and short positions. Describe how (specify clearly number of options,
strike price, type of option, etc)

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 PART C - 22 points

Question 12. [22 points]

You are given the following information about the current prices of three risk-free bonds:

Maturity (years) 1 2 3
Coupon rate (annual) 0% 3% 3.5%
Bond price (per $100 face value) $ 95.500 $ 98.231 $ 97.195

Note that the coupon payments are annual, with the first coupon payment exactly one year from today.
Assume that there is no arbitrage.

Part (i) [7 points]

Determine the yield-to-maturity of a one-year zero coupon bond.

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Part (ii) [7 points]
Determine the yield-to-maturity of a two-year zero coupon bond.

Part (iii) [8 points]

Determine the price of a three-year coupon-paying bond with annual coupon payments and a coupon
rate of 5%.