Financial Markets Trial Exam Questions – EBC2006 – 2010/11

Financial Markets Trial Exam Questions – EBC2006 – 2010/11

[Question 1-2]

Cool Enterprises is expected to have free cash flow in the coming year of $8 million, and this free cash flow is expected to grow at a rate of 3% per year thereafter. Cool Enterprises has an equity cost of capital of 13%, a debt cost of capital of 7%, and it is in the 35% corporate tax bracket.

1 .T/?/F         If Cool Enterprises maintains a 0.5 debt to equity ratio, then Cool Enterprises’ pre-tax WACC is lower than 12%.

2 .T/?/F         The value of Cool Enterprises as an all equity firm is higher than $120 Million.

[Question 3-4]

Pinball Industries has no debt and expects to generate free cash flows of $48 million each year.  Pinball believes that if it permanently increases its level of debt to $100 million, the risk of financial distress may cause it to lose some customers and receive less favorable terms from its suppliers.  As a result, Pinball’s expected free cash flows with debt will be only $44 million per year.  Suppose Pinball’s tax rate is 40%, the risk-free rate is 6%, the expected return of the market is 14%, and the beta of Pinball’s free cash flows is 1.25 (Assume the beta is the same with or without leverage).

3. T/?/F         The value of Pinball without leverage is larger than $250 million.

4. T/?/F         The value of Pinball with leverage is smaller than $300 million.

5. T/?/F         Call options with strike prices above the current stock price are in-the-money, as are put options with strike prices below the current stock price.

[Question 6]

You pay €3.25 for a call option on DSM that expires in three months with a strike price of €40.00.  Three months later, at expiration, DSM is trading at €41.00 per share.

6. T/?/F         Your loss per share on this transaction is €2.25, so you will not exercise the option.

[Question 7]

Shell does not pay dividend and is currently trading at $30 per share. The current risk-free rate of interest is 6%. An option on Shell has a strike price of $35 that expires in 80 days and N(d1) = 0.588 and N(d2) = 0.412.

7. T/?/F        The price of a call option on Shell is $3.40.

[Question 8]

The current price of Brave Industries’ stock is $30. In the next year the stock price will either go up by 20% or go down by 20%.  Brave Industries pays no dividends. The one year risk-free rate is 5% and will remain constant.

8. T/?/F        Using risk neutral probabilities, the calculated price of a one-year call option on Brave Industries’ stock with a strike price of $30 is $2.14.

[Questions 9-10]

Eco-Clark is a household products manufacturer considering entering the PC business. The PC industry has an average debt-to-equity ratio of 50%. The average cost of equity for this industry is rs = 18% and the industry’s borrowing rate is 10%. The corporate tax rate for both the PC industry and Eco-Clark is Tc = 30%. Eco-Clark’s target debt-to-capital ratio after expanding its business is 2/5. Its expected borrowing rate is 12%.

9. T/?/F   The hypothetical all-equity cost of capital for the PC industry is higher than 17.0%.

10. T/?/F       The weighted average cost of capital for the new PC business of Eco-Clark is higher than 12.0%.

11. T/?/F       Assume that debt has a beta of zero. The equity-beta increases more rapidly with the leverage under corporate tax than it does in a world without corporate taxes.

[Questions 12-13]

Use the Modigliani and Miller model for valuation under personal and corporate taxes. Assume perpetual earnings before interest and taxes (EBIT) are €2 million, the corporate tax rate (Tc) is 34% and the cost of capital to an all-equity firm is 15%. The personal tax rate on interest (Tb) is 28% and the personal tax rate on dividends and other equity distributions (Ts) is 20%. The value of debt (B) is €1 million.

12. T/?/F       The value of the firm is higher than €9 million.

13. T/?/F       According to Miller’s model, as long as Tb and Ts are equal, personal taxes do not affect the value of the levered firm.

[Questions 14-15]

M-Town N.V. has 10 million shares outstanding at €25 per share and has currently no debt outstanding. It has €50 million cash available. M-Town’s management, however, does not believe that the current market value of the share price is reflecting its intrinsic value. Management believes that the correct share price equals €30. Therefore, it considers repurchasing some shares using the available cash. Management further expects that after the announcement of the repurchase program, investors will immediately revise their opinion about the firm, which implies that after the repurchase program they will agree with M-Town’s management about the firm’s true value.

14. T/?/F       If investors, however, become aware of the true market value of M-Town before the repurchase program, then the total amount of shares outstanding after the share repurchase program equals 8 million.

15. T/?/F       Assume now that M-Town N.V. is able to repurchase shares prior to the market becoming aware of the new information about M-Town’s true value. After the repurchase, and following the release of the new information regarding the true value of M-Town, the firm’s share price equals €31.25.

[Questions 16-17]

The current stock price of company ABC is € 19.92. A call option that expires in exactly two months and has an exercise price of € 18.25 is selling at € 2.55. The put option with the same exercise price and maturity is selling at € 0.65. A call option with the same maturity and an exercise price of € 20 is selling at € 0.64.

16. T/?/F       The price of a put option on stock ABC that matures in three months and that has an exercise price of € 20 can be calculated with the available information.

17. T/?/F       According to put-call parity the annual risk-free rate will be larger than 7.0%.

[Questions 18-19]

Wildcat Drilling is an oil and gas exploration company that currently operating two active oil fields with a market value of $200 million dollars each.  Unfortunately, Wildcat Drilling has $500 million in debt coming due at the end of the year.  A large oil company has offered Wildcat drilling a highly speculative, but potentially very valuable, oil and gas lease in exchange for one of their active oil fields.  If Wildcat accepts the trade, there is a 10% chance that Wildcat will discover a major new oil field that would be worth $1.2 billion, a 15% that Wildcat will discover a productive oil field that would be worth $600 million, and a 75% chance that Wildcat will not discover oil at all.

18.  T/?/F      The overall expected payoff to Wildcat from the speculative oil lease deal is  $360 million

19.  T/?/F      The expected payoff to debt holders with the speculative oil lease deal is $275 million

20.  T/?/F      In most U.S. states, the law requires that when existing shareholders of a target firm are forced to sell their shares, they receive the market price for their shares. In most cases, this concept is interpreted as the value inclusive of any value that arises because of the merger itself.

[Questions 21-22]

Rearden Metal has earnings per share of $2. It has 10 million shares outstanding and is trading at $20 per share. Rearden Metal is thinking of buying Associated Steel, which has earnings per share of $1.25, 4 million shares outstanding, and a price per share of $15. Rearden Metal will pay for Associated Steel by issuing new shares. There are no expected synergies from the transaction.

21.  T/?/F      If Rearden pays no premium to buy Associated Steel, then Rearden’s earnings per share after the merger will be  $1.85.

22.  T/?/F      If Rearden offers an exchange ratio such that, at current pre-announcement share prices for both firms, the offer represents a 20% premium to buy Associated Steel, then Rearden’s earnings per share after the merger will be closest to $1.85

23.  T/?/F      The role of the corporate governance system is to mitigate the conflict of interest that results from the combination of ownership and control without unduly burdening managers with the risk of the firm.

24.  T/?/F      In the United States, the board of directors has a clear fiduciary duty to protect the interests of both the owners of the firm (the shareholders) and the interests of other stakeholders in the firm (such as the employees).

25. T/?/F       A board is said to be classified when its monitoring duties have been compromised by connections or perceived loyalties to management.

26. T/?/F       In addition to the evidence that board independence matters for major activities such as firing CEOs and making corporate acquisitions, researchers have found a strong connection between board structure and firm performance.

27. T/?/F       By backdating the option the executive receives a stock option that is already out-of-the-money, with a strike price equal to the higher price on the supposed grant date.

28. T/?/F       Likely because hostile takeovers and internal governance systems are substitute mechanisms, researchers have found that boards are less likely to fire managers for poor performance during active takeover markets than they are during lulls in takeover activity.

29. T/?/F       The Cadbury Commission stiffened the criminal penalties for providing false information to shareholders.

30. T/?/F       In the post Sarbanes-Oxley world, accounting firms are no longer allowed to offer both audit and non-audit services to the same firm.

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