EDHEC MASTER BM 1

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19_M1_LI_BM_S1_CCO_FIN_644

CORPORATE FINANCE

FINAL EXAM – 20 DECEMBER 2018

Professors / Lecturers: Philippe COGNEAU, Gary van VUUREN,

Milos VULANOVIC, Pascal VAN WYNENDAELE

DURATION: 2h00

INSTRUCTIONS:
DOCUMENT NOT ALLOWED
CACULATOR ALLOWED (NON- PROGRAMMABLE)
1
Part 1. Theoretical questions
1 point per question

1. Generally, a corporation is owned by its:

I) managers II) board of directors III) shareholders IV) bondholders

Circle the good answer:

A.I only B. II and III C. III only D. I, II, and III E. III and IV

2. Which of the following is true?

A. 𝛽𝐷 > 𝛽𝐴 > 𝛽𝐸
B. 𝛽𝐸 > 𝛽𝐴 > 𝛽𝐷
C. 𝛽𝐴 > 𝛽𝐸 > 𝛽𝐷
D. 𝛽𝐴 > 𝛽𝐷 > 𝛽𝐸
E. 𝛽𝐸 > 𝛽𝐷 > 𝛽𝐴

3. The systematic risk of the market is measured by:

Circle the good answer:

A. 𝛽 = 1.0 B. 𝛽 = 0.0 C. Variance = 1

D. Standard Deviation = 0.0 E. Standard Deviation = 1.0

4. A security that is under-priced will have a return ………….... the Security Market Line.

Circle the best answer:

A. Below B. On or below C. On or above D. On E. Above

5. Which of the following statements about the relationship between interest rates and bond
prices is true?
I) There is an inverse relationship between bond prices and interest rates.
II) There is a direct relationship between bond prices and interest rates.
III) The price of short-term bonds fluctuates more than the price of long-term bonds for a given
change in interest rates (assuming that the coupon rate is the same for both).
IV) The price of long-term bonds fluctuates more than the price of short-term bonds for a given
change in interest rates (assuming that the coupon rate is the same for both).

Circle the good answer:

A. I and IV only B. I and III only C. II and III only D. II and IV only E. I only
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Part 2. Exercises
Show the approach you use to obtain the final solution: Partial credit is given to answers that
are numerically incorrect but that show correct reasoning. Conversely a wrong answer without
any explanation will not obtain any partial credit.

1. A house is sold for a perpetual annual amount of 18,000 € increasing by 2%. If the value is
estimated at 340,000 €, what is the return rate?
(0.5 point)

18000𝑥(1 + 2%) 18000𝑥(1 + 2%)

340000 = 18000 + ⇔ 322000 = ⇔
𝑟 − 0.02 𝑟 − 0.02
18000𝑥(1 + 2%) 18000𝑥(1 + 2%)
𝑟 − 0.02 = ⇔𝑟= + 0.02 = 𝟎. 𝟎𝟕𝟕𝟎𝟐
322000 322000

It is not explicitly mentioned that the first payment of the perpetuity is now … so I’d rather
consider the following solution :

18000 18000 18000

340000 = ⇔ 𝑟 − 0.02 = ⇔𝑟= + 0.02 = 𝟎. 𝟎𝟕𝟐𝟗𝟒
𝑟 − 0.02 340000 340000

2. A Corporate bond has a 12% coupon and pays interest annually. The nominal value is
$1,000. The bond matures in 10 years and is reimbursed at par. If the market interest rate is 9%,
calculate the market value of this bond.
(1 point)

120 120 120 1000

𝑃𝑟𝑖𝑐𝑒 = 1
+ 2
+ ⋯+ 10
+
(1 + 9%) (1 + 9%) (1 + 9%) (1 + 9%)10
120 1 1000
= . (1 − ) + = 𝟕𝟕𝟎, 𝟏𝟏𝟗 + 𝟒𝟐𝟐, 𝟒𝟏𝟏 = 𝟏𝟏𝟗𝟐, 𝟓𝟑𝟎
9% (1 + 9%)10 (1 + 9%)10

1
(1− )
(1+9%)10
Alternative calculation by considering the annuity factor : 6.4176 = 9%
1000
𝑃𝑟𝑖𝑐𝑒 = 6.4176 ∗ 120 + = 𝟕𝟕𝟎, 𝟏𝟏𝟗 + 𝟒𝟐𝟐, 𝟒𝟏𝟏 = 𝟏𝟏𝟗𝟐, 𝟓𝟑𝟎
(1 + 9%)10

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3. Company DEH expects to pay the following dividends:
- In 2019: 3.9 €
- In 2020: 4.1 €
- In 2021: 4.4 €
- In 2022: 5.1 €
After this, dividends are expected to increase by 6% / year.
What is the value of this share if the interest rate is 10%?
(1 point)
5.1
3.9 4.1 4.4 10% − 6%
𝑃𝑟𝑖𝑐𝑒 = + + +
(1 + 10%)1 (1 + 10%)2 (1 + 10%)3 (1 + 10%)3
𝟏𝟐𝟕. 𝟓
= 3,5455 + 3,3884 + 3,3058 +
(1 + 10%)3
= 𝟑, 𝟓𝟒𝟓𝟓 + 𝟑, 𝟑𝟖𝟖𝟒 + 𝟑, 𝟑𝟎𝟓𝟖 + 𝟗𝟓, 𝟕𝟗𝟑 = 𝟏𝟎𝟔, 𝟎𝟑

Alternative calculation :
5.1 ∗ (1 + 6%)
3.9 4.1 4.4 5.1 10% − 6%
𝑃𝑟𝑖𝑐𝑒 = + + +
(1 + 10%)1 (1 + 10%)2 (1 + 10%)3 (1 + 10%)4 (1 + 10%)4
𝟏𝟑𝟓. 𝟏𝟓
= 3,5455 + 3,3884 + 3,3058 + 3,4834 +
(1 + 10%)4
= 𝟑, 𝟓𝟒𝟓𝟓 + 𝟑, 𝟑𝟖𝟖𝟒 + 𝟑, 𝟑𝟎𝟓𝟖 + 𝟑, 𝟒𝟖𝟑𝟒 + 𝟗𝟐, 𝟑𝟎𝟗 = 𝟏𝟎𝟔, 𝟎𝟑

4. a) Calculate the net present value of the following project for discount rates of 5%, 10%, and
15%:
C0 -13,049
C1 8,155
C2 7,235.07

(0.5 point)

8155 7235.07
𝑁𝑃𝑉5% = −13049 + 1
+ = −13049 + 7.766,67 + 6.562,42
(1 + 5%) (1 + 5%)2
= 𝟏. 𝟐𝟖𝟎, 𝟎𝟗
8155 7235.07
𝑁𝑃𝑉10% = −13049 + + = −13049 + 7.413,64 + 5.979,40
(1 + 10%)1 (1 + 10%)2
= 𝟑𝟒𝟒. 𝟎𝟑
8155 7235.07
𝑁𝑃𝑉15% = −13049 + + = −13049 + 7.091,30 + 5.470,75
(1 + 15%)1 (1 + 15%)2
= −𝟒𝟖𝟔. 𝟗𝟒

b) Deduce from these figures the value of the IRR of the project and show that your answer is
correct.
(0.5 point)

It must be between 10% and 15% … therefore, through ‘trials and errors’ we have

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 8155 7235.07
𝑁𝑃𝑉12% = −13049 + + = −13049 + 𝟕𝟐𝟖𝟏, 𝟐𝟓 + 𝟓𝟕𝟔𝟕, 𝟕𝟓𝟑
(1 + 𝟏𝟐%)1 (1 + 𝟏𝟐%)2
= 0

Alternative calculation through ‘linear interpolation’ :

(𝑥% − 10%) (0 − 344.03) (−344.03)
= ⇔ 𝑥% = . (5%) + 10% = 12.07%
(15% − 10%) (−486.94 − 344.03) (−830.98)

5. Consider the following projects:

1 2 3 4 5

Project 𝑪𝟎 𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝟒 𝑪𝟓

A -6 000 0 6 000 11 000 6 000 0

B -12 000 10 000 2 000 0 0 19 000

C -4 500 4 500 0 4 000 2 000 0

a) If the opportunity cost of capital is 4%, which project should you launch if they are
mutually exclusive?
6000 11000 6000
𝑁𝑃𝑉𝐴 = −6000 + 2
+ 3
+
(1 + 4%) (1 + 12%) (1 + 12%)4
= −6000 + 5.547 + 9.779 + 5.129 = 𝟏𝟒. 𝟒𝟓𝟓, 𝟏𝟐
10000 2000 19000
𝑁𝑃𝑉𝐵 = −12000 + 1
+ 2
+
(1 + 4%) (1 + 4%) (1 + 4%)5
= −12000 + 9.615 + 1.849 + 15.617 = 𝟏𝟓. 𝟎𝟖𝟏, 𝟏𝟏
4500 4000 2000
𝑁𝑃𝑉𝐴 = −4500 + + +
(1 + 4%)1 (1 + 4%)3 (1 + 4%)4
= −4500 + 4.327 + 3.556 + 1.710 = 𝟓. 𝟎𝟗𝟐, 𝟓𝟐

b) Calculate the payback period for each project: which project is the best according to this
criterion?
PaybackA = 2 ; PaybackB = 2 ; Paybackc = 1

c) Determine the profitability index of the three projects with rate 4%: which project is the
best according to this criterion?
(−6000+5547)
Discounted. PaybackA = 2 + = 2 + 0.046 = 𝟐. 𝟎𝟒𝟔
9779
(−12000+9.615+1.849)
Discounted. PaybackB = 4 + = 4 + 0.034 = 𝟒. 𝟎𝟑𝟒
15.617
(−45000+4327)
Discounted. PaybackC = 2 + = 2 + 0.049 = 𝟐. 𝟎𝟒𝟗
3556

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 d) Compare the results obtained in previous sub questions and explain them.
a) Rate of 4% doesn’t heavily penalize CF that occur far in the future ==> B is preferred to A.
b) pay back favors short-term projects ==> C is preferred
b) and c) A is preferred to C, as the CF3 is relatively more important, and even if A is penalized
by the discounted effect (same amount as the CF0 occurs in year 2 whereas in Year 1 for C)
a), b) & c) B for a), C for b) and A for c).
(2 points)

6. The distribution of the Market Returns and the returns from investing in Gold is given in the
following table:

State Probability Market return Gold return

Good 0.3 5% 3%
Bad 0.7 1% 6%

Calculate the standard deviation of the Market Return σ(rm) and of Gold Return σ(rg).
Compute the correlation between Gold and Market returns and justify the value of the
correlation.
(1.5 points)
𝐸(𝑟𝑀𝑎𝑟𝑘𝑒𝑡 ) = 0.3 𝑥 5% + 0.7𝑥1% = 1.5% + 0.7% = 𝟐. 𝟐%
𝐸(𝑟𝐺𝑜𝑙𝑑 ) = 0.3 𝑥 3% + 0.7𝑥6% = 0.9% + 4.2% = 𝟓. 𝟏%

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𝑉(𝑟𝑀𝑎𝑟𝑘𝑒𝑡 ) = 0.3 𝑥 (5% − 2.2%)2 + 0.7𝑥1(1% − 2.2%)2 = 0,0002352 + 0,0001008
= 𝟎. 𝟎𝟎𝟎𝟑𝟑𝟔
𝑆𝑡𝑑(𝑟𝑀𝑎𝑟𝑘𝑒𝑡 ) = √0,000336 = 𝟏. 𝟖𝟑𝟑%
𝑉(𝑟𝐺𝑜𝑙𝑑 ) = 0.3 𝑥 (3% − 5.1%)2 + 0.7𝑥1(6% − 5.1%)2 = 0,0002352 + 0,0001008
= 𝟎. 𝟎𝟎𝟎𝟏𝟖𝟗
𝑆𝑡𝑑(𝑟𝐺𝑜𝑙𝑑 ) = √0,000189 = 𝟏. 𝟑𝟕𝟓%
𝐶𝑜𝑣(𝑟𝑀𝑎𝑟𝑘𝑒𝑡 , 𝑟𝐺𝑜𝑙𝑑 ) = 0.3𝑥(5% − 2.2%)𝑥(3% − 5.1%) + 0.7𝑥(1% − 2.2%)𝑥(6% − 5.1%)
= −𝟎. 𝟎𝟎𝟎𝟐𝟓
−0.00025
𝐶𝑜𝑟𝑟(𝑟𝑀𝑎𝑟𝑘𝑒𝑡 , 𝑟𝐺𝑜𝑙𝑑 ) = = −𝟏
0.000336𝑥0.000189

7. You manage a fund with an expected return of 7% and a standard deviation of 30%. The T-
bill rate is 2%.
a) Your client chooses to invest in your fund a proportion 𝑤 of her total investment budget and
the rest in the T-bill, so that her total portfolio will have an expected rate of return of 5.5%.
What is the proportion 𝑤?
What is the standard deviation of your client’s portfolio?
(1 point)

5.5% = 𝑤𝑥7% + (1 − 𝑤)𝑥2% ⇔ 0.055 = 0.07𝑤 + 0.02 − 0.02𝑤 ⇔ 0.035 = 0.05𝑤

0.035
⇔𝑤= = 𝟎. 𝟕
0.05
𝑉(𝑟𝑃𝑓 ) = 0.72 𝑥0.32 + (1 − 0.7)𝑥02 + 2𝑥0.7𝑥0.3𝑥0 = 𝟎. 𝟎𝟒𝟒𝟏
𝑆𝑡𝑑(𝑟𝑃𝑓 ) = √0,0441 = 21% 𝑜𝑟 𝑆𝑡𝑑(𝑟𝑃𝑓 ) = 0.7𝑥30% = 𝟐𝟏%

b) Instead, your client wishes to invest in your fund and in the T-bill so that the standard
deviation of her portfolio will be 24%.
What is the proportion 𝑤?
What is the expected rate of return?
(1 point)

24%
24% = 𝑤𝑥30% ⇔ 𝑤 = = 𝟎. 𝟖
30%
𝐸(𝑟𝑃𝑓 ) = 0.8𝑥7% + (1 − 0.8)𝑥2% = 𝟔%

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8. Suppose you observe the following situation:
Asset 1: 𝛽 = 0.8, expected return = 4.5%
Asset 2: 𝛽 = 1.3, expected return = 7%
Assume these securities are correctly priced. Based on the CAPM, what is the market risk
premium?
(1 point)
(1) 4.5% = 𝑟𝑓 + 0.8𝑥(𝐸(𝑟𝑀 ) − 𝑟𝑓 )

(2) 7% = 𝑟𝑓 + 1.3𝑥(𝐸(𝑟𝑀 ) − 𝑟𝑓 )

(2) − (1) 2.5% = 0.5𝑥 (𝐸(𝑟𝑀 ) − 𝑟𝑓 ) ⇔ (𝐸(𝑟𝑀 ) − 𝑟𝑓 ) = 5%

(1) 4.5% = 𝑟𝑓 + 0.8𝑥5% ⇔ 𝒓𝒇 = 𝟎. 𝟓%

(𝐸(𝑟𝑀 ) − 𝑟𝑓 ) = 5% ⇔ 𝐸(𝒓𝑴 ) = 𝟓. 𝟓%

9. You are given the covariance matrix of the rate of return on stock 1, stock 2 and the market
portfolio:

𝒓𝟏 𝒓𝟐 𝒓𝒎
𝒓𝟏 0.25 0.05 0.18
𝒓𝟐 0.05 0.16 0.07
𝒓𝒎 0.18 0.07 0.15

What are the 𝛽s of assets 1 and 2 and of a portfolio P composed of 35% of asset 1 and 65% of
asset 2?
0.18
𝛽1 = = 𝟏. 𝟐
0.15
0.07
𝛽2 = = 𝟎. 𝟒𝟔𝟕
0.15
𝛽𝑃𝑓 = 35%𝑥1.2 + 65%𝑥0.467 = 0.42 + 0.303 = 𝟎. 𝟕𝟐𝟑

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If the expected return of the market is 8%, and the risk-free rate is 2%, what are the expected
returns of stock 1, of stock 2 and of a portfolio P’ equally invested in stock 1 and in stock 2?
(1.5 points)
𝐸(𝑟1 ) = 2% + 1.2𝑥(8% − 2%) = 𝟗. 𝟐%
𝐸(𝑟2 ) = 2% + 0.467𝑥(8% − 2%) = 𝟒. 𝟖%
𝐸(𝑟𝑃𝑓 ) = 0.5𝑥9.2% + 0.5𝑥4.8% = 𝟕%
𝛽𝑃𝑓 = 50%𝑥1.2 + 50%𝑥0.467 = 𝟎. 𝟖𝟑𝟑 ⇔ 𝐸(𝑟𝑃𝑓 ) = 2% + 0.833𝑥(8% − 2%) = 𝟕%

10. a) Company Z is financed solely by stocks. It has issued 12,000 stocks which market value
is 300 € and 𝛽 = 1.8. The rate of the T-Bills is 2% and the market risk premium is 9%.
What is the value of this company? What is its WACC?
(0.5 point)

ValueZ = 12000 x 300 = 3600000€

𝑊𝐴𝐶𝐶 = 2% + 1.8𝑥9% = 𝟏𝟖. 𝟐%

b) The company intends to buy back 3,000 stocks and by issuing bonds maturing in 10 years;
the 𝛽 of the debt 𝛽𝐷 = 0.2.
i. If there is no tax:
 What is the new WACC?
 What is the new 𝛽 of equity?
ii. If there are taxes, whose level is 30%:
 What is the new value of the company?
(1.5 points)

The new WACC is 18.2% (unchanged)

Debt proportion = 3000/12000 = 25%
25%
βEquity,New = 1.8 + 𝑥(1.8 − 0.2) = 𝟐. 𝟑𝟑𝟑𝟑𝟑
75%
rD = 2% + 0.2𝑥9% = 𝟑. 𝟖%
Debt = 3000 x 300€ = 900000€
Yearly Tax Shield = 30% x 900000€ x 3.8% = 10260€
1
(1− )
(1+18.2%)10
Annuity Factor = = 𝟒. 𝟒𝟔𝟐
18.2%
10260 1
PV(Tax Shield) = 18.2% 𝑥 (1 − (1+18.2%)10 ) = 𝟒𝟓𝟕𝟖𝟑. 𝟓€ or 4.462𝑥10260 = 𝟒𝟓𝟕𝟖𝟑. 𝟓€

New Value of Company = 3600000€ + 45783,5€ = 3645783.5€

11. The WACC of your company is 12%. Compute the present value of interest tax shields
generated by these two debt issues (consider corporate taxes only, the marginal tax rate is Tc =
30%).
a) 200,000 € 1 year loan at 5%
Debt = 200000€ x 5% = 10000€
9
Yearly Tax shield = 30% x 20000€ x 5% = 3000€
3000
Tax Shield = (1+12%) = 𝟐𝟔𝟕𝟖. 𝟓𝟏€

b) 90,000 € perpetuity at 7%
Debt = 90000€ x 7% = 6300€
Yearly Tax shield = 30% x 90000€ x 7% = 1890€
1890
Tax Shield = 12% = 𝟏𝟓𝟕𝟓𝟎€

(1 point)

10
Future Value of Annuity

(1 + 𝑟)𝑛 − 1
𝐹𝑉annuity = 𝐶 ⋅ [ ]
𝑟

Total Risk decomposition formula

2
𝑉𝑎𝑟(𝑟𝑖 ) = 𝛽
⏟ ⏟𝑖𝑚 ⋅ 𝑉𝑎𝑟(𝑟̃𝑖 ) + 𝑉𝑎𝑟(𝜀̃)
⏟ 𝑖
Total risk Systematic risk Unsystematic risk

CAPM formula

𝐸(𝑟𝑖 ) = 𝑟𝑓 + 𝛽𝑖𝑚 ⋅ ⏟
(𝐸(𝑟𝑚 ) − 𝑟𝑓 )
Market risk
premium

Weighted average

𝑥 = 𝑤1 ⋅ 𝑥1 + 𝑤2 ⋅ 𝑥2 ⋯ 𝑤𝑛 ⋅ 𝑥𝑛

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