UNIVERSITY OF MAURITIUS

FACULTY OF LAW AND MANAGEMENT

SECOND SEMESTER EXAMINATIONS

MAY 2012

PROGRAMME BSc (Hons) Banking & Finance

BSc (Hons) International Business Finance
MODULE NAME BUSINESS FINANCE DECISION MAKING & APPLICATIONS

Tuesday
MODULE CODE DFA2035Y(3)
DATE 15 May 2012

13.30-16.30
TIME DURATION 3 Hours
Hours

NO. OF NO. OF
QUESTIONS SET 5 QUESTIONS TO BE 5
ATTEMPTED

INSTRUCTIONS TO CANDIDATES
This paper consists of FIVE (5) Questions

Answer ALL Questions

Normal Distribution Table is attached
 BUSINESS FINANCE DECISION MAKING & APPLICATION

Question 1

(a) An aggresive mutual fund promises an expected return of 16% with a possible
volatility of 20%. On the other hand, a conservative mutual fund promises an
expected return of 13% and volatility of 15%.

(i) Which fund would you like to invest in? [2 Marks]

(ii) Would you like to invest in both if you have money? [1 Mark]

(iii) Assuming you can borrow at 10%, which fund would you invest your
money in? Would you consider both funds if you could lend or borrow
your money at 10%? [2 Marks]

(b) What is the Capital Asset Pricing Model? What are the assumptions that underlie
the model? [6 Marks]

(c) Briefly explain the difference between the CAPM and the Arbitrage Pricing
Theory. [4 Marks]

(d) What is the current status of the APT? [3 Marks]

(e) Suppose you are given the following information. The beta of company B is 0.9,
the risk free rate is 6.8% and the expected market premium is 6.3%. Because your
company is larger than average and more successful than average, you think that
the APT might be more appropriate than the CAPM. You estimate the additional
coefficients from the APT model: the coefficient for the size effect is -0.5, and the
coefficient for the book to market effect is -0.3. If the expected value of the size
effect is 4% and the expected value of the book to market factor is 5%:

(i) What is the required return using the APT 3 factor model? [4 Marks]

(ii) What is the required return using the CAPM? [3 Marks]

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 BUSINESS FINANCE DECISION MAKING & APPLICATION

Question 2

(a) Identify four broad sets of factors which affect dividend policy? [3 Marks]

(b) What constraints affect dividend policy? [2 Marks]

(c) Estimate the current after-tax cost of debt (APR) for a large telecommunications
company from a recent $1000 bond quotation: 8.2% coupon (semiannual),
matures in 2024; current price = 89.5. Their marginal tax rate is 35%. Today is
2002. [3 Marks]

(d) West Corporation issued a large preferred stock issue five years ago. The $100
face value preferred pays a $7 annual dividend and currently is priced at $92.
What is West's current cost of preferred stock if it has a marginal tax rate of 35%?
[3 Marks]

(e) TRZ Corporation has issued $10 million in bonds (10,000 bonds) several years
ago and the current book value of equity is $25 million (1 million shares). What
weights or proportions should TRZ Corporation assign debt and equity as it
calculates its weighted average cost of capital (WACC)? Today its bonds are
priced at 93 and the stock is selling for $32/share. [4 Marks]

(f) Amsted Corp. has asked you to calculate its weighted average cost of capital. It
estimates that the pre-tax cost of debt is 7% and 16% for equity. The market
value of equity represents about 70% of the capital structure and the marginal tax
rate is 40%. [3 Marks]

(g) As a new analyst in a major industrial company, you have just walked out of the
office of the Assistant Chief Financial Officer. You had just interviewed her
about estimates for a weighted average cost of capital assignment. You
remember that she said the WACC was 12% and the cost of equity is estimated to
be 16%, but you cannot remember what she said the pre-tax cost of debt was! If
debt makes up 40% of the market value of the company's capital structure and
the marginal tax rate is 35%, can you calculate the pre-tax cost of debt from the
information you have and not have to go back into her office? [5 Marks]

(h) Why is the after tax cost of debt rather than the before tax cost used to calculate
the WACC? [2 Marks]

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 BUSINESS FINANCE DECISION MAKING & APPLICATION

Question 3

(a) What is the significance of cost of capital in financial decision making? [3 Marks]

(b) “The M&M theory is based on unrealistic assumptions.” Evaluate the reality of
the assumptions made by M&M. [6 Marks]

(c) Firm A and B are similar except that A is unlevered, while B has Rs 200000 of 5%
debentures outstanding. Assume that the tax rate is 40%; the net operating
income is Rs 40,000 and the cost of equity is 10%.

(i) Calculate the value of the firms is the M&M assumptions are met.

[4 Marks]

(ii) Suppose the value of firm B is |Rs 360000. According to M&M, do these
represent equilibrium values? How will equilibrium be set? Explain.

[4 Marks]

(d) Bouba Manufacturing Co. has a total capitalization of Rs 1m and it normally

earns Rs 100000 (before interest and taxes). The financial manager if the firm
wants to take a decision regarding the capital structure. After a study of the
capital market, he gathers the following data:

Amount of Debt (Rs) Interest Rate (%) Equity Capitalization

Rate (%)

0 - 10.00

100 000 4.0 10.50

200 000 4.0 11.00

300 000 4.5 11.60

400 000 5.0 12.40

500 000 5.5 13.50

600 000 6.0 16.00

700 000 8.0 20.00

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 BUSINESS FINANCE DECISION MAKING & APPLICATION

(i) What amount of debt should be employed by the firm if the traditional
approach is valid? [4 Marks]

(ii) If the M&M approach is followed, what should be the equity

capitalization rate? [4 Marks]

Question 4

(a) What are the most important aspects of the design of a new option contract?
[2 Marks]
(b) Show the payoff profiles of a long in both a foreign exchange call and put
options.
[3 Marks]
(c) Write down and explain the Black Scholes European call option pricing formula.
Discuss how the call price varies with the parameters of the formula.
[2 Marks]

(d) You are given the following information about B limited company.

The current share price of B plc shares = £ 100

The exercise price = £ 95

Risk free rate of interest = 12%

Standard deviation of return on the shares return = 50%

Time to expiry = 5 months

Required:

Calculate the value of the call option. [3 Marks]

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 BUSINESS FINANCE DECISION MAKING & APPLICATION

Question 5

(a) “Debt is the cheapest source of funds”. Explain. [3 Marks]

(b) What are the main advantages a business can gain if it makes use of corporate
debts? [2 Marks]

(c) What is bond immunization and explain how the concept of immunization can
be applied in business? [4 Marks]

(d) In preparation for estimating the cost of capital, ABC Corp. would like to
estimate its cost of debt. Five years ago it issued $1000 twenty-year bonds with a
coupon rate of 9 per cent (semiannually). The notes are currently priced at $900.
What is the current cost of debt for ABC Corp.? [3 Marks]

(e) Twin Rivers, a company with a tax rate of 35%, has a WACC of 13% and a pretax
cost of debt of 8%. With a permanent debt level of $20 million, calculate the
present value of the tax shield of debt. [3 Marks]

- END OF QUESTION PAPER -

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