Final Exam
2016
ADM 2352
Finance Theory
Professor: Dr. Samir Saadi
Duration: 180 minutes
INSTRUCTIONS
1. Answer all questions.
2. The question paper must be returned at the end of the exam.
3. This is not an open book exam.
4. The only aids permitted are financial (or scientific) calculator and a two-sided, 8.5" x 11"
crib sheet. Crib sheet must be returned at the end of the exam.
5. Failure to return the crib sheet or use of course materials during the exam will result in an
exam grade of zero, and a grade of “F” for the course.
NAME: __________________________________________
STUDENT #: ______________________________________
Statement of Academic Integrity
The School of Management does not condone academic fraud, an act by a student that may
result in a false academic evaluation of that student or of another student. Without limiting the
generality of this definition, academic fraud occurs when a student commits any of the
following offences: plagiarism or cheating of any kind, use of books, notes, mathematical
tables, dictionaries or other study aid unless an explicit written note to the contrary appears on
the exam, to have in his/her possession cameras, radios (radios with headsets), tape
recorders, pagers, cell phones, or any other communication device which has not been
previously authorized in writing.
Statement to be signed by the student:
I have read the text on academic integrity and I pledge not to have committed or
attempted to commit academic fraud in this examination.
Signed:______________________________________
Note: an examination copy or booklet without that signed statement will not be graded and
will receive a final exam grade of zero.
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Multiple Choice Questions (2 mark each, total 40 marks)
Clearly circle the best response to each of the following questions.
1) The hypothesis that states that it is nearly impossible to predict exactly when stocks
will do well relative to bonds is known as the:
a) fair price hypothesis.
b) efficient market hypothesis.
c) full information hypothesis.
d) arbitrage hypothesis.
e) None of the above
2) Which of the following is a drawback to the historical approach of estimating an
asset’s expected return?
a) The risk of the firm may have changed over time.
b) History always repeats itself.
c) The range of potential outcomes is often very broad.
d) All of the above.
e) None of the above
3) Given the following levels of risk, which stock should have the highest price if each
stock is expected to produce the same level of cash over its future life?
Stock A
Stock B
Stock C
a)
b)
c)
d)
e)
Systematic risk units
10
12
5
Unsystematic risk units
3
5
300
Stock A
Stock B
Stock C
There is not enough information to decide
None of the above
4) According to the CAPM (capital asset pricing model), what is the single factor that
explains differences in returns across securities?
a) the expected risk premium on the market portfolio
b) the beta of a security
c) the expected return on the market portfolio
d) the volatility of a security
e) None of the above
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5) Which of the following statements is false?
a) Rather than relying on the efficiency of a single portfolio (such as the market),
multifactor models rely on the weaker condition that an efficient portfolio can be
constructed from a collection of well-diversified portfolios or factors.
b) A positive alpha in a single factor model means that the portfolios that implement
the trading strategy capture risk that is not captured by the market portfolio.
c) Multifactor models have a distinct advantage over single-factor models in that it
is much easier to identify a collection of portfolios that captures systematic risk
than just a single portfolio.
d) Trading strategies based on market capitalization, book-to-market ratios, and
momentum have been developed that appear to have zero alphas.
e) None of the above
6) A stock that pays no dividends is currently priced at $40 and is expected to increase
in price to $45 by year end. The expected risk premium on the market portfolio is 6%
and the risk-free rate is 5%. If you believe in the CAPM and if the stock has a beta of
0.6, the stock is
a) overpriced
b) underpriced
c) appropriately priced
d) Cannot tell from the given information
e) None of the above
7) Rose Industries is currently trading for $47 per share. The stock pays no dividends. A
one-year European call option on Rose Industries with a strike price of $45 is
currently trading for $7.45. If the risk-free interest rate is 6% per year, what is the
price of a one-year European put option on Rose Industries with a strike price of $45?
a) $7.30
b) $7.10
c) $2.90
d) $7.45
e) None of the above
8) Which of the following will NOT increase the value of a put option?
a) An increase in the time to maturity
b) A decrease in the stock price
c) A decrease in the stock's volatility
d) An increase in the exercise price
e) None of the above
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9) Suppose Sarah can borrow and lend at the risk free-rate of 3%. Which of the
following risky portfolios should she hold in combination with a position in the riskfree asset?
a) portfolio with a standard deviation of 15% and an expected return of 12%
b) portfolio with a standard deviation of 19% and an expected return of 15%
c) portfolio with a standard deviation of 12% and an expected return of 9%
d) she should be indifferent in holding any of the three portfolios
e) None of the above
10)
An investor put 40% of her money in Stock A and 60% in Stock B. Stock A has a
beta of 1.2 and Stock B has a beta of 1.6. If the risk-free rate is 5% and the expected
return on the market is 12%, what is the investor’s expected return?
a) 22.28%
b) 14.80%
c) -14.80%
d) 15.08%
e) None of the above
11)
Which of the following statements is false?
a) The intrinsic value of an option is the value it would have if it expired
immediately.
b) A European option cannot be worth less than its American counterpart.
c) Put options increase in value as the stock price falls.
d) A put option cannot be worth more than its strike price.
e) None of the above
12)
Which of the following statements is false?
a) Portfolios with high market capitalizations will have positive alphas if the market
portfolio is not efficient.
b) The size effect is the observation that firms with high book-to-market ratios have
positive alphas.
c) If the market portfolio is not efficient, then a portfolio of high book-to-market
stocks will likely have positive alphas.
d) Portfolios with low book-to-market ratios will have negative alphas if the market
portfolio is not efficient.
e) None of the above
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13)
KD Industries' stock is currently trading at $32 per share. Consider a put option
on KD stock with a strike price of $30. The maximum value of this put option is:
a) $0
b) $32
c) $30
d) $2
e) None of the above
14)
Which of the following statements is false?
a) If the value of the firm's assets exceeds the required debt payment, debt holders
are fully repaid.
b) Another way to view corporate debt is as a portfolio of riskless debt and a short
position in a call option on the firm's assets with a strike price equal to the
required debt payment.
c) Viewing debt as an option portfolio is useful as it provides insight into how credit
spreads for risky debt are determined.
d) You can think of the debt holders as owning the firm and having sold a call
option with a strike price equal to the required debt payment.
e) None of the above
15)
Asset 1 has a beta of 1.2 and Asset 2 has a beta of 0.6. Which of the following
statements is correct?
a) Asset 1 is more volatile than Asset 2.
b) Asset 1 has a higher expected return than Asset 2.
c) In a simple regression with individual asset’s return as the dependent variable
and the market return as the independent variable, the R-squared value is higher
for Asset 1 than it is for Asset 2.
d) All the above statements are correct.
e) None of the above
16)
For many start-ups, the first round of outside private equity financing is often
obtained from ________ which may also bring expertise to the firm that the
entrepreneur lacks.
a) venture capital firms
b) angel investors
c) institutional investors
d) corporate investors
e) All of the above
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17)
Which of the following statements is false?
a) An American call on a non-dividend-paying stock has the same price as its
European counterpart.
b) The price of any call option on a non-dividend-paying stock always exceeds its
intrinsic value.
c) It is never optimal to exercise a call option on a dividend-paying stock early – you
are always better off just selling the option.
d) If the present value of the dividend payment is large enough, the time value of a
European call option can be negative, implying that its price could be less than its
intrinsic value.
e) None of the above
18)
a)
b)
c)
d)
e)
One of the major differences between a real option and a financial option is that
a real option is traded in competitive markets.
a real option is less risky than a financial option.
a real option has more risk than a financial option.
a real option is not traded in competitive markets.
None of the above
19)
While the Sarbanes-Oxley Act (SOX) contains many provisions, the overall intent
of the legislation was to improve the accuracy of information given to both boards
and to shareholders. SOX attempted to achieve this goal in all of the following ways
EXCEPT
a) Overhauling incentives and independence in the auditing process.
b) Mandating the separation of the positions of CEO and Chairman of the Board.
c) Stiffening penalties for providing false information.
d) Forcing companies to validate their internal financial control processes.
e) None of the above
20)
In addition to the value of the current NPV of the investment, what other two
factors affect the value of an investment and the decision to wait?
a) Financing sources and capital decision procedures
b) Uncertainty and future cash inflows
c) Financing sources and risks
d) Uncertainty and the capital budgeting process
e) None of the above
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Problem 1 (10 marks)
Consider an equally weighted portfolio of stocks in which each stock has a volatility of
30%, and the correlation between each pair of stocks is 15%.
a) What is the volatility of the portfolio as the number of stocks becomes arbitrarily
large?
b) What is the average correlation of each stock with this large portfolio?
a. Average Covariance = 30% * 30% * 15% = 0.0135
Limit Volume = (0.0135)0.50 = 0.116189 = 11.62%
b. Correlation = SD(Rp) / SD(Ri) = 11.62% / 30% = 38.733%
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Problem 2 (10 marks)
Provide a detailed proof showing that the Put-Call parity can be used to characterize the
capital structure of a company.
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Problem 3 (10 marks)
Luther Industries is in the process of selling shares of stock in an auction IPO. At the
end of the bidding period, Luther's investment bank has received the following bids:
Price ($)
$19.50
$19.25
$19.10
$19.00
$18.75
$18.50
$18.25
$18.00
$17.75
$17.50
$17.25
$17.00
$16.90
$16.75
$16.50
$16.25
Number of Shares Bid
50,000
25,000
25,000
100,000
125,000
75,000
150,000
240,000
80,000
125,000
150,000
100,000
60,000
80,000
75,000
200,000
a) What will the offer price of these shares be if Luther is selling 1 million shares? (5
marks)
offer price of one million shares would be
$17.25
b) What are the proceeds from the IPO if Luther is selling 1.25 million shares Text
(instead of selling 1 million shares)? (5 marks)
Proceeds for 1.25 million shares= $1,125,000
Price: 19.50
Shares: 50,000
Cumulative: 50,000
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Problem 4 (20 marks)
Suppose that the American Congress (AC) passes a bill that prohibits the short selling of
stocks, which makes impossible for investors to have profit when stock prices go down.
However, AC doesn’t impose any restrictions on option trading. As a student of
ADM2352, what is your advice to the investors who want to be short in a particular
stock? In other words, provide a strategy on how to accomplish the equivalence of a
short sale by using options and borrowed capital. Create a payoff table of the strategy,
to back your answer.
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Essay Question (10 marks)
Explain why has the IPO volume in the U.S. declined since 2000?
IPO volume is declining in the US as firms are first seeking more
angel investors and capital venture firms to issue the required
financing. This enables the firm to maintain more ownership control
while given up less equity as they would typically give up in an
IPO. There has been a book in angel investors through companies
such as Kickstart, which also decreases the amount of IPOs seen
in the market.
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