Corporate Finance – Spring 2023
(B.Sc. SEM)
Mock Examination
Lecturer: Yingjie Qi
May 2023
IMPORTANT, PLEASE READ
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Students are allowed to bring:
USB key for uploading of notes, books, and compendiums in a non-executable format (no
applications, application fragments, IT tools etc.)
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Any calculator
Books (including translation dictionaries), compendiums, and notes in paper format
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Electronic devices that make it possible to communicate with others are NOT allowed
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The exam has two parts, both of which should be answered. Part I consists of 10 multiple
choice questions with a total weight of 50%. Part II consists of 2 independent questions
with a total weight of 50%. These weights only indicate the amount of time that should
roughly be used on each part or question. The final grade will not rely on these weights
but will take the overall impression into account.
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Answers to Part I should state the correct answer without further explanations (see also
instructions in the beginning of Part I), whereas answers to Part II should be carefully
explained and supplemented with relevant calculations and illustrations. Keep your
answers brief, concise and to the point (lengthy, irrelevant statements or calculations will
weaken the overall impression of your solutions).
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All answers should be provided electronically through the examination computer.
The design of the questions is such that even though you are not able to answer one subquestion, you may be able to answer the following sub-questions. If you feel you are
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missing information in this case, you should make assumptions that enable you to
proceed.
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At any time, if you believe that you lack information to proceed or that the question
might have been incorrectly stated, you should make – and explicitly state –
assumptions that enable you to proceed.
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The exam is 6 pages (including title pages).
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Part I – Multiple choice (weight 50 %)
You must write the answer to the following multiple-choice questions by clearly stating the
number of the question and its answer (e.g., Question 1: a). Only one answer per question is
correct (no partial credit given if multiple answers provided). There is no penalty for wrong
answers.
Question 1. Firm A has a beta of 1, the risk-free rate is 1%, and the market risk premium is 7%.
What is the expected return on equity of firm A?
a.
b.
c.
d.
6%
5%
7%
8%
Q1: d.
Question 2. Firm A is all equity financed and has two divisions: a “core division” and a “fringe
division”. The WACC of the core (fringe) division is WACCCORE (WACCFRINGE) and the beta of
the core (fringe) division is BetaCORE (BetaFRINGE). Which of the following statements is correct?
a.
According to the “WACC fallacy”, firm A should never use WACCCORE as a
discount factor when evaluating a new project of the “fringe division”.
b.
According to CAPM, if BetaCORE < BetaFRINGE, all else equal, new projects are
more likely to be approved if WACCCORE is used as a discount factor instead of
WACCFRINGE.
c.
If WACCFRINGE > WACCCORE, then the fringe division’s returns are less sensitive
to market risk than the core division’s returns.
d.
If WACCFRINGE is equal to WACCCORE then WACCCORE is the correct discount
factor for any project of the “fringe division”.
Q2: b.
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Question 3. A portfolio consisting of Stock A and Stock B has a beta of 1.2. If the beta of Stock
A is 1.4, the expected return of Stock B is 9.7%, the expected return of Stock A is 12.7%, and the
market risk premium is 8%, what fraction of the portfolio is invested in Stock A?
a.
b.
c.
d.
67%
47%
37%
77%
Q3: b.
Question 4. If the rate of inflation in Denmark is negative, which of the following statements is
correct?
a.
b.
c.
d.
Assuming positive inflation in the US, nominal interest rate in Denmark must be
lower than that of the US.
interest rate parity no longer holds.
the nominal rate in the economy is increasing, but at a decreasing rate.
the real interest rate in Denmark is higher than the real interest rate in US.
Q4: a.
Question 5. In a perfect market, investors can easily undo the actions of a firm. This implies that
they are not willing to pay more for a firm which:
a.
b.
c.
d.
Prefers to payout excess cash using share repurchases instead of dividends.
Targets a fixed capital structure.
Diversifies its operations by investing in different industries.
All the above.
Q5: b.
Question 6. Firms typically experience an increase in their stock price upon the announcement
of a dividend increase. Which of the following is unlikely an explanation for this phenomenon?
a.
Modigliani and Miller proposition 1.
b.
c.
d.
Firms have “Free Cash Flow” problem.
Managers having an informational advantage over outside investors.
Investors have a preference for high dividend payout firms.
Q6: a.
Question 7. Assume Firm A has 10,000 shares outstanding and is considering using its $50,000
cash position to repurchase shares at the current market price of $20 per share. What percent of
his shares must an investor who wants to hold his ownership fraction constant sell in the
repurchase program? Assume a perfect capital market.
a.
20%
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b.
c.
d.
10%
25%
0%
Q7: c.
Question 8 (NPV). You are considering buying a car for $20,000. You expect that the car has a
resell value of $5,000 after 5 years. As an alternative to buying the car, the dealer offers that you
can also lease it instead for 5 years. If the interest rate is 6%, what is the maximum lease
payment where you would still prefer leasing over buying the car?
NPV of buying car: -$16 895,39
NPV Of drinking
a.
b.
c.
d.
When the yearly lease payment is $3860.95 or less.
When the yearly lease payment is $3369.41 or less.
When the yearly lease payment is $3126.07 or less.
When the yearly lease payment is $3569.41 or less.
Q8: c.
Question 9. Purchasing Power Parity indicates that:
a.
Differences in interest rates between countries cannot be totally offset by expected
changes in exchange rates.
b.
Forward exchange rates may be locked in today to eliminate foreign exchange
risk, but investors will not be able to profit from moving capital to countries with
higher interest rates.
c.
Inflation differentials between countries affect both interest rates and currency
exchange rates.
d.
The country with a higher inflation rate will see its currency depreciate against
currency of another country with a lower inflation rate.
Q9: d.
Question 10. In practice, the market portfolio is often represented by:
a.
b.
c.
d.
A portfolio of U.S. Treasury securities
A diversified stock market index
An investor's S&P 500 mutual fund portfolio
The historic record of S&P 500 stock market returns
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Q10: c.
Part II (weight 50%)
In this part of the exam your answers should be carefully explained and supplemented with
relevant calculations and illustrations. Keep your answers brief, concise, and to the point
(lengthy, irrelevant statements or calculations will weaken the overall impression of your
solutions).
Question 1 (weight ~ 25 %) (calculate the market portfolio rate)
Given a risk-free rate of 2% and a market risk premium of 9%
a) Draw the security market line and explain which are the two dots you are connecting to get
a straight line.
The green dot represents the risk free rate of 2%, where the StD is 0. Te
Purple dot represents the market portfolio rate of 11% where the security
market line is a tangent of the efficient frontier.
b)
According to the CAPM, if a stock has an expected return of 1.5%, what should the
stock beta be? Give one reason why there is demand for such a stock.
Rf: 2%
Risk premium: 8%
ROR: 1,5%
Beta: (0,015-0,02)/0,08 = -6,25%
This is a stock with a negative correlation to the market. This would be attractive for a firm
that also acts in opposite patterns of the market, like a bankruptcy firm. In this case the stock
will excel the rest of the market is in bad shape.
Now imagine two stocks, stock A and stock B. Stock A has a beta of 2 and an expected return of
18%. Stock B has a beta of 0.5 and an expected return of 8%.
c) According to the CAPM, which of these two stocks is the most lucrative investment?
Why? Explain with max. 3 sentences.
Stock A: Expected: 18%Cost of capital: 20%
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We expect to get 18% but we need 20%
Stock B: Expected return 8% Cost of capital 6,5%
- We expect to get 8% but we only need 6,5%
Stock A has a higher Beta and is therefore more sensitive to changes in the market and can be seen
as more risky. However, it does have a higher return than stock B. In relation to beta, the ratio of
beta to return in stock A is also higher, and should therefore be the preferred investment.
Question 2 (weight ~ 25 %)
You are considering purchasing a 10-year government bond that has a remaining life of 9 years,
a face value of $1,000, a yield to maturity (YTM) of 8% and a coupon rate of 6.00%.
a) What do you expect the price of such a bond to be?
The price of such a bond will be: $875,06
Future value (Face value)
Number of Periods (yrs)
Coupon rate
Yield to maturity
coupon payments
Bond price
1000
10
0,06
0,08
=B16*B14
=PV(B17;B15;-B18;-B14)
b) One year after you have purchased the bond, interest rate turns out to be 5%. What will be
the new price of the bond?
Price will be $1 064,74
c) Describe briefly what you could do to hedge interest rate risk after you have purchased the
bond. Assume that you can only use bond futures.
To hedge risk we could sell a futures contract on the 8% interest to make sure to buy the stocks at
the price of $875 instead of $1 065.
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