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UNIVERSITY OF WARWICK
Department Warwick Business School
Level 2
Module Code IB1320
Module Title Foundations of Finance
Exam Paper Code IB1320_C
Exam Paper Title IB1320_Foundations of Finance_Exam
Paper Summer 2021_15 CATS
Duration 2 hours
Exam Paper Type Fixed time – Open Book

STUDENT INSTRUCTIONS

1. Read all instructions carefully. We recommend you read through the entire paper at least
once before writing

2. All candidates should answer:

All the questions in Section A.
One question in Section B
Two questions from Section C.

3. You should not submit answers to more than the required number of questions

4. Section A carries 25 marks (5 marks per question). Section B carries 25 marks and Section
C carries 50 marks.

5. Where handwritten answers are permitted, please ensure you write legibly, preferably in
dark blue or black ink. If you use a pencil, please ensure it is not too faint to be captured by
scan or photograph. It is your responsibility to ensure your work can be read

6. If uploading photographs or scanned copies of your work, please check for legibility
before uploading. It is your responsibility to ensure your work can be read

7. Add your student number to all uploaded files

8. You are permitted to access module materials, notes, resources, references and the
internet during the online assessment

IB1320_C


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IB1320_C
9. You must not communicate with any other candidate during the assessment period,
unless instructed to do so as part of the assessment requirement(s)

10. By starting this assessment, you are declaring yourself fit to undertake it. You are
expected to make a reasonable attempt at the assessment by answering the questions in
the paper


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IB1320_C
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Your assessment starts below.


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IB1320_C
SECTION A
(25 marks)


1. Attempt ALL questions in this section. Each question is worth 5 marks.

2. For numerical questions, please round decimal numbers to 2 decimal points and if you think
there is missing information necessary to answer the question, you can make your own assumptions,
provided that you state your assumptions clearly in your answers.



Question A1

If the central bank lowers the annual risk-free rate from 3% to 2.7%, will the price of bonds increase or
decrease?

In no more than 10 lines, please justify your answer.
(5 marks)



Question A2

In no more than 10 lines, discuss one advantage and one disadvantage of debt financing.
(5 marks)





Question A3

In no more than 10 lines, please discuss what are the control rights and cash flow rights of creditors
and shareholders in general. Draw a payoff diagram for equity holders and creditors, as we vary the
firm values. Label both the x-axis and y-axis, as well as any special point(s) on the graph.
(5 marks)











Continued…


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IB1320_C
Question A4

There are two states of the world economy, expansion (E) and recession (R). There is a 60%
probability that the economy expands, and a 40% probability that the economy will go into recession.
The table below shows the returns of Asset A and Asset B in each state of the world.

State Probability p that
State n happens
Payoff of Asset A Payoff of Asset B
E 60% -1£ +1£
R 40% +1£ -1£

Suppose that, the way it is constructed, the value of your portfolio increases during recession and
decreases during expansion. You are risk averse. Which asset would you like to include in your
portfolio, A or B?

In no more than 10 lines, please justify your answer.

(5 marks)



Question A5

In no more than 10 lines, please discuss what the two basic forms of pay-out to equity holders are.
What may explain the recent popularity of companies using one form (which one?) comparing with
the other?
(5 marks)







END OF SECTION A











Continued…


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IB1320_C
SECTION B
(25 Marks)

For numerical questions, please round decimal numbers to 2 decimal points and if you think there is
missing information necessary to answer the question, you can make your own assumptions,
provided that you state your assumptions clearly in your answers.


Question B

Adidas is considering designing a new apparel line for Naomi Osaka, after the tennis player decided to
quit her sponsor collaboration with Nike. In three-year’s time, if Naomi keeps playing as expected and
wins additional Grand Slam titles, the company will receive a payoff from the apparel line equal to
120 million dollars. This could happen with 70+x% of probability, where x is the last digit of your
student ID. However, if Naomi has only moderate success, then the payoff from this investment in
three years’ time will equal 40 million dollars. This could happen with 30-x% probability, where x is
the last digit of your student ID. The one-year interest rate in this economy is 5%. Assuming that the
market is perfect and that investors are risk neutral, calculate the following, showing all relevant
calculations.

(i) Calculate the price for this project, and its rate of return in the “bad” state of the world.
(15%)

(ii) In no more than three lines, please comment on the sign of the return in the bad state of
the world.
(5%)

(iii) Assume that you choose to partly finance this project by borrowing 40 million today (i.e.,
by issuing a bond). The remaining money will be raised by issuing equity. Calculate the
promised cash flows and promised returns to the bond holder.
(15%)

(iv) Calculate the cash flows and returns the levered equity holder should receive in the good
state of the world.
(20%)

(v) Without doing any calculations, state the expected return that would be earned by the
bond holder and the levered equity holder in this three-year period, and briefly discuss
why this is the case.
(10%)

(vi) Calculate the standard deviation of the return of the bond holder and the levered equity
holder. Which one is highest, and why?
(25%)

Question B Continues on the next page…




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IB1320_C
(vii) Assuming instead that investors were risk averse, which investors (bond holders or equity
holders) should demand a higher return, and why? Please discuss your answer in no more
than 3 lines.
(10%)

END OF SECTION B



Continued…



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IB1320_C
SECTION C
(50 Marks)

For numerical questions, please round decimal numbers to 2 decimal points and if you think there is
missing information necessary to answer the question, you can make your own assumptions, provided
that you state your assumptions clearly in your answers.

Attempt ANY TWO questions in this section.


Question C1
Leaming.ton Ltd. is an IT company located in the Warwickshire. It’s 2020 and the company is
considering investing in a new project on renewables (we call it Project A). The cash flows for the
project are shown in the table below (in million pounds). Assume that the appropriate monthly cost of
capital for this project is 0.6%.

Year 0 1 2
Cash flows -300 120 280

(i) Make a suggestion on whether Leaming.ton should accept this project using the NPV capital
budgeting rule.
(15%)

(ii) In 2019, the manager of Leaming.ton had considered investing in a cycling app project (we call it
project B). The estimated hurdle rate of this project was 8.5% and, based on the estimated cash flows
from the app, the IRR of the project was 7%.
Briefly discuss the advantages and disadvantages of IRR rule in relation to the NPV rule.
(20%)

(iii) Based on the IRR and the hurdle rate, the manager decided to undertake the cycling app project.
Explain in no more than 5 lines whether this was a good or a bad choice from a capital budgeting
perspective, and why.
(20%)

(iv) Assume now that the company is considering another project which costs £300M today and will
return £325M in 1 year (project C). Explain how the payback rule can be generally applied to choose
between projects. Which project does the payback rule prefer between A and C? What are the limitations
of the capital budgeting rule?
(20%)

(v) It’s December 2021 and the CEO of Leming.ton decides to retire. They receive from the company
a retirement bonus of £105,000. They decide to use these funds to buy a Tesla. Specifically, they plan
to buy the Tesla (which costs exactly as much as the retirement bonus, i.e. £105,000) through a 20-
years fixed rate mortgage loan with equal monthly instalments starting next month, January 2022.
What is the amount of each individual monthly payment the CEO will make to buy the car, assuming
that the annual r = 5%?
(25%)

Continued…


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IB1320_C
Question C2

On March 23, 2021, Pfizer announced that it aims to expand its vaccine business by becoming a leader
in the new gene-based technology behind its successful Covid-19 shots. The following is a
hypothetical scenario. Suppose the company undertakes a research and development project and uses
the technology called mRNA to target other viruses and pathogens beyond the coronavirus.

The project costs $500 million immediately and will generate a payoff of $ 1 billion next year if things
go well, which happens with (65%+x%) probability. Note that x is the last digit of your student ID
number. If things turn out not to work, however, the project will not generate any cash flows. The
appropriate before-tax cost of capital for this project is 20% per year. The company has to pay taxes on
the profit of this project at the rate of 21% (this low tax rate is a result of the US tax reform legislation
enacted on 22 December 2017, i.e., P.L. 115-97), and the relevant marginal income tax rate of a
representative investor of Pfizer is regarded as 30%.

(i) Assuming that the project is 100% equity financed, calculate the net present value (NPV) of the
project.

(25%)

(ii) Assuming that the project is 100% equity financed, and the inflation rate is expected to be 3% for
the year. What is the NPV of the project?
(15%)


(iii) Assume now that the firm finances the project by a 1-year debt of $200M at an annual interest rate
of 9%, and the remainder with equity. Assume there is no inflation. By the end of the year, the firm
needs to pay the interest on the debt, but can defer the debt principal repayment until later (so you
don’t need to worry about the cash flow of debt principal in your calculation). Calculate the NPV of
the project using the Adjusted Present Value (APV) method under this alternative capital structure.

(25%)

(iv) Suppose you find that Pfizer has a debt-equity ratio of 3:2 (in terms of their values). The
company’s equity beta is 0.62 and debt beta is 0.05, what other information do you need in order to
calculate Pfizer’s adjusted weighted average cost of capital (AWACC)? How will you do the
calculation? How can this AWACC be used for capital budgeting decisions of Pfizer?

(15%)

(v) An investor bought 100 shares of Pfizer’s common stock before the Covid-19 pandemic, say on
November 11, 2019 when the bid price was $35.37/share and the difference between bid price and ask
price was $0.1/share. She then sold all the shares after the announcement of its vaccine news on
November 30, 2020 when the ask price was $41.01/share and the difference between bid and ask
prices was $0.1/share. Pfizer had issued one dividend of $0.4/share during this period. What was the
investor’s after-tax profits, if she faces a capital gains tax rate of 15% and a dividend tax rate of 30%?

(20%)


Continued…


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IB1320_C
Question C3
According to Execucomp (a comprehensive dataset on US public companies’ executive
compensation), Tesla is one of the top three companies in the US when it comes to the value of stock
options granted to executives/directors since 2017. In the 2020 proxy statement (form DEF14A) of
Tesla, Inc. that was issued in May 2020, it was mentioned (with slight modification) that:

“The 2018 CEO Performance Award (to Elon Musk) is comprised of a 10-year maximum term stock
option to purchase 20,264,040 shares of Tesla’s common stock, divided equally among 12 separate
tranches that are each equivalent to 1% of the issued and outstanding shares of Tesla’s common stock
at the time of grant, at an exercise price of $350 per share. Each of the 12 vesting tranches of the 2018
CEO Performance Award vests upon certification by the Board that both (i) the market capitalization
milestone for such tranche, which begins at $100 billion for the first tranche and increases by
increments of $50 billion thereafter, and (ii) any one of the 8 pre-specified operational milestones
focused on revenue or 8 operational milestones focused on profitability, has been met.”

In order to value Mr. Musk’s first tranche of the stock option, you collected some data. Yahoo
Finance shows that at the time of granting the options, the price of Tesla’s common stocks was
$70/share. Your friend reminded you that there was a stock split later in 2020 and suspected the price
on Yahoo Finance had been adjusted ex-post to reflect that stock split. Indeed, you dug further and
found out that the stock option was actually granted at-the-money. Now suppose at the time of option
granting, the first vesting period was expected to be 2 years, the standard deviation of the stock return
was estimated as 50%, risk free rate was 3%, the annual growth rate of the stock return was thought to
be 20%, no dividend was expected.

Please answer the following questions:

[Hint: Here is the Black-Scholes formula with discrete compounding: call option value = ×
(1) − () × (2), where 1 =
(

()
)
√
+
√
2
, and 2 = 1 − √.

From the normal distribution table, you gathered that (0.4372) = 0.6690,(−0.2699) = 0.3936,
(0.4366) = 0.6688,(−0.2734) = 0.3923, (0.3762) = 0.6466,(−0.3309) = 0.3704,
(0.2983) = 0.6173,(−0.4088) = 0.3413. You can pick the relevant ones that are closest to your
calculation.]

(i) With the 2018 Performance Award, did Elon Musk get a put option or a call option? Was he the
writer of the option? When is the expiration date of the option? Is this an American option or a
European option? (25%)
(ii) By the Black-Scholes formula (using discrete compounding), what’s the value of the first tranche
of the stock option when it was granted? If you had used the stock price shown by Yahoo Finance, will
you over-estimate or under-estimate the value of Mr. Musk’s stock option? (30%)
(iii) Given what you obtained in (a), apply the put-call parity to get the value of a put option with the
10 shares of Tesla’s common stock as the underlying asset. What’s the strike price of this put option?
What’s the expiration date of this put option? (25%)
(iv) In no more than 5 lines, discuss differences and similarities of options and futures. (20%)

End of Paper