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SECTION 1: TRUE OR FALSE QUESTIONS (15 MARKS)
This section consists of THREE (3) compulsory questions. This section is worth
FIFTEEN (15) marks.
There are 3 questions, each question is worth 5 marks.
You need to justify your answers in your own words (and without formulas). For each
question, you will get:
 1 mark for the correct answer (i.e. true or false).
 Up to 4 additional marks, depending on the quality of your justification (a short
and precise justification is better than a long and vague one).
Please type your answers and do not use more than 50 words per justification.
1.1 If the interest rate is fixed at 2% per year for 35 years, the future value (i.e. at the
end of the 35 years) of £100, including compounded interests, is approximately
£200.
[5 marks]
1.2 Buying an annuity (with a first payment in a year and a final payment in 10 years)
corresponds to buying a corresponding perpetuity (with the same first payment in
a year) and selling an equivalent perpetuity with a first payment in 11 years.
[5 marks]
1.3 Depreciation rules affect free cash flows through their impact on taxable income.
[5 marks]
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SECTION 2: COMPULSORY QUESTIONS (25 MARKS)
This section consists of TWO (2) compulsory questions. Candidates should attempt
ALL parts of the question. This section is worth TWENTY FIVE (25) marks.
2.1. Due to the Covid-19 crisis, the UK Government, like many others, has offered to
firms a series of “bailout packages”. For instance, the UK Government has:
 offered to pay a large fraction of the wage of employees that would be
furloughed (i.e. would stay with the company, but would not work for a given
period of time);
 provided guarantees to banks extending new credit to firms (thereby allowing
these firms to borrow at a much lower interest rate than otherwise).
However, this government help was subject to some restrictions. For instance,
firms benefitting from such help were banned from paying dividends to
shareholders or from giving bonuses to their executives.
Given what you have learned in class, explain in your own words why, from a
corporate finance perspective, the Government may want to:
i) help struggling companies in such ways;
ii) impose such restrictions.
Please type your answer and use no more than 250 words.
[15 marks]
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2.2 Consider a 10-year amortizing loan taken 1 year ago. The loan has a 2.80% APR
with monthly compounding and monthly payments of £100. What was the present
value of the loan when it was taken? What is the remaining balance after 5 years?
[10 marks]
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SECTION 3: CAPITAL STRUCTURE AND SECURITY VALUATION (30 MARKS)
This section consists of THREE (3) compulsory questions. Candidates should attempt
ALL parts of the question. This section is worth THIRTY (30) marks.
You are an entrepreneur with an investment opportunity. This is a project that lasts 1
year. The initial investment is £1,500. This investment generates the following final
cash flows:
 If the economy is strong, which occurs with 40% probability: £2,500.
 If the economy is neutral, which occurs with 40% probability: £1,550.
 If the economy is weak, which occurs with 20% probability: £600.
The risk-free rate is 5%, and the risk premium associated with such cash flows is 10%
(note: this is exclusively systematic risk). Financial markets are competitive.
Questions
3.1 If you fully finance this opportunity with your own money, what is the expected
rate of return? What is the NPV?
[5 marks]
3.2 Knowing that, at the beginning of the year, the price of the Arrow security that
promises to pay £1 when the economy is neutral (and 0 otherwise) is £0.39, what is
the price of the other two Arrow securities.
[10 marks]
3.3 Now, assume you finance this investment by raising money from other
investors. Namely, you raise £800 with bonds and the rest (£700) with equity. What
is the minimum interest rate that you need to promise investors in order for them to
buy your bonds? Accordingly, what percentage of shares can you retain in the
company, and what is the market value of your retained shares?
[15 marks]
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SECTION 4: CAPITAL STRUCTURE PROBLEM WITH FRICTIONS (30 MARKS)
This section consists of THREE (3) compulsory questions. Candidates should attempt
ALL parts of the question. This section is worth THIRTY (30) marks.
Consider a firm in the following environment:
 There is only 1 period and there are two 2 states (H and L) equally probable.
 There is no tax, there are no bankruptcy costs, and risk is diversifiable.
 The current risk-free interest rate is equal to 0 (to simplify computations).
Initially, the firm has;
 C in cash;
 an existing project with cash flows (at the end of the period) equal to X (in state
H) or 0 (in state L);
 debt with face value D, which will mature at the end of the year, and will require
a payment (interest included) of D(1+r) < X, where r>0 is the interest rate;
 equity with book value 20.
There is a risky investment opportunity: Investing I, gives a payoff at date 2 of WH (in
state H) or WL (in state L), with WH > WL.
The firm is run in the best interest of its shareholders.
Questions:
4.1 First, assume I = C. What is the best use of its cash for the firm? Pay a dividend
of C or invest it in the opportunity? Is it necessary, for the firm to prefer to invest, that
the investment opportunity has a positive NPV? Is it sufficient? Is it both necessary
and sufficient? Does the firm decision benefit debtholders?
[15 marks]
4.2 Second, assume instead that C=0, I = 1, and WL < D. Furthermore, assume that
existing debt is protected by a covenant stipulating that the firm cannot issue more
debt. So, the only way for the firm to invest in the opportunity is to raise more equity
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from the shareholders. Does the firm want to do so? Explain the economic mechanism
behind the result.
[10 marks]
4.3 Would your answer to the second question be different if the interest rate on
existing debt (that is, r), was renegotiable?
[5 marks]
END OF PAPER
MSIN0149 2019/20