FN1202
FN1202 Introduction to Finance (October 2023)
Candidates should answer all 5 questions, each worth 20 marks. Students
should consider the most reasonable interpretation given the material covered
in the course. If anything is unclear then students should make additional
assumptions they deem necessary and state them clearly. Clarification
questions will not be answered.
Please find questions on the following page.
© University of London 2023 Page 1 of 4
Question 1
(Total = 20 marks)
Consider the information on table 1 for bond A, B and C. Coupon payments are
annual and there is no risk of default.
Table 1
Bond Face Value Coupon rate Maturity YTM (%)
(years)
A $1000 2% 1 2%
B $1000 2% 2 4%
C $1000 2% 3 6%
a) Compute the prices of bonds A, B and C. (4 marks)
b) Are these bonds trading at a discount, at a premium or at par? Briefly explain
why. (3 marks)
c) Derive the one-, two- and three-year spot interest rates in the economy. (6
marks)
d) Now assume there is a risk-free 1% coupon (Bond D) with 2 years maturity and
face value equal to $1000. Bond D is currently trading in the market for $940.
Is there an arbitrage opportunity? If yes, clearly detail the arbitrage strategy and
show all resultant cash flows. Use four decimal places and ignore the rounding
effects. (7 marks)
Question 2
(Total = 20 marks)
Consider the Binomial Option Pricing Model. The current price of the stock is $80. For
the next period, the stock will either move up by 10% or down by 10%. The risk-free
interest rate for this period is 5%. Consider an at-the-money European put option.
Assume there are no dividends.
a) What is the risk-neutral probability of a rise in the share price? And of a fall?
(5 marks)
b) What is the strike price of this option? (3 marks)
c) Using the risk-neutral method, price this option. (6 marks)
d) Would your answer to item c) possibly change if the put option was
American? Why? (6 marks)
Page 2 of 4
Question 3
(Total = 20 marks)
Assume the CAPM holds. Consider the annual information on table 2. The annual
risk-free rate of 2%. The market standard deviation is 15%.
Table 2
Expected Return Standard deviation
Stock A 7% 50%
Stock B 5% 40%
a) Stock A is expected to pay no dividends for the next 3 years. In year 4, it is
expected to pay $5 per year every year. Stock B is expected to pay a dividend
of $2 next year growing at 1% per year. Compute the price of the 2 stocks today.
(5 marks)
b) Stock A has a beta of 1.2, what is the beta of stock B? (5 marks)
c) What portfolio delivers the lowest possible standard deviation for an investor
who requires an expected return of 7%? What is the standard deviation of this
portfolio? Compare it with Stock A’s standard deviation. (7 marks)
d) Compute the non-arbitrage price of a forward contract to deliver stock A in 2
years. (3 marks)
Question 4
(Total = 20 marks)
Company XYZ currently has 100 million shares of stock outstanding at a price of $25
per share. The company would like to raise money and has announced a rights issue.
One new share can be purchased for every twenty shares existing shareholders own.
The share price under this rights issue is $20 per share.
a) If all rights are exercised, what is the number of new shares issued? (3
marks)
b) How much money will the company raise? (3 marks)
c) What is the expected share price after the issue? What is the value of the
right to purchase one share? (7 marks)
d) Suppose the company now decides to issue the new stock at $18 instead of
$20 per share. How many new shares would it have needed to sell to raise
the same sum of money as in item b)? What would be the new expected
share price now? (7 marks)
Page 3 of 4
Question 5
(Total = 20 marks)
Company ABC has 100 shares at a price of $6 each and a firm value of $1,000. Its
equity cost of capital is 10% and its debt cost of capital is 5%. The corporate tax rate
is 33%. ABC considers a new project with expected free cash flows as in table 3.
Table 3
Year 0 1 2 3
FCF -100 40 90 50
The project has average risk and ABC plans to maintain a constant debt-equity ratio.
a) Calculate ABC’s WACC and the value of the project according to the WACC
method. Determine the NPV of the project. (6 marks)
b) Calculate ABC’s unlevered cost of capital and the unlevered value of the
project. (3 marks)
c) Determine the total value of ABC’s debt and equity at time zero right after
announcing, financing, and investing in the new project. (7 marks)
d) Assume the company had not planned to maintain a constant debt-equity
ratio, and instead, had just decided to finance the entire project with
permanent debt. How would you compute the present value of the interest tax
shield coming from this project? Assume same debt cost of capital as before.
(4 marks)
END OF PAPER
Page 4 of 4
