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IB1320
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
IMPORTANT INFORMATION
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within 2 hours (+45 minutes upload/download time)
If you are unable to submit your assessment, you can record Mitigating Circumstances
and the Board of Examiners will consider your case
Students with approved Alternative Exam Arrangements (Reasonable Adjustments) that
permit extra time and/or rest breaks will have this time added on to the stated duration
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Your assessment starts below.
Page 4 of 10
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)
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…
