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THE UNIVERSITY OF HONG KONG

Faculty of Business & Economics
2021-2022 2nd Semester Examination

Finance: FINA1310 F/G/H/I/J/K/L

Corporate Finance
Sub-class F/G/H: Dr MZ Tai
Sub-class I/J: Dr SY Huang
Sub-class K/L: Dr J Zhang

May 13, 2022 6:30 pm - 8:30 pm

This is a close-book exam. Only approved calculators as announced by the Examinations

Secretary can be used in this examination. It is candidates’ responsibility to ensure that
their calculator operates satisfactorily, and candidates must record the name and type of
the calculator used on the front page of the examination script.

The exam has two parts. Part I is MC questions, containing 12

questions. Part II is short answer questions, containing 4 questions.

Please finish all questions and HAND WRITE your answers clearly
using black or blue ink. You are responsible for scanning your work
clearly and uploading your answers within the time allowed.

You should finish your work within the 2-hour exam period and you are
NOT allowed to continue to work on your answers after 8:30PM.

Good luck!

University Number: ________________________

Subclass: _________________________________

Name and type of calculator: _________________

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Part I: Multiple Choice Questions. (1.5 points each for Question 1-10, 2.5 points for
Question 11-12. 20 points in total.) Please input your answer in the table below.

Please select ONE BEST choice from the choices given. For numerical questions,
please select the closest answer if you cannot find the exact answer.

Q1 Q2 Q3 Q4 Q5 Q6

Q7 Q8 Q9 Q10 Q11 Q12

1. Which of the following arguments are CORRECT?

I. Andy is the owner of a sole proprietorship. This year the business goes bankrupt.
Creditors take away all business assets but cannot take Andy’s personal assets.
II. Bob is a general partner of a partnership business. This year the business goes
bankrupt. Creditors take away all business assets but cannot take Bob’s personal assets.
III. A limited liability partnership has tax advantage compared to a corporation.
IV. A corporation can have an infinitely long life.

A. I and III only

B. I and IV only
C. II and III only
D. II and IV only
E. III and IV only

2. Which one of the following statements about the agency problem are INCORRECT?

I. A corporation might face more severe agency problems if the CEO holds a larger share
of the corporation’s equity.
II. A corporation might face more severe agency problems if the CEO receives a fixed
compensation package every year.
III. The CEO decides to terminate an on-going project that costs $100 million to initiate 5
years ago. The project generates $10 million cash flow over each of the past 5 years and
is expected to generate $10 million cash flow over each of the next 5 years. The discount
rate is 10%. This investment decision might reveal agency conflicts between the CEO
and the shareholders.
IV. The CEO decides to open a new factory overseas. The factory is expected to have a
15% internal rate of return and its beta is 1.5. The market expected return is 10% and
risk-free rate is 2%. This investment decision might reveal agency conflicts between the
CEO and the shareholders.

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A. I and III only

B. II and III only
C. I and IV only
D. II and IV only
E. III and IV only

3. Sally would like to save money every year for retirement in 30 years. She plans to
start by depositing $1,000 next month in an account that pays 6% annual percentage rate.
Afterwards, the amount of her deposit will grow by 0.5% each month. Which of the
following will increase the total amount of savings she can have at retirement?

I. Deposit a constant amount of $2,000 every month

II. Deposit $1,500 in the first month and the savings grows by 0.2% each month
III. Deposit $800 in the first month and the savings grows by 0.65% each month
IV. Deposit in a different account that pays 6.2% effective annual rate.

A. I and II only
B. I and III only
C. II and III only
D. II and IV only
E. III and IV only

4. Which of the following are CORRECT about risks in the capital market?

I. The US Federal Reserve Bank just announced a 0.5% interest rate increase. This
impacts the systematic risk in the US capital market.
II. The Heng Seng Index has a higher variance recently. This means the unsystematic risk
is higher in the Hong Kong capital market.
III. Two stocks are traded in the Hong Kong Stock Exchange. Stock A’s return comoves
with the Heng Seng Index more closely than Stock B. Stock A has a higher systematic
risk.
IV. Two stocks are traded in the Hong Kong Stock Exchange. Stock A’s return comoves
with the Heng Seng Index more closely than Stock B. Stock A has a higher unsystematic
risk.

A. I and III only

B. I and IV only
C. II and III only
D. II and IV only
E. I and II only

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5. Which of the following statements are CORRECT concerning a portfolio?

I. The portfolio weight of an asset is a percentage term between 0% and 100%.

II. A portfolio’s standard deviation is the weighted average of the standard deviations of
the individual securities contained in the portfolio.
III. A portfolio’s beta is the weighted average of the betas of the individual securities
contained in the portfolio.
IV. A portfolio’s beta cannot be higher than the highest beta of assets in this portfolio.

A. I and II only
B. II and IV only
C. III and IV only
D. III only
E. IV only

6. Which of the following statements about the efficient market hypothesis are
CORRECT?

I. Under the strong form efficient market hypothesis, a star fund manager cannot make
positive NPV investment in an efficient market by doing fundamental analysis.
II. Under the strong form efficient market hypothesis, a star fund manager can make
positive NPV investment in an efficient market if she knows inside information.
III. Under the weak form efficient market hypothesis, an individual investor can make
positive NPV investment in an efficient market if she knows inside information.
IV. Under the weak form efficient market hypothesis, an individual investor cannot make
positive NPV investment in an efficient market by doing fundamental analysis.

A. I and III only

B. I and IV only
C. II and III only
D. II and IV only
E. IV only

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7. SolarGreen just started a project to produce and sell solar panels at a unit price of
$1,000 over the next ten years. The variable cost is $600 per panel and the fixed cost is
$100,000 each year. The initial investment on this project is $500,000 with straight-line
depreciation, and the tax life of the fixed assets ends at the end of the project. The project
needs $50,000 net working capital every year. The tax rate is 40% and the required return
is 15%. What is the accounting and cash breakeven of this project?

A. 250, 167
B. 375, 167
C. 250, 125
D. 375, 125
E. 250, 375

8. You are considering the following three independent projects. The required rate of
return is 15 percent for all projects and the required payback period is 2 years. Which of
the following statements are CORRECT?

Year Project A Project B Project C

0 -$50,000 -$50,000 -$100,000
1 20,000 30,000 40,000
2 20,000 25,000 50,000
3 40,000 20,000 55,000

I. Under the NPV rule, you should take Project A.

II. Under the payback rule, you should take project B.
III. If you only have $100,000 budget, you should take project C.
IV. If you only have $100,000 budget, you should take project A and B.

A. I and III only

B. I and IV only
C. II and III only
D. II and IV only
E. I and II only

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9. Nelson Mfg. owns a factory that is currently sitting idle. The factory originally costed
the firm $1,600,000 to build ten years ago. It has a 20-year tax life and depreciates in a
straight-line basis. The firm received an offer of $1,200,000 for the factory last week. The
firm's management rejected this bid even though they were told that it is a reasonable
offer in today's market. The firm is evaluating a potential project that will use the factory.
In addition, the project will also need the firm spend $500,000 to purchase and assemble
a new production line in the factory. What is the initial cost of this project?

A. $2,100,000
B. $1,700,000
C. $1,600,000
D. $1,300,000
E. $1,200,000

10. Reddit is considering going public through IPO. The firm would like to sell 50
million shares and use Morgan Stanley as the underwriter. Morgan Stanley plans to
purchase the 50 million shares at $14 per share. The bank expects these shares could be
sold to the public market at $16 per share. What type of underwriting does Morgan
Stanley uses for this deal?

A. Firm commitment
B. Dutch auction
C. Best efforts
D. Private placement
E. Over-subscription

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11. John took a 30-year mortgage of $1 million five years ago. The mortgage requires
monthly fixed equal payment with 6% interest rate. This year, John heard that his friend
just took a new mortgage loan with only 4.5% interest rate from another bank. After
knowing this, John decides to refinance his old mortgage. This means, he is going to
make a lump sum payment to fully pay back the remaining balance of his old mortgage,
and this lump sum payment is financed by a new, 25-year mortgage with fixed equal
payment but only 4.5% interest rate. How much does John pay each month for the new
mortgage?

A. $5,995.51
B. $5,902.28
C. $5,172.26
D. $5,066.85
E. $4,631.94

12. Kate would like to borrow $50,000 for five years and she is comparing two loan
contracts. Contract A requires fixed equal monthly payment, with 9% interest rate at
reducing balance basis (that is to say, every month the interest payment is only based on
the remaining principal balance). Contract B requires fixed equal quarterly payment, with
8% interest rate at annual flat basis (that is to say, the payment each quarter equals to
$50,000/N+$50,000*r, where N is the number of payments and r is the quarterly interest
rate). What is the effective annual interest rate under each of these two contracts?

A. 9.38%; 8.24%
B. 9.38%; 14.50%
C. 9.38%; 15.08%
D. 9.31%; 8.24%
E. 9.31%; 15.08%

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Part II: Short Answer Questions. (There are 4 questions and a total of 80 points)
Unless otherwise stated, please keep 2 decimal points for your answers.

Q1. (16 points)

You are interested in making some investment in stocks of US companies. Your financial
advisor recommended three stocks: Airbnb, Microsoft, and Tesla. She provides you
information about each of these stocks using the following security market line plot:

The current market price per share for each of these three stocks is $150 (Airbnb), $300
(Microsoft), and $1,000 (Tesla). You believe the US stock market is efficient and all
CAPM assumptions hold in this market.

a. (4 Points) What is the expected return of SP500 index and the 3-month treasury
bill? (Hint: the SP500 index is considered the market portfolio. The 3-month
treasury bill is considered the risk-free asset.)
b. (2 Points) What is the expected return of Tesla?
c. (5 Points) You would like to hold a portfolio that include 40 shares of Airbnb, 200
shares of Microsoft, and also some shares of Tesla. How many shares of Tesla do
you need to hold if you want the portfolio to have the same systematic risk as the
SP500 index?

Your financial advisor also suggests you to consider the stock of Bank of America, which
is currently sold at $40 per share. The company is expected to pay $2.4 dividend next
year and you expect the dividend payment will grow every year at a constant rate of 3%.
You also believe Bank of America has the same systematic risk as Microsoft.

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d. (3 Points) Is Bank of America below or above the security market line? Do you
think it is a good idea to invest in Bank of America?
e. (2 Points) What should be Bank of America’s dividend growth if you are
indifferent between investing in Microsoft versus Bank of America?

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Q2 (24 points)
Gold Bridge Shipping Ltd. is a Hong Kong shipping company which specializes on
chemical and oil shipments. The company is considering buying a new ship, which can
conduct 8 transits between Hong Kong and the Mideast every year for thirty years once it
starts operation. Each transit is expected to generate a gross revenue of $1.6 million and
costs $1 million. Besides, this ship also incurs a fixed maintenance cost of $400,000
every year. The ship costs $12 million to purchase, and it depreciates at a straight-line
basis over thirty years. At the end of its tax life (thirty years from now), this ship can be
disposed at a market salvage value of $1 million. Every year, the company needs an
amount of net working capital that equals to 5% of the total gross revenue to support the
operation of this ship. The tax rate is 40% and investors’ required return on this shipping
line is 20%.

a. (4 Points) How much operating cash flow do we expect to generate from this ship
every year?
b. (2 Points) What is the after-tax salvage value of this ship thirty years from now?
c. (4 Points) What are the cash flows regarding changes in net working capital? (If
the cash flows are different across years, please specify the value for each
corresponding year.)
d. (4 points) What is the NPV of this ship? Under the NPV rule, should the company
buy this ship?

Now ignore changes in net working capital for the next two questions:

e. (4 points) The ship carries 10,000 barrels of crude oil per transit. Thus, the $1.6
million expected gross revenue per transit is charged based on a unit freight
charge of $160 per barrel. What is the lowest unit freight charge that the company
can accept? (Hint: what is the charge that generates zero NPV?)
f. (6 points) The company’s director, Captain Lau Pong Sze is worried about the
future uncertainties with the unit freight charge and cost per transit. Assume both
the unit freight charge and cost per transit can be higher or lower by 10% than the
expected level. What is the NPV under the worst-case and best-case scenarios?

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Q3 (20 Points)
CoCo Inc. is a conglomerate firm in the United States. Its business covers many sectors,
such as real estate, finance, and hotels. To make sure optimal financial decisions are
made, the CEO, Mr. Richard Cookson wants to better understand the company’s cost of
capital. Currently, CoCo Inc. has 10 million shares of common stocks outstanding,
100,000 grade A corporate bonds, as well as 250,000 grade B+ corporate bonds. The
common stock has a book value of $10 per share and currently sells for $30 per share.
The common stock’s total risk is twice as much as the market portfolio and its systematic
risk is 1.5 times the market portfolio. The grade A bond sells at 90% of its face value,
with semi-annual coupon payment, 10% coupon rate, and 10 years to maturity. The grade
B+ bond sells at 110% of its face value, with annual coupon payment, 20% coupon rate,
and 10 years to maturity. The return of the risk-free asset is 4%. The return of the market
portfolio is 12%. The tax rate is 40%. (The face value is $1,000 for each bond.)

a. (4 Points) What is the CoCo Inc.’s cost of stock and cost of debt?
b. (6 Points) What is CoCo Inc.’s WACC?

Mr. Cookson is evaluating the following two independent projects:

Project X is in the real estate industry and last for three years. It requires an initial
investment of $1.5 million and will generate cash inflows of $0.5 million in each of the
first two years, and $1 million in the last year. Meanwhile, another company that purely
focuses on the very similar real estate business has a beta of 1.
Project Y is in the finance industry. It requires an initial investment of $2 million and will
generate a cash inflow of $0.2 million in each year forever. Another company that purely
focuses on the very similar finance business has a beta of 0.5.

c. (4 Points) What are the IRRs for Projects X and Y?

d. (2 Points) Given the project information and the firm’s WACC, which project
should the company accept and why? (Must provide explanation to get any point.)
e. (4 Points) What are the discounted payback periods for each of these two projects?
What are their profitability indexes?

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Q4. (20 points)

ZeroLeverage Co. is a manufacturing company. It is expected to earn $500,000 EBIT
next year, and the EBIT will grow at a constant rate of 2% forever. It always distributes
all its net earnings as dividends to shareholders. The company faces a 40% corporate tax
rate. ZeroLeverage Co. is so far fully equity financed. There are 100,000 shares of
common stocks outstanding and the stock price per share is $30.

Recently, the CEO of ZeroLeverage Co., Mr. Peter Kyle, attended a Corporate Finance
class. He learned that different capital structure may have some impacts on firm value.
Due to the company’s stable earnings performance and limited debt liability, many
investment banks and financial advisors have approached Mr. Peter Kyle about the
possibility of issuing new bonds.

Mr. Peter Kyle wants to know if it is a good idea to issue additional debt and use the
proceeds to buy back shares. To be specific, Mr. Peter Kyle is thinking about offering
$2.5 million perpetual debt paying 6% interest rate and using the money to buy back
some shares of the outstanding common stocks. Please help him evaluate the following
questions.

For questions (a)-(d), assume there are no bankruptcy costs.

a. (3 Points) What is the WACC of the company now?
b. (3 Points) What is the market value of ZeroLeverage Co. after it issues $2.5
million perpetual bond paying 10% interest rate per year and uses the money to
buy back some shares of common stocks?
c. (6 Points) What is the cost of equity and WACC of ZeroLeverage Co. after it
issues the debt?
d. (5 Points) If ZeroLeverage Co. issues $2.5 million perpetual debt and uses the
money to buy back some shares of common stocks, how many shares of common
stocks could it buy back and what is the new stock price?

e. (3 Points) What are possible relationships between capital structure and firm
value/WACC under the Modigliani-Miller Theorem without corporate tax and
bankruptcy cost, MM theorem with only corporate tax, and MM theorem with
both corporate tax and bankruptcy cost, respectively?

-----------------------------End of Exam Paper --------------------------

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