MSIN0001 Corporate Finance Sample Paper: Detailed Solutions & Analysis

This document presents solutions to a Corporate Finance sample paper, covering topics such as Capital Asset Pricing Model (CAPM), Net Present Value (NPV), Black-Scholes model, and debt/equity valuation. The solutions include calculations for expected returns, portfolio standard deviation, firm valuation under different scenarios, and analysis of investment decisions. The paper also examines the impact of leverage, the implications of investment choices on debt and equity holders, and the calculation of credit default swap premiums. Project A is recommended based on NPV calculations.

MSIN0001 Corporate Finance
Sample paper

TABLE OF CONTENTS
QUESTION 1...................................................................................................................................3
A..................................................................................................................................................3
B..................................................................................................................................................3
C..................................................................................................................................................3
D..................................................................................................................................................4
QUESTION 2...................................................................................................................................4
A..................................................................................................................................................4
B..................................................................................................................................................4
C..................................................................................................................................................5
D..................................................................................................................................................5
QUESTION 3...................................................................................................................................5
A..................................................................................................................................................5
B..................................................................................................................................................5
C..................................................................................................................................................7
D..................................................................................................................................................7
QUESTION 4...................................................................................................................................7
A..................................................................................................................................................7
B..................................................................................................................................................7
C..................................................................................................................................................7
D..................................................................................................................................................8

QUESTION 1
A
Beta = (30% / 20%) * 0.4
= 1.5 * 0.4
= 0.6
B
Expected return of stock A
Capital assets pricing model
Particulars Formula Figures
Rf (Risk free rate) 4%
Beta 0.6
Rm (market return) 10%
CAPM Rf + Beta (Rm - Rf) 7.6%
C
Expected return of portfolio
investment Weight probability
Expected
return
Risk free asset 300 30% 4% 0.012
Stock A 400 40% 7.60% 0.0304
Market portfolio 300 30% 10% 0.03
0.0724
Expected return of the
portfolio 7.24
Portfolio Standard Deviation
Weight of risk free asset 0.30
Standard deviation of risk free asset 20.00%
Weight of stock A 0.40
Standard Deviation of stock A 30.00%
Correlation between THE THREE 0.40
weight of market portfolio 0.3
Standard Deviation of market portfolio 30.00%

Portfolio Standard Deviation 15.41%
D
investment Weight Probability
Expected
return
Risk free asset 500 15% 4% 0.006
Stock A 400 25% 7.60% 0.019
Market portfolio 100 60% 10% 0.06
0.085
Expected return of the
portfolio 8.5
In case the securities will be divided in the above proportion then the expected return of
the portfolio will be 8.5 %. The volatility of the project will be high as majority of investment is
done in the option which is having higher return. The higher the return, the more will be the
volatility.
QUESTION 2
A
The current market value of equity
= (0.8 * 50) + (0.2 * 20)
= 40 + 4
= 44
E = 44/ 1.10
= 40million
B
In case debt has face value of 20 million then
D= 20/1.05
= 19.05
E= 40 – 19.05
= 20.95 million
C
Without leverage

R= (44/ 40)- 1 = 10%
With leverage
R= [(44 – 20)/ 20.952] – 1
= 14.55 %
D
Without leverage
R= 20/ 40-1
= -50%
With leverage
R= (0/20.952)- 1
= -100%
QUESTION 3
A
Calculation of Value of the firm at t = 0
Cash Flows at t = 1 Probability Expected cash flow
£200 0.5 £100 million
£100 0.5 £50 million
Total Value of firm (note) £150 million
Note* the total value of firm at t=1 is same as at t=0 it is because the discount rate for all cash
flows is zero.
Calculation of value of the firm’s debt at t = 0
Face value of debt at t = 0 is £150 million
Calculation of value of the firm’s equity at t = 0
Total value of firm at t = 0 – debt value at t = 0
= £150 million - £150 million = 0
B
Calculation of value of firm on both Project A and Project B as per NPV criteria
Project A
The cash flow will increase by £40 million

Cash Flows at t = 1 Probability Expected cash flow
£240 0.5 £120 million
£140 0.5 £70 million
Total Value of firm (note) £190 million
Project B
Scenario 1 If cash flow increase by £50 million
Cash Flows at t = 1 Probability Expected cash flow
£250 0.5 £125 million
£150 0.5 £75 million
Total Value of firm (note) £200 million
Scenario 2 If cash flow decreases by £50 million
Cash Flows at t = 1 Probability Expected cash flow
£150 0.5 £75 million
£50 0.5 £25 million
Total Value of firm (note) £100 million
Note* the total value of firm at t=1 is same as at t=0 it is because the discount rate for all
cash flows is zero.
On the basis of above calculation, it can be state that the initial investment of £30 million
will definitely result into the increase in firm value if the company will select Project A. If the
company will select Project A than its firm value increase by £40 million. But, if the company
invest in Project B over the chance of increase in firm value by £50 million but also there is a
chance of decrease in firm value by £50 million. So, on this basis, it is advisable to manager that
they should opt for Project A as there is no chance of decrease in firm value.
If the company select Project A, then the value of equity is as follows:
Total value of firm at t = 0 – debt value at t = 0
= £190 - £150 = £40 million.
So, on this basis it can be said that shareholders are willing to provide £30 million for the
investment in Project A by contributing equity capital.

C
Yes, the existing debtholder must agree to waive the seniority of covenant because, the
project A is safe and this will result in earning more profit. Hence, the firm can issue the new
debt of 30 to finance the project.
D
In case the company makes the decision of invest in interest of equity holder then this will
be affecting the debtholders. The existing debtholders will not be willing to waive the seniority
covenant as they might lose the power within the company and this can affect their positon as
well.
QUESTION 4
A
Black-Scholes
V spot
price
100
million
D (strike
price)
70
million
r 0.04
T 8
σ 0.3
Equity
Value
53.81
million
B
Debt value
= total value – equity value
= 100 – 53.81
= 46.19
C
Yield to maturity= 17.709
D
The credit default swap is purchased and the premium is calculated as follows-
In year 5, the debt value is 46.19 and CDS is purchased then the premium will be

= 46.19 * 2%
= 0.9238