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UNIVERSITY OF MAURITIUS

FACULTY OF LAW AND MANAGEMENT

SECOND SEMESTER EXAMINATIONS DATE

BSc (HONS) BUSINESS STUDIES – TUESDAY


LEVEL IV 29 MAY 2007

BSc (HONS) FINANCE – LEVEL III

BSc (HONS) FINANCIAL SERVICES – LEVEL I

SERIES MODULE TIME

MAY 2007 PRINCIPLES OF FINANCE 13:30 – 15:30 HRS

[ACF 1002 (1)]

INSTRUCTIONS TO CANDIDATES

TIME ALLOWED : 2 HOURS


NO. OF QUESTIONS SET : SIX (6)
NO. OF QUESTIONS TO BE ATTEMPTED : FOUR (4) -
SECTION A IS COMPULSORY, ANY TWO (2) QUESTIONS FROM
SECTION B AND ANY ONE (1) QUESTION FROM SECTION C

USE SEPARATE ANSWER BOOKS FOR EACH SECTION.


SECTION A (COMPULSORY)
USE SEPARATE ANSWER BOOKS FOR EACH SECTION.

Question 1 [30 marks]

Part I

An investor is considering acquiring shares from Plum Company and Widget


Company. The stocks of the two companies have the following possible returns :

Plum Company

Possible Rate of Return Probability


-0.1 0.1
-0.05 0.05
0.1 0.2
0.2 0.65

Widget Company
Possible Rate of Return Probability
-0.9 0.1
-0.4 0.05
-0.3875 0.2
0.5 0.65

(i) Calculate the expected rates of return of the stocks of Plum Company and
Widget Company. [2 marks]

(ii) Without doing any calculations, explain which of the two stocks is riskier.
[5 marks]

(iii) Calculate the standard deviations of the stocks of Plum Company and
Widget Company. [5 marks]

(iv) A rational investor will buy stocks from Plum Company or Widget
Company? Explain. [3 marks]

Part II

An investor must choose between the following portfolios: Portfolio I and


Portfolio II

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Portfolio I

Weights (Wi) Expected Rate of Standard


Assets Return (%) Deviation (%)
Stock A 0.25 20 30
Stock B 0.75 12 15

Portfolio II

Weights (Wi) Expected Rate of Standard Deviation


Assets Return (%) (%)
Stock C 0.75 12 15
Stock D 0.25 20 30

The correlation coefficient between the returns of stocks A and B (rAB) is equal to
-0.5 and the correlation coefficient between the returns of stocks C and D (rCD) is
equal to -1.

(i) Without doing any calculations, by analyzing the data that has been
provided for the two portfolios, which portfolio among portfolios I and II
should have the lowest level of risk? [5 marks]

(ii) Calculate the expected rate of return of portfolios I and II. [2 marks]

(iii) Calculate the standard deviations of portfolios I and II. [5 marks]

(iv) By using the answers obtained in sections (i) and (ii), explain which
portfolio a rational investor would choose. [3 marks]

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SECTION B
USE SEPARATE ANSWER BOOKS FOR EACH SECTION.

Answer ANY TWO (2) questions from section B

Question 2 [20 marks]

Part I

An investor is looking for a four-year investment. One share of common stock of


ABC Company is selling for Rs75. The company plans to pay a dividend of Rs7.50
per share each at the end of first and second years and Rs9 and Rs15 respectively
at the end of third and fourth years. The rate of return is equal to 12% and the
share’s price at the end of fourth year is Rs70.

(i) Calculate the value of one share of common stock. [6 marks]

(ii) Would this be a desirable investment? [2 marks]

Part II

A prospective investor is evaluating the shares of common stock of Automobiles


Company. He is considering the following two scenarios :

- First scenario : the company will increase its dividend payment by a


constant rate of 4% indefinitely.

- Second scenario : the dividend will grow at a high rate of 12% per year
for the first three years; a medium rate of 7% for the next three years and
then at a constant rate of 4% indefinitely.

The last year’s dividend per share is Rs3 and the current market price of the share
is Rs60. The investor’s required rate of return is equal to 10%.

(i) Calculate the value of the share under the first scenario. [3 marks]

(ii) Calculate the value of the share under the second scenario. [6 marks]

(iii) By considering the two scenarios, explain under which scenario the
investor would be willing to buy the shares of Automobile Company.
[3 marks]

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Question 3 [20 marks]

(i) An individual has bought a zero-coupon bond that has a maturity of three
years. At maturity date the bondholder obtains a repayment of Rs1000. If
the yield to maturity of the bond is equal to 9%, calculate the price of the
bond. [4 marks]

(ii) Advice Company has issued a bond with annual coupon rate equal to 8%
and the fixed-interest bond offers a semi-annual coupon payment equal to
Rs40. The bond has a maturity of 3 years.

- Calculate the actual value of the bond if the market interest rate is
equal to 8.4%. [8 marks]

- If the market price of the bond were equal to Rs1000, would a


rational investor buy the bond? [3 marks]

(iii) A bond has nominal value of Rs100; it pays a coupon rate of 5% and has a
maturity of 2 years. If the market price of the bond is equal to Rs98 and it is
assumed that the bond is fairly priced, calculate the yield to maturity of the
bond. [5 marks]

Question 4 [20 marks]

(i) A company is considering a capital expenditure that requires an initial


investment of Rs 22000 and cash inflows would be equal to Rs 7000 per year
for 5 years. The company has a cutoff year of 3 years.

- Determine the payback period for this project. [3 marks]

- Will the company accept the project? Explain the decision taken by
the company. [3 marks]

(ii) If the cost of capital (market rate of return) is equal to 16%;

- Calculate the IRR of the project. [6 marks]

- By comparing the cost of capital with the IRR (rate of return of the
project), determine whether the company will accept the project.
Explain the decision taken by the company. [3 marks]

(iii) Compare the answers obtained in sections (i) and (ii) of this question;
which of the two investment appraisal methods will enable the company to
take a better investment decision? Explain why. [5 marks]

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SECTION C

USE SEPARATE ANSWER BOOKS FOR EACH SECTION

Answer ANY ONE (1) question from Section C

Question 5 [15 marks]

(i) “Financial market is efficient if the market prices fully reflect all available
information at all instants.” (Fama 1970)
Explain what you understand from the above quotation. [7 marks]

(ii) Give two forms of market efficiency and for each form of market efficiency,
give a test that can be used to verify the particular form of market
efficiency. [8 marks]

Question 6 [15 marks]

(i) Explain the difference between direct finance and financial intermediation.
[3 marks]

(ii) What are the two main categories of securities that are exchanged in capital
markets? [2 marks]

(iii) For each category of security, give two examples of securities found in each
category. [4 marks]

(iv) Give the general characteristics possessed by the securities found in the two
categories. [6 marks]

- END OF QUESTION PAPER -

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