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FBE 432 - Midterm Examination
March 8, 2001
PRACTICE
Name______________________________________
QUESTIONS
Student No.__________________
PART I - MULTIPLE CHOICE - WRITE YOUR NAME AND MARK BEST ANSWERS ON
SCANTRON.
1. Using market comparables to value firms results in
a.
b.
c.
d.
e.
under-valuation of firms.
over-valuation of firms.
exact valuation of firms.
the worst estimated values.
None of the above.
2. Examples of market comparables used in valuation are all of the following except
a.
b.
c.
d.
e.
price-to-book ratio.
price-earnings ratio.
sales-to-asset ratio.
times-interest-earned ratio.
cash-flow-to-value ratio.
3. As an issuer of a fixed-income debt security who believes interest rates will fall, you could
a. enter swap to receive fixed and pay a variable rate.
b. enter a swap to pay fixed and receive a variable rate.
c. Sell calls.
d. Buy puts.
e. All of the above.
4. Discounted cash flow estimates of value are better because they avoid
a. under-valuation of firms.
b. over-valuation of firms.
c. problems with estimated costs of capital.
d. forecasting errors in estimated values.
e. None of the above.
5. Venture-capital investors expect returns approximately equal to
a.
b.
c.
d.
e.
long-term government bond rate.
CAPM cost of capital.
Treasury bill rate.
average return on equities since 1927.
None of the above.
6. If the risk-free rate is 6 percent, a firm’s beta is 1.5, and the risk-premium is 8 percent, the firm’s cost of
equity is approximately
a. 6 percent.
b. 8 percent.
c. 9 percent.
d. 14 percent.
e. Higher than any of the above rates of return.
7. If the firm in question 6 had a debt-equity ratio of 1.0, the firm’s unlevered cost of capital would be
a. 10 percent.
b. 12 percent.
c. 14 percent.
d. 18 percent.
e. Cannot be determined from the data provided.
8. Debt should be considered as a source of financing for a firm because
a. debt changes the business risk of the firm.
b. debt reduces the overall financial risk of the firm.
c. interest is tax deductable.
d. investors pay a premium for leverage
e. debt is virtually free money.
FBE 432 - Midterm Examination
March 8, 2001
PRACTICE
QUESTIONS
Name______________________________________
Student No.__________________
PART II - LONGER ANSWERS - WRITE ANSWERS IN SPACE PROVIDED.
1. Venture capitalists provide a useful role in an economy, but they expect to earn high rates of return.
Discuss the role venture capitalists play with start-up firms in terms of the (a) types of services they provide
to management, (b) typical structure of venture-capital firms and their sources of funds, and (c) how they
get their money back, (d) economic justification for the returns they earn, and (e) the allocation of the
profits from investmens among the participants in a venture-capital fund. Be explicit and use the
appropriate industry vocabulary.
2. Use the following quotes from the March 2, 2001, Wall Street Journal in answering this question:
FUTURES PRICES: INTEREST RATES
EURODOLLAR (CME) - $1 MILLION; PTS OF 100%
Yield
Open
Open High Low Settle Chg Settle Chg Interest
Mar01 94.98 95.01 94.98 95.00 +.01 5.00 -.01 565,662
Apr 95.12 95.13 95.11 95.12 +.01 4.88 -.01 13,469
May 95.22 95.22 95.18 95.21 … 4.79 …
1,280
Strike
Price
9475
9500
FUTURES OPTIONS PRICES
EURODOLLAR (CME)
($ million pts of 100%)
Calls-Settle
Puts-Settle
Mar Apr May Mar Apr May
2.65 5.45 … 0.07 0.10. …
0.70 3.20 3.55 0.62 0.35 0.70
a. A bank is issuing CDs in April, 2001, to finance a $10 million fixed loan investment. What is
the bank’s exposure (long or short)? How could it hedge its interest rate risk using Eurodollar futures?
What borrowing costs could the bank lock into? What happens to the bank’s income statement if rates go to
8% (annualized)?
b. What options contract could the bank use? Contrast the cost of using options and futures
contracts.
c. It is possible to get the same price exposure from buying and selling options as from a futures
contract. Using a diagram, show which options reproduce the price risk exposure of a long position in the
futures market.
d. Is there an arbitrage opportunity from buying and selling options and going long/short in the
futures market? Demonstrate the basis of your answer using the above quotes.
FBE 432 - Midterm Examination
March 8, 2001
A N S W E R S T O PRACTICE
QUESTIONS
Part I
1.
2.
3.
4.
5.
6.
7.
8.
e
d
a
e
e
e
b
c
Part II
1. (a) Venture capitalists provide seed money, first- and second-round and mezzanine financing for start-up
or emerging firms and provide funding for corporate spin-offs and leveraged buy-outs coming from
restructuring of existing firms. In addition to funds, venture capitalists monitor firms and provide advice in
areas like strategy and staffing, and often find replacements for ineffective or incompetent management.
(b) Most venture capital firms are structured as partnerships, with the investments selected and
monitoring and other services provided by the general partners and funds provided by limited partners. The
limited partners can be wealthy individuals, financial institutions, or pension or other institutional funds.
(c) The venture capital funds generally get their money out when the firm they are financing goes public
in an initial public offering (IPO) or is acquired by another firm.
(d) The high returns for venture capital are justified by the high risks; many investments are either
complete failures or return negative or no profits. A few big winners are required to justify the risks for
investors.
(e) Profits from venture capitalist are general returned to limited partners partly as payment up to some
maximum contractually fixed return and additionally with a participation in profits above that rate,
typically 80 percent. The general partners receive management fees and participation in returns above a
minimum level, usually 20 percent of the excess profits.
2. (a) The bank is long (it has a liability to sell and the bank’s liability is an investor’s asset). To hedge
this risk, the bank could go short in the futures market. Shorting the April, 2001, Eurodollar would
guarantee the bank a cost of funds of 4.88 percent (annualized and discounted), ignoring basis risk. If rates
went to 8 percent, the bank would gain on its future position since it could cover its short with lower costs.
This profit (3.12 percent on an annual basis) would off-set the higher borrowing costs of 8 percent,
producing a net cost of funds of 4.88 percent, again ignoring basis risk. The actual delivery price of the 90day Eurodollar futures contract in April is 98.78 percent (100 – 4.88x90/360) of face value.
(b) The bank could use put option on Eurodollar futures, for example the April 9500 put costing .35 % of
face value. If interest rates rose to 8 percent, the bank could exercise the put, gaining 3 percent profit minus
the put premium of .35%, which would offset the higher borrowing cost of 8 percent, netting around 5.35%.
If rates fell, the bank could borrow more cheaply and saving accordingly, but would lose the put premium
of .35 percent. For example, if rates fell to 3 percent, the bank’s cost of funds would be 3.35 percent,
including the lost put premium.
(c) You can get the same price exposure as a short position by buying a put and selling a call, as shown
below. The net outlay 3.20 - .35 or 2.85 percent of face value.
Short Futures
Buy put, sell call
(d) The April futures contract settled at 95.12 percent, translating to 98.78 percent delivery price (see
above). Buying a put and selling a call at strike prices would net 2.85 + 95.00 (since you will receive the
strike price) or 97.85 percent of face value in April. Since both positions have the same risk, there appears
to be an opportunity to make arbitrage profits by selling futures, which are relatively overvalued, and
covering the risk by the opposite options position (buy call, sell put) as the example. You would have no
price exposure and would make nearly a 1 percent profit.