13. Continued
(a) (3 points) Demonstrate whether Butterscotch’s shareholders or Caramel’s
shareholders will benefit more from the purchase of Nougat. Show your work.
(b) (3 points) Adjust the second assumption to assume a corporate tax rate of 25%.
Under this assumption demonstrate whether Butterscotch’s shareholders or
Caramel’s shareholders will benefit more from the purchase of Nougat. Show
your work.
(c) (3 points) Explain the reasoning behind the results of (a) and (b).
(d) (4 points) Fudge has just finished a promotional agreement with a songwriter.
They believe that it will increase their market share with young consumers. This
has not yet been announced to the public.
Determine how Fudge should fund the acquisition under:
(i) The pecking order hypothesis
(ii) The signaling theory
(e) (2 points) Describe the issues that Fudge might face if it tries to issue only long
term debt to fund the acquisition of Nougat.
(f) (2 points) Describe the empirical evidence that could explain Caramel’s and
Fudge’s current capital structures.
COURSE 8: Fall 2003 - 14 - GO ON TO NEXT PAGE
Finance
Afternoon Session
14. (9 points) You have been asked to evaluate the performance of the managing directors of
your bank’s three trading units. You are given the following data from the trading
operations:
Target RAROC = 30%
Fixed Income
Trading (FI)
Equity Trading
(EQ)
Money Market
Trading (MM)
Trading Earnings 100 70 30
Utilized CaR 300 250 100
Allocated CaR 500 300 100
Correlation Matrix Between Trading Unit Returns:
FI EQ MM
FI 1.0 -0.2 0.3
EQ -0.2 1.0 -0.1
MM 0.3 -0.1 1.0
(a) (2 points) Assess the risk-adjusted performance of the bank and each trading unit
assuming perfect correlation among the units. Show your work.
(b) (5 points) Assess the risk-adjusted performance of the bank and each trading unit
incorporating imperfect correlation effects. Use an appropriate method to allocate
diversification benefits. Show your work.
(c) (2 points) Evaluate which risk-adjusted measure is best for this purpose.
COURSE 8: Fall 2003 15 STOP
FINANCE
Afternoon Session
15. (3 points) The CEO of a small public company has asked you to sit on his board. At the
first meeting you learn that the company offers a “savings plan” to its employees.
Employees contribute after-tax money to this “savings plan”.
Individual employee account balances are tracked, but all money in the fund is credited
with the same interest rate. The rate credited to the plan is the return on the assets, less
the actual expenses incurred. Each January 15 the company declares the credited rate for
the prior year. Employees who terminate receive a lump sum equal to their full account
balance within 30 days of termination. For those employees, interest is applied at the
prior year’s crediting rate from January 1 to the termination date.
You point out that the plan is taking interest rate risk, and, since the plan is not a separate
entity, the company is assuming the risk. You suggest hedging this risk.
The CEO replies, “Hedging is too expensive! I want to make sure the employees get the
highest return possible, and the costs would eat into their returns. Besides, any public
company that spends its money to hedge anything is stealing from its shareholders.
Business is about risk!”
(a) Using the principles of qualitative asset transformation, explain why the savings
plan is a financial intermediary.
(b) From the shareholders’ point of view, describe the factors the company should
consider in evaluating whether or not to hedge.
**END OF EXAMINATION**
AFTERNOON SESSION

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