# ECO 3111 : THEORY OF FINANCE

MAASAI MARA UNIVERSITY
REGULAR UNIVERSITY EXAMINATIONS
THIRD YEAR FIRST SEMESTER
BACHELOR OF SCIENCE IN FINANCIAL ECONOMICS

COURSE CODE: ECO 3111
COURSE TITLE: THEORY OF FINANCE
DATE:7TH DECEMBER 2018 TIME: 11.00AM -1.00PM
INSTRUCTIONS TO CANDIDATES
Answer Question ONE and any other THREE questions
This paper consists of 4 printed pages. Please turn over.
ECO 3111: Theory of Finance Page 2
QUESTION ONE
(a). Use examples and illustrations explain eight principals of finance. (8mks)
(b). Make-Em happy Corp. (MEH) has a different security for sale. You pay MEH Kshs
1000 today and the company will give you back Kshs 100 at the end of the first year, sh
200 at the end of year 2…….. Kshs 1000 at the end of year 10.
(i). Calculate the internal rate of returns of this investment. (5mks)
(ii). Show an amortization table for the investment. (5mks)
(c). Explain the following concepts as used in theory of finance. (7mks)
(i). Net present value
(ii). Effective annual interest rate
(iii). Capital market line (CML)
(iv). Stock market line. (SML)
(vi). Weighted average cost of capital. (WACC)
(vii). Marginal rate of time preference.
QUESTION TWO
(a). Explain how a financial intermediary reduces the cost of contracting and
information processing. (3mks)
(b). Your firm is considering two projects with the following cash flows.
Year project A project B
0 _____________ -500 ____________ -500
1 _____________ 167 ____________ 200
2 _____________ 180 ____________ 250
3 _____________ 160 _____________ 170
4 _____________ 100 _____________ 25
5 _____________ 100 _____________ 30
(i). If the appropriate discount rate is 12% rank the two projects. (3mks)
(ii). Which project is preferred if you rank by IRR? (2mks)
ECO 3111: Theory of Finance Page 3
(iii). Calculate the crossover rate and discount rate in which the NPVs of both
projects are equal. (3mks)
(iv). Should you use NPV or IRP to choose between the two projects? Give brief
discussion. (4mks)
QUESTION THREE
(a). The XYZ company limited has the following information.
Market value of debt Kshs 2,500,000
Market value of equityKshs 1,000,000
Cost of debt,rD 5%
Tax rate, Tc 25%
WACC 10%
Calculate the cost of equity rE. (5mks)
(b). A boudy corp’s stock price is currently Kshs 22 per share. The company has paid a
dividend of ksh. 0.55 per share and shareholders anticipate that this dividends will
grow in the future at rate of 6% per year. Use the Gordon model to calculate the
company’s cost of equity rE. (4mks)
(c). Explain the risk associated with the mortgage origination process. (3mks)
(d). Explain the key features of an option market. (3mks)
QUESTION FOUR
(a). Explain the difference between a spot exchange rate and a forward exchange rate.
(3mks)
(b). The following are the spot exchange rates reported on July 24,2018:
Japanese yen British pound Canadian dollar
US \$ 0.008864 1.477 0.6596
The exchange rate indicate the number of US dollar necessary to purchase one unit of the
foreign currency
(i). From the perspective of a US investor, explain whether the preceding foreign
exchange rates are direct or indirect. (3mks)
ECO 3111: Theory of Finance Page 4
(ii). How much of each of the foreign currencies is needed to buy one US dollar?
(3mks)
(iii). Calculate the theoretical cross rates. (3mks)
(c). The assumptions underlying the Miller-Modigliani (MM) dividend irrelevance
hypothesis are unrealistic. Discuss with illustrations and examples. (3mks).
QUESTION FIVE
(a). Explain the difference between the primary and the secondary markets (4mks)
(b). Use the Black-Scholes model to price the following:
(i). A call option on a stock whose current price is s=50, with exercise price x=50, T=0.5,
r=10%, and δ=25%. (4mks)
(ii). A put option with same parameters. (2mks)
(c). Explain the main source of capital and their limitations. (5mks)

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