FIN 2200 Corporation Finance

Midterm Examination Solutions

MULTIPLE CHOICE (2 marks each X 20 questions = 40 marks) 1. You are a shareholder in a publicly owned corporation. This corporation earns $4 per share before taxes. After it has paid taxes, it will distribute the remainder of its earnings to you as a dividend. The dividend is income to you, so you will then pay taxes on these earnings. The corporate tax rate is 35% and your tax rate on dividend income is 15%. The effective tax rate on your share of the corporations earnings is closest to: a. 15% b. 55% c. 45% d. 50% e. None of the above is within 5% of the correct answer. 2. Which of the following is NOT a reason why cash flow may not equal net income? a. Capital expenditures are not recorded on the income statement. b. Amortization is added in when calculating net income. c. Depreciation is deducted when calculating net income. d. Changes in inventory will change cash flows but not income. e. None of the above. 3. Use the information for the question below. Alaska North Slope Crude Oil (ANS) $71.75 per barrel West Texas Intermediate Crude Oil (WTI) $73.06 per barrel Your company acquires crude oil and refines it. If you acquire and refine one barrel of oil from ANS, you are able to produce $76 worth of unleaded gasoline. If you acquire and refine one barrel of oil from WTI, you are able to produce $77 worth of unleaded gasoline. This is due to the fact that WTI crude oil has lower sulfur content. You currently own 10,000 barrels of WTI crude oil. You are considering selling all of your WTI crude oil and using the proceeds to purchase and refine ANS crude oil. What is the added benefit (cost) of this consideration? a. ($1,400) b. $1,400 c. ($3,900) d. $3,900 e. None of the above is within $50 of the correct answer.

FIN 2200 Corporation Finance 4. Use the information for the question below.

Midterm Examination Solutions

An exchange traded fund (ETF) is a security that represents a portfolio of individual stocks. Consider an ETF for which each share represents a portfolio of two shares of International Business Machines (IBM), three shares of Merck (MRK), and three shares of Citigroup Inc. (C). Suppose the current market price of each individual stock is shown below: Stock IBM MRK C Current Price $79.50 $40.00 $48.50

The price per share of the ETF in a normal market is closest to: a. $168.00 b. $336.00 c. $424.50 d. $504.00 e. More information is needed to determine the ETFs price per share. 5. Use the table for the question below. Consider the following zero-coupon yields on default-free securities: Maturity (years) Zero-Coupon YTM 1 2 3 4 5 5.80% 5.50% 5.20% 5.00% 4.80%

The price today of a 3-year default-free security with a face value of $1000 and an annual coupon rate of 6% is closest to: a. $1,021 b. $1,013 c. $1,000 d. $1,005 e. None of the above is within $10 of the correct answer. 6. Which of the following statements is false? a. The required return of an investment security is the expected return of other investments available in the market with equivalent risk. b. If you observed the current stock price was less than your calculation of P0, this would seem to be a negative NPV investment, and you would expect investors to rush in and sell it. c. The price of a share of stock is equal to the present value of the expected future dividends it will pay. d. The law of one price implies that to value any security, we must determine the expected cash flows an investor will receive from owning it.

FIN 2200 Corporation Finance 7. Use the table for the question below. Consider the following list of projects: Project A B C D E F G H I Investment 135,000 200,000 125,000 150,000 175,000 75,000 80,000 200,000 50,000 NPV 6,000 30,000 20,000 2,000 10,000 10,000 9,000 20,000 4,000

Midterm Examination Solutions

Assume that your capital is constrained, so that you only have $500,000 available to invest in projects. If you invest in the optimal combination of projects given your capital constraint, then the total NPV for all the projects you invest in will be closest to: a. $80,000 b. $69,000 c. $111,000 d. $58,000 e. $70,000 8. Which of the following statements regarding real and nominal interest rates is true? a. Although nominal interest rates may be either positive or negative, real interest rates will always be positive. b. Although real interest rates may be either positive or negative, nominal interest rates will always be positive. c. If a security has a positive nominal return, then its real return will also be positive. d. Both real and nominal interest rates may be either positive or negative. e. None of the above. 9. Assume that investors are indifferent between short-term and long-term risk-free investment opportunities. Which of the following statements is most correct? a. The yield curve for risk-free investments will be flat. b. The yield curve for risk-free investments cannot be downward sloping. c. Long-term investment opportunities will earn higher returns than short-term investments d. Long-term investment opportunities will earn lower returns than short-term investments. e. The Liquidity Premium is zero. f. None of the above.

FIN 2200 Corporation Finance

Midterm Examination Solutions

10. You observe the following term structure for Treasury bills: Maturity 1 year 2 years 3 years 4 years 5 years Yield (%) 5.1 5.4 5.6 5.8 6.1

Assume that the pure expectations theory holds. What does the market expect will be the yield on 1-year Treasury securities three years from today? a. 5.1% b. 5.4% c. 5.5% d. 5.6% e. 5.7% f. 5.8% g. 6.0% h. 6.1% i. 6.4% 11. In addition to the normal NPV evaluation criterion, ABCs management requires a 2-year payback period on all projects. ABC is considering two independent investments, Project A and Project B. There are sufficient funds for both projects. As payback period is 1.5 years; Bs payback period is 2.5 years. If the required rate of return on projects of similar risk is 12% and it has been calculated that NPVA > NPVB, what would shareholders want management to do? a. Choose project A provided that NPVA ! 0; reject B. b. Choose project A provided that NPVB ! 0; reject B. c. Choose project B if NPVB ! 0; reject A. d. Choose projects A and B if IRRB ! 12%. e. Choose projects A and B if PBA ! 1.5 years and PBB ! 2.5 years. f. More information is needed to answer the question. 12. Bill wants to sell his personal computer to you for $1,400. You dont have to pay any money today. Instead, Bill wants you to pay him $36 bi-weekly (i.e., every two weeks) 2 years, beginning two weeks after you buy the computer. After applying your knowledge from this course you realize that Bill is effectively charging you an annual interest rate of: a. 56.21%. b. 34.94%. c. 36.55%. d. 30.14% e. 40.94%. f. 115.93%. g. none of the above.

FIN 2200 Corporation Finance 13. Consider the following information on a project: Initial outlay: ? Required rate of return: 10% Annual cash in-flows: Year Cash in-flows 1 $0 2 $11,500 3 $0 4 $10,000

Midterm Examination Solutions

If the Profitability Index (PI) of the above project (rounded to 2 decimal places) is 0.96 then a. the initial investment in the project is $8,333.81. b. the NPV of the project is $16,333.27. c. the IRR of the project is less than 20%. d. the NPV of the project is $8,000.46. e. the project is not an investment project; it is a financing project. f. both a) and b) are true. g. both a) and d) are true. h. none of the above is true. 14. Aidens Plumbing Company (APC) is bidding on a City of Winnipeg construction contract. The contract is for a 3-year period. The contract calls for the city to pay APC $6,000,000 at the start of the contract and $2,000,000 at the end of each of the three years of the contract. APC estimates that its expenses will be $5,000,000 at the end of each of the 3 years. If APC uses IRR to evaluate its project opportunities, it would only accept this contract if its required return for such projects is a. < 12.97800069%. b. < 23.37519285%. c. < 25%. d. < 33.33333333%. e. > 12.97800069%. f. > 23.37519285%. g. > 25%. h. > 33.33333333%.

FIN 2200 Corporation Finance

Midterm Examination Solutions

15. A $10,000 loan is to be amortized over 5 years, with annual end-of-year payments. Given the following facts, which of these statements is most correct? a. The annual payments would be larger if the interest rate were lower. b. If the loan were amortized over 10 years rather than 5 years, and if the interest rate were the same in either case, the first payment would include more dollars of interest under the 5-year amortization plan. c. The last payment would have a higher proportion of interest than the first payment. d. The proportion of interest versus principal repayment would be the same for each of the 5 payments. e. The proportion of each payment that represents interest as opposed to repayment of principal would be higher if the interest rate were higher. f. None of the above. 16. Your sister has agreed to deposit $6,000 in your savings account at the beginning of each of the next five years (t = 0, 1, 2, 3, and 4). You estimate that you can earn 9 percent a year on your investments. How much will you have in your account four years from now (at t = 4)? (Assume that no money is withdrawn from the account.) a. $27,438.78 b. $35,908.26 c. $39,140.00 d. $42,860.90 e. $44,872.24 17. A security sells today for $80,000. The security pays $10,000 in one year, $20,000 in two years, $X in three years, and $40,000 in four years. The discount rate on the security is 10 percent. What is X? a. $36,016 b. $32,742 c. $27,060 d. $24,328 e. $10,000 f. None of the above is within $10 of the correct answer.

FIN 2200 Corporation Finance 18. If a project has a net present value equal to zero, then:

Midterm Examination Solutions

I. the present value of the cash inflows exceeds the present value of the cash outflows of the project. II. the project produces a rate of return that just equals the rate required to accept the project. III. the project is expected to produce only the minimally required cash inflows. IV. a delay in receiving the projected cash inflows will cause the project to have a negative npv. a. b. c. d. e. f. g. h. II and III only II and IV only I, II, and IV only II, III, and IV only I, II, and III only I and II only I, II, III, and IV None of the above

19. A Firm is considering two mutually exclusive, conventional: projects A and B. It has determined that the crossover rate for these projects is 11.7%. Project A has an internal rate of return of 15.3% and Project B has an internal rate of return of 16.5%. Given that the firms required rate of return is 10%, which one of the following statements is most correct? a. Project A should be accepted because its IRR is closer to the crossover point than is Project B's IRR. b. Project A should be accepted because it has a higher NPV at 10% than Project B. c. Project B should be accepted because it has a higher IRR than Project B. d. Both projects should be accepted because both of the project's IRRs exceed the crossover rate. e. Neither project should be accepted because both of the project's IRRs exceed the crossover rate. f. You cannot determine which project should be accepted given the information provided.

FIN 2200 Corporation Finance

Midterm Examination Solutions

QUESTION ONE (9 marks) Step 1 FV62 of contributions: Marking guide: 3 marks (1 mark for payments; 1 mark for effective monthly rate; 1 mark for setup of formula with substitutions.)

469 payments 0.10 /2 = .05 = 5.0%, effective, semi ! annually

(1 + .05) 6 mo ! 1 = .00816485 effective monthly

FVt + n = C n (1 + r) n ! (1 + g) r!g

1mo

]
]

FV62 =

$300 (1.00816...) 469 ! (1.005) 469 .00816... ! .005

FV62 = $3,312,790.46591...
Step 2 FV65 (no contributions during this period) Marking guide: 2 marks (2 or 0)

FVt + n = PVt (1 + r)

FV65 = PV62 (1 + .08)

FV65 = $4,173,161.90339...

Step 3 calculate withdrawals (first withdrawal at 66th birthday, semi-annual withdrawals):

FIN 2200 Corporation Finance

Midterm Examination Solutions

Marking guide: 4 marks in total 2 marks for finding PV at 65 years (2 or 0); 2 marks for converting resulting PV into annuity ( - 1 each error). 20 payments

(1.05)12 mo ! 1 = .0024695...effective, semi ! monthly

PV65.5 years = " % C 1 $1 ! ' 0.024695... # (1 + .024695...) 20 &

6 mo

Where PV65.5 years = PV65 years 1 + reff .semiannual = $4,173,161.90339...(1 + .024695...) = $4,276,218.45626...

$4,276,218.45626... =

" % C 1 $1 ! ' 0.024695... # (1 + .024695...) 20 &

C = $273,517.66

FIN 2200 Corporation Finance QUESTION TWO (9 marks) Marking guide: Pre-announcement valuation 3 marks (-1 each error)

Midterm Examination Solutions

Post-announcement valuation 4 marks (1 mark for PV 1st dividend; 1 mark for PV 2nd dividend; 2 marks for PV growing perpetuity) Calculation of incremental stock price 2 marks (2 or 0). Answer:
effectivequarterly return = (1 + .017)
1 4

! 1 = .04003143

Current stock price ( pre ! announcement ) : $2.50 PV!1month = = $62.4509... .04003143... FVToday = $62.4509...(1.04003143...)
1 3

= $63.273378...

New stock price ( post ! announcement ) : PV!1month = $2.50 $2.50 + + (1 + .04003143...) (1 + .04003143...) 2 $2.50(1.012) (.04003143... ! 0.012)

(1 + .04003143...) 2

= $2.40377350 + $2.31125082 + $83.44153460 = $88.15655892 FVToday = $88.156...(1.04003143...)

1 3

= $89.31754652...

Increasein stock price = $89.3175... ! $63.2722... = $26.04

FIN 2200 Corporation Finance QUESTION THREE (8 marks) a) Marking guide: 4 marks (-1 each error) Answer:

Midterm Examination Solutions

20 x 24 = 480 payments .07 /2 = .035 = 3.500%, effective, semi ! annually

(1.035)
PV =

1 mo 2 6 mo

! 1 = .00287090 effective, semi ! monthly

C" 1 % $1 ! ' r # (1 + r) n & " % C 1 $1 ! ' .00287070 # (1 + .00287090) 480 &

$150,000 =

C = $576.16
b) Marking guide: 4 marks (-1 each error) Answer: 16 x 24 = 384 payments

PV96 = PV96 =

C" 1 % $1 ! ' r # (1 + r) n & % $1,000 " 1 $1 ! ' = $232,474.34 .00287070 # (1 + .00287090) 384 &

new effective semi ! annual return = .055 /2 = .0275 = 2.750%, effective, semi ! annually

(1.0275)

1 mo 2 6 mo

! 1 = .00226328 effective, semi ! monthly

C" 1 % ' PV96 ! extra payment = $1 ! r # (1 + r) n & $232,474.34 ! $5,000 = C = $887.26 " % C 1 $1 ! ' .00226328 # (1 + .00226328) 384 &