Final Exam Solutions 2012 1 Spring

FNAN 301, Spring 2012, final, solutions
Find PV of one investment to find value of other and then when other makes single CF
1. Georgia owns two investments, A and B, that have a combined total value of $38,000.
Investment A is expected to pay $23,000 in 5 years from today and has an expected return of 4.6
percent per year. Investment B is expected to pay $32,000 in T years from today and has an
expected return of 6.4 percent per year. What is T, the number of years from today that
investment B is expected to pay $32,000?
A. A number less than 7.50 or a number greater than 10.50
B. A number equal to or greater than 7.50 but less than 8.30
C. A number equal to or greater than 8.30 but less than 9.00
D. A number equal to or greater than 9.00 but less than 9.80
E. A number equal to or greater than 9.80 but less than 10.50

Find next CF of growing perpetuity and then use growth rate to get future CF
2. Georgia owns a vending machine that is worth $38,000 and is expected to make annual cash
flows forever. The cost of capital is 9.3%. The next annual cash flow is expected in one year
from today and all subsequent cash flows are expected to grow annually by 5.7%. What is the
cash flow produced by the vending machine in 5 years from today expected to be?

Find payment with PV annuity and an extra, interim cash flow
3. Dat just took out a loan from the bank for $13,000. He plans to repay this loan by making a
special payment to the bank of $4,000 in 3 years and by also making equal, regular annual
payments of X per year for 5 years. If the interest rate on the loan is 12.3 percent per year and he
makes his first regular annual payment in 1 year, then what is X, Dats regular annual payment?
Assume that Dat makes two payments in 3 years: the extra payment of $4,000 and the regular
annual payment of X.
A. An amount less than $2,735.00 or an amount greater than or equal to $2,935.00
B. An amount equal to or greater than $2,735.00 but less than $2,785.00
C. An amount equal to or greater than $2,785.00 but less than $2,835.00
D. An amount equal to or greater than $2,835.00 but less than $2,885.00
E. An amount equal to or greater than $2,885.00 but less than $2,935.00
3

Find annuity due value and expected return from fixed perpetuity to compare value & risk
4. Investment A has an expected return of 9.7 percent and is expected to pay $75 per year for a finite
number of years such that its first annual payment is expected later today and its last annual payment is
expected in 5 years from today. Investment B is expected to pay $31 per year forever, is expected to
make its first payment in 1 year from today, and has a value of $325. Based on the given information,
which one of the following assertions is true?
A. Investment A is more valuable than investment B and investment A has more risk than investment B
B. Investment A is more valuable than investment B and investment B has more risk than investment A
C. Investment B is more valuable than investment A and investment A has more risk than investment B
D. Investment B is more valuable than investment A and investment B has more risk than investment A
E. Investment A is equally as valuable as investment B or investment A has the same amount of risk as
investment B
A. Investment A is more valuable than investment B and investment A has more risk than investment B
B. Investment A is more valuable than investment B and investment B has more risk than investment A
C. Investment B is more valuable than investment A and investment A has more risk than investment B
D. Investment B is more valuable than investment A and investment B has more risk than investment A
investment B
A. Investment B is more valuable than investment A and investment B has more risk than investment A
B. Investment B is more valuable than investment A and investment A has more risk than investment B
C. Investment A is more valuable than investment B and investment B has more risk than investment A
D. Investment A is more valuable than investment B and investment A has more risk than investment B
investment B
A. Investment B is more valuable than investment A and investment B has more risk than investment A
B. Investment B is more valuable than investment A and investment A has more risk than investment B
C. Investment A is more valuable than investment B and investment B has more risk than investment A
D. Investment A is more valuable than investment B and investment A has more risk than investment B
investment B

Find missing CF associated with future value of multiple cash flows
5. If Georgia expects to invest $13,400 in 1 year from today in an account that is expected to earn
5.1 percent per year, and she expects to make another investment in the same account in 4 years
from today, then how much money does Georgia expect to invest in 4 years from today if she
expects to have $38,000 in her account in 6 years from today?
A. An amount less than $15,000 or an amount greater than or equal to $19,000
B. An amount equal to or greater than $15,000 but less than $16,000
C. An amount equal to or greater than $16,000 but less than $17,000
D. An amount equal to or greater than $17,000 but less than $18,000
E. An amount equal to or greater than $18,000 but less than $19,000

Save with annuity and then give a growing perpetuity: what is first perpetuity CF
6. Georgia wants to create a scholarship fund by making annual savings donations to the fund for
several years before the fund starts making annual scholarship payments forever. She plans to
save $45,000 per year in a trust fund for 4 years. Her first savings donation to the trust fund is
expected in 1 year from today. What is the expected amount of the scholarship payment that the
trust fund will make in 5 years from today if the fund is expected to have a return of 8.3 percent
per year, make annual scholarship payments that grow annually by 4.4 percent forever, and make
its first annual scholarship payment in 5 years from today?

Find R then EAR from FV and payments
7. Dat is planning to save $47 each month for 4 years. He plans to make his first contribution to
his account in 1 month from today. If he has $900 in his account today and expects to have
$3,940.83 in his account in 4 years from today, immediately after making his last payment, then
what is the EAR that he expects to earn on his account?
A. A rate less than 8.00% or a rate greater than or equal to 9.60%
B. A rate equal to or greater than 8.00% but less than 8.40%
C. A rate equal to or greater than 8.40% but less than 8.80%
D. A rate equal to or greater than 8.80% but less than 9.20%
E. A rate equal to or greater than 9.20% but less than 9.60%

Conceptual: identify which bond has higher coupon rate and higher YTM from relative price
8. Bonds A, B, C, and D have face values of $1000, pay semi-annual coupons with the next
coupon due in 6 months, and mature in T years. Bonds A and B have different coupon rates, and
bonds C and D have different yields-to-maturity. Which assertion is true if PA > PB > 0, PD >
PC > 0, T > 0, Y > 0, and C > 0? Note that all bonds with a time-to-maturity of T have the same
time-to-maturity, all bonds with a yield-to-maturity of Y have the same yield-to-maturity (YTM),
and all bonds with a coupon rate of C have the same coupon rate.
Bond
Bond Price
Time-to-maturity
Yield-to-maturity
A
PA
T
Y
B
PB
T
Y
Bond
Bond Price
Time-to-maturity
Coupon rate
C
PC
T
C
D
PD
T
C
A. Bond A has a higher coupon rate than bond B and bond C has a higher YTM than bond D
B. Bond A has a higher coupon rate than bond B and bond D has a higher YTM than bond C
C. Bond B has a higher coupon rate than bond A and bond C has a higher YTM than bond D
D. Bond B has a higher coupon rate than bond A and bond D has a higher YTM than bond C
E. None of the above assertions is true
bonds C and D have different yields-to-maturity. Which assertion is true if PA > PB > 0, PC >
PD > 0, T > 0, Y > 0, and C > 0? Note that all bonds with a time-to-maturity of T have the same
Bond
Bond Price
Time-to-maturity
Yield-to-maturity
A
PA
T
Y
B
PB
T
Y
Bond
Bond Price
Time-to-maturity
Coupon rate
C
PC
T
C
D
PD
T
C

bonds C and D have different yields-to-maturity. Which assertion is true if PB > PA > 0, PD >
Bond
Bond Price
Time-to-maturity
Yield-to-maturity
A
PA
T
Y
B
PB
T
Y
Bond
Bond Price
Time-to-maturity
Coupon rate
C
PC
T
C
D
PD
T
C
bonds C and D have different yields-to-maturity. Which assertion is true if PB > PA > 0, PC >
Bond
Bond Price
Time-to-maturity
Yield-to-maturity
A
PA
T
Y
B
PB
T
Y
Bond
Bond Price
Time-to-maturity
Coupon rate
C
PC
T
C
D
PD
T
C

Find semi-annual coupon from return and then find coupon rate
9. Bonds issued by Erie Shipping were priced at $976.00 six months ago and are priced at
$971.00 today. The bonds have a face value of $1,000, pay semi-annual coupons, and just made
a coupon payment. The bonds had a percentage return over the past six months of 5.6%. What
is the coupon rate of the bonds?
10

Find current price from expected dividend and price in quarter with annual expected return
10. Erie Shipping stock pays quarterly dividends and has an expected annual return of 13.2
percent. The stock is expected to have a share price of $23.68 immediately after paying its next
quarterly dividend in 3 months from today and is expected to have a share price of $24.11
immediately after paying its quarterly dividend in 6 months from today. What is the current price
of Erie Shipping stock if the quarterly dividend in 3 months from today is expected to be $1.29?
A. An amount less than $24.00 or an amount greater than or equal to $54.00
B. An amount equal to or greater than $24.00 but less than $26.00
C. An amount equal to or greater than $26.00 but less than $28.00
D. An amount equal to or greater than $28.00 but less than $46.00
E. An amount equal to or greater than $46.00 but less than $54.00
11

Find g from ER, D1, and P0 computed by valuing bond
11. Georgia has one share of stock and one bond issued by Erie Shipping. The total value of the
two securities is $1,300. The bond has a YTM of 8.0 percent, an annual coupon rate of 9.8
percent, and a face value of $1,000. The bond matures in 11 years and pays semi-annual
coupons with the next one expected in 6 months. The stock is expected to pay an annual
dividend every year forever, the next dividend is expected to be $5.61 in 1 year, all subsequent
dividends are expected to grow at the same annual growth rate, and the expected return for the
stock is 11.2%. What is the annual growth rate of the stocks dividend expected to be?
12

Find NPV and payback to decide whether to accept/reject a project
12. The following table presents information on a potential project with conventional cash flows currently being
evaluated by Erie Shipping. Which assertion about statement 1 and statement 2 is true?
Expected cash flows (number of years from today)
Opportunity cost of
0
1
2
3
4
capital
-76,000
38,000
29,000
19,000
6,000
13.2%
Statement 1: Erie Shipping would accept the project based on the projects net present value (NPV) and the NPV rule
Statement 2: Erie Shipping would accept the project based on the projects payback period and the payback rule if
the payback threshold is 2.55 years
A. Statement 1 is true and statement 2 is true
B. Statement 1 is true and statement 2 is false
C. Statement 1 is false and statement 2 is true
D. Statement 1 is false and statement 2 is false
Opportunity cost of
0
1
2
3
4
capital
-76,000
38,000
18,000
35,000
6,000
14.3%
A. Statement 1 is false and statement 2 is false
B. Statement 1 is false and statement 2 is true
C. Statement 1 is true and statement 2 is false
D. Statement 1 is true and statement 2 is true
Opportunity cost of
0
1
2
3
4
capital
-67,000
38,000
24,000
12,000
6,000
12.5%
Opportunity cost of
0
1
2
3
4
capital
-67,000
38,000
22,000
18,000
6,000
14.4%
13

Find NPV with opportunity cost, terminal value, and project sale
13. Erie Shipping is evaluating the turbine project. Today, the project would require an initial investment in
equipment of $65,000. Relevant annual operating cash flows of $41,000 per year are expected in years 1, 2, and
3, and relevant operating cash flows that are not equal to $0 are expected in years 4, 5 and 6. In 4 years, the
project is expected to have an after-tax terminal value of $54,000. In 2 years, the project is expected to be sold
by Erie Shipping for an after-tax amount of $45,000. Instead of pursuing the turbine project, Erie Shipping
could sell the rights to the project to Huron Shipping for a $36,000 after-tax payment today from Huron
Shipping. The cost of capital for this project is 11 percent. What is the net present value of the turbine project?
A. An amount less than $0 or an amount equal to or greater than $70,000
B. An amount equal to or greater than $0 but less than or equal to $10,000
14

Find NPV from revs/costs/investment/asset sale
14. Erie Shipping is considering a project that would last for 2 years. The project would involve an initial
investment of $270,000 for new equipment that would be sold for an expected price of $184,000 at the
end of the project in 2 years. The equipment would be depreciated to zero over 5 years using straight-line
depreciation. In years 1 and 2, relevant, incremental annual revenue from the project is expected to be
$144,000 per year and relevant, incremental annual costs for the project are expected to be $56,000 per
year. The tax rate is 40 percent and the cost of capital for the project is 5.2 percent. What is the net
present value (NPV) of the project?
Find initial CA from initial CL, NWC change, and ending NWC
15. Erie Shipping is evaluating a potential project such that the cash flow effect from the change in net
working capital (NWC) is expected to be -$20 at time 2 and the level of net working capital is expected to
be $80 at time 2. What is the level of current assets for the project expected to be at time 1 if the level of
current liabilities for the project is expected to be $230 at time 1?
working capital (NWC) is expected to be $20 at time 2 and the level of net working capital is expected to
working capital (NWC) is expected to be -$40 at time 2 and the level of net working capital is expected to
working capital (NWC) is expected to be $40 at time 2 and the level of net working capital is expected to
15

OCF of 2 years using MACRS
16. Erie Shipping is evaluating a project that would require an initial investment in equipment of
$800,000 and is expected to be in operation for 4 years. MACRS depreciation would be used
with a three-year schedule where the depreciation rates in years 1, 2, 3, and 4 are 33.33%,
44.44%, 14.82%, and 7.41%, respectively. For each year of the project, Erie Shipping expects
relevant, incremental revenue associated with the project to be $158,000 and relevant,
incremental costs associated with the project to be $74,000. The tax rate is 25 percent. What is
(X plus Y) if X is the relevant operating cash flow (OCF) associated with the project expected in
year 2 of the project and Y is the relevant OCF associated with the project expected in year 4 of
the project?
the project?
the project?
the project?
16

Get geometric from arithmetic and all but one return
17. A stock had returns of 17%, -24%, and 13% in each of the past three years. Over the past
four years, the arithmetic average annual return for the stock was 6.5%. What was the geometric
return for the stock over the past four years?
17

Get expected SD from 2 states and P0, D1, and P1 in those states
18. Shares of Erie Shipping are currently priced at $16.00 per share. The following table indicates what
could happen with the Erie Shipping stock price and dividend per share over the next year. What is the
expected standard deviation of Erie Shipping stocks returns?
Probability of Price of Erie Shipping stock Dividend paid by Erie Shipping
Outcome
outcome
in 1 year
in 1 year
Good
.2
$25.70
$1.50
Bad
.8
$14.55
$0.25
Outcome
outcome
in 1 year
in 1 year
Good
.2
$26.20
$1.80
Bad
.8
$12.95
$0.25
Outcome
outcome
in 1 year
in 1 year
Good
.2
$25.70
$1.50
Bad
.8
$13.75
$0.25
Outcome
outcome
in 1 year
in 1 year
Good
.2
$26.20
$1.80
Bad
.8
$14.55
$0.25
18

Conceptual: insider trading and ethics
19. According to the class overheads and basic ethics, which one of the following assertions
about insider trading, which is against the law, is true?
A. Insider trading is illegal and should not be considered as a potential approach to investing
B. Insider trading is illegal and should be considered as a potential approach to investing
C. Insider trading is legal and should not be considered as a potential approach to investing
D. Insider trading is legal and should be considered as a potential approach to investing
19

Conceptual: portfolio unsystematic and individual stock systematic risk
20. Which assertion about statement 1 and statement 2 is true?
Statement 1: A well-diversified portfolio with a beta of zero has the same amount of
unsystematic risk as the risk-free asset
Statement 2: If Royal Royale Inc. common stock has a beta of 0.75, then the company is more
likely to own and operate grocery stores than jewelry stores.
likely to own and operate jewelry stores than grocery stores.
Statement 1: A well-diversified portfolio with a beta of zero does not have the same amount of
20

Find value of one portfolio component from value of other and all betas
21. Georgia owns 800 shares of Erie Shipping stock priced at $12 per share and some Treasury
bills. Erie Shipping stock has a beta of 0.8 and her portfolio has a beta of 0.5. What is the value
of Georgias holdings in Treasury bills?
21

Conceptual: expected return is positively related to beta
22. The expected return on the market is greater than the risk-free rate, which is greater than zero. Based
on the information in the table and in this paragraph, which stock is most likely to have the highest
expected return?
Geometric average Arithmetic average
Standard
annual return over annual return over
deviation of
Stock
the past 15 years
the past 15 years
Share price
Beta
returns
A
21%
29%
$5.65
0.87
12%
B
14%
26%
$4.25
1.28
21%
C
-19%
-12%
$7.25
0.64
32%
D
-11%
-4%
$6.55
1.16
22%
E
-25%
-16%
$3.45
0.72
36%
expected return?
Standard
deviation of
Stock
the past 15 years
the past 15 years
Share price
Beta
returns
A
14%
26%
$4.25
1.45
26%
B
-19%
-13%
$5.65
0.66
31%
C
-11%
-3%
$6.55
1.57
22%
D
-25%
-17%
$5.65
0.79
35%
E
23%
29%
$3.45
0.84
13%
expected return?
Standard
deviation of
Stock
the past 15 years
the past 15 years
Share price
Beta
returns
A
21%
27%
$4.25
0.82
12%
B
14%
26%
$3.45
1.28
17%
C
-19%
-13%
$7.25
0.64
32%
D
-11%
-3%
$5.65
1.45
21%
E
-25%
-17%
$6.55
0.77
36%
expected return?
Standard
deviation of
Stock
the past 15 years
the past 15 years
Share price
Beta
returns
A
-25%
-17%
$5.65
0.82
21%
B
23%
29%
$6.55
0.99
13%
C
14%
26%
$7.25
1.29
26%
D
-19%
-13%
$3.45
0.57
35%
E
-11%
-3%
$4.25
1.37
19%
22

Find P1 from P0 and D1 after finding R from CAPM
23. Erie Shipping stock is currently priced at $23.50 per share and is expected to pay its next
dividend, which is expected to be $1.39, in 1 year. The stock has a beta of 0.75. The market has
an expected return of 19.0% and the risk-free rate is 7.0%. What is the stock price of Erie
Shipping expected to be in 1 year?
Compute WACC with 2 items after finding YTM
24. Erie Shipping has 3,000,000 shares of common equity outstanding that have an expected return
of 15.40% and a current price of $15.00 each. Erie Shipping has issued 100,000 bonds with a face
value of $1,000, a market value of $850.00 each, an annual coupon rate of 8.60%, a current yield
of 10.12%, and that pay annual coupons with the next one due in 1 year. The bonds mature in 12
years. If the tax rate is 40%, what is the weighted-average cost of capital for Erie Shipping?
23

Conceptual: appropriate project cost of capital from pure play and subjective approaches
Statement 1: If Erie Shipping has a weighted-average cost of capital of 11.1% and is evaluating project
Z, which is a potential project that is more risky than the average-risk project at Erie Shipping, then
12.4% could be the appropriate cost of capital for Erie Shipping to use to evaluate project Z.
Statement 2: Based on the information in the following table and applying the pure play approach to
determining a projects cost of capital, 9.1% is more appropriate than both 11.1% and 13.1% for Erie
Shipping, which is a company that transports goods in ships across oceans, to use as the cost of capital
for evaluating project X, which is a potential project that would involve transporting goods in trains
over railroad tracks. Note that this statement is true if 9.1% is a more appropriate cost of capital for
project X than 11.1% and if 9.1% is also a more appropriate cost of capital for project X than 13.1%.
The statement is not true if 11.1% is a more appropriate cost of capital for project X than 9.1% or if
13.1% is a more appropriate cost of capital for project X than 9.1% or if both 11.1% and 13.1% are
more appropriate costs of capital for project X than 9.1%.
Firm
Line of business
WACC
Erie Shipping
Transports goods in ships across oceans
11.1 percent
Thomas Shipping
Transports goods in trains over railroad tracks
9.1 percent
Diversified Shipping
Transports goods in ships, trains, trucks, and airplanes
13.1 percent

13.1% is a more appropriate cost of capital for project X than 11.1% or if both 9.1% and 13.1% are
more appropriate costs of capital for project X than 11.1%.
Firm
Line of business
WACC
Erie Shipping
9.1 percent
Thomas Shipping
11.1 percent
13.1 percent
24

9.1% is a more appropriate cost of capital for project X than 11.1% or if both 13.1% and 9.1% are more
appropriate costs of capital for project X than 11.1%.
Firm
Line of business
WACC
Erie Shipping
13.1 percent
Thomas Shipping
11.1 percent
9.1 percent

over railroad tracks. . Note that this statement is true if 13.1% is a more appropriate cost of capital for
9.1% is a more appropriate cost of capital for project X than 13.1% or if both 11.1% and 9.1% are more
appropriate costs of capital for project X than 13.1%.
Firm
Line of business
WACC
Erie Shipping
11.1 percent
Thomas Shipping
13.1 percent
9.1 percent
25

Find PV of one investment to find value of other and then when other makes single CF
To solve:
1) Find the value of investment A
2) Find the value of investment B as the combined value of both A and B minus the value of A
3) Find T, the number of years from today that investment B is expected to pay $32,000
PV0 = Ct / (1+r)t
Ct = 23,000
r = .046
t=5
PV0 = C5 / (1+r)5
= 23,000 / (1.046)5
= $18,368
Mode is not relevant since PMT = 0
Enter
5
4.6
N
I%
PV
Solve for
-18,368
Investment A is worth $18,368
0
PMT
23,000
FV
2) Find the value of investment B as the value of both A and B minus the value of A
Value of B = value of A and B value of A
Value of A and B = $38,000
Value of A = $18,368
Value of B = $38,000 $18,368 = $19,632
Enter
6.4
-19,632
0
32,000
N
I%
PV
PMT
FV
Solve for
7.88
Answers may vary slightly due to rounding
Answer: B
7.88 is number equal to or greater than 7.50 but less than 8.30
26

To solve:
PV0 = Ct / (1+r)t
Ct = 32,000
r = .046
t=5
PV0 = C5 / (1+r)5
= 32,000 / (1.046)5
= $25,556
Enter
5
4.6
N
I%
PV
Solve for
-25,556
0
PMT
32,000
FV
Value of B = $38,000 $25,556 = $12,444
Enter
6.4
-12,444
0
23,000
N
I%
PV
PMT
FV
Solve for
9.90
Answer: E
27

To solve:
PV0 = Ct / (1+r)t
Ct = 23,000
r = .064
t=5
PV0 = C5 / (1+r)5
= 23,000 / (1.064)5
= $16,866
Enter
5
6.4
N
I%
PV
Solve for
-16,866
0
PMT
23,000
FV
Value of B = $38,000 $16,866 = $21,134
Enter
4.6
-21,134
0
32,000
N
I%
PV
PMT
FV
Solve for
9.22
Answer: D
28

To solve:
PV0 = Ct / (1+r)t
Ct = 32,000
r = .064
t=5
PV0 = C5 / (1+r)5
= 32,000 / (1.064)5
= $25,556
Enter
5
6.4
N
I%
PV
Solve for
-23,466
0
PMT
32,000
FV
Value of B = $38,000 $23,466 = $14,534
Enter
4.6
-14,534
0
23,000
N
I%
PV
PMT
FV
Solve for
10.21
Answer: E
29

Find next CF of growing perpetuity and then use growth rate to get future CF
A. $1,708 (plus or minus $10)
B. $1,805 (plus or minus $10)
C. $1,908 (plus or minus $10)
D. $1,952 (plus or minus $10)
E. None of the above is within $10 of the correct answer
Time
Cash
flow
Present
value
2
?
(1.057)
3
?
(1.057)2
4
?
(1.057)3
5
?
(1.057)4
6
?
(1.057)5
7
?
(1.057)6
8
?
(1.057)7
38,000
Approach:
1) find the expected cash flow in 1 year
2) use the expected cash flow in 1 year and the growth rate to find the expected cash flow in
5 years
The cash flows reflect a growing perpetuity
PV = C1 / (r g)
PV = 38,000
r = .093
g = .057
38,000 = C1 / (.093 .057) = C1 / .036
C1 = 38,000 .036 = $1,368
5 years
We know that C5 = C1 (1+g)4
= 1,368 (1.057)4
= 1,707.69
30

Time
Cash
flow
Present
value
2
?
(1.057)
3
?
(1.057)2
4
?
(1.057)3
5
?
(1.057)4
6
?
(1.057)5
7
?
(1.057)6
8
?
(1.057)7
38,000
Approach:
6 years
PV = C1 / (r g)
PV = 38,000
r = .093
g = .057
38,000 = C1 / (.093 .057) = C1 / .036
C1 = 38,000 .036 = $1,368
6 years
= 1,368 (1.057)5
= 1,804.93
31

Time
Cash
flow
Present
value
2
?
(1.057)
3
?
(1.057)2
4
?
(1.057)3
5
?
(1.057)4
6
?
(1.057)5
7
?
(1.057)6
8
?
(1.057)7
38,000
Approach:
7 years
PV = C1 / (r g)
PV = 38,000
r = .093
g = .057
38,000 = C1 / (.093 .057) = C1 / .036
C1 = 38,000 .036 = $1,368
7 years
= 1,368 (1.057)6
= 1,907.81
32

Time
Cash
flow
Present
value
2
?
(1.057)
3
?
(1.057)2
4
?
(1.057)3
5
?
(1.057)4
6
?
(1.057)5
7
?
(1.057)6
8
?
(1.057)7
38,000
Approach:
8 years
PV = C1 / (r g)
PV = 38,000
r = .093
g = .057
38,000 = C1 / (.093 .057) = C1 / .036
C1 = 38,000 .036 = $1,368
8 years
= 1,368 (1.057)7
= 2,016.56
33

Find payment with PV annuity and an extra, interim cash flow
Time
Payment #
Regular Pmt amt
Extra Pmt
Present value
0
0
0
0
-$13,000
1
1
?
0
2
2
?
0
3
3
?
-4,000
4
4
?
0
5
5
?
0
The annual payment can not be found in one step on the financial calculator.
Approach
1) Find the present value of the extra payment made in 3 years
2) Find the present value of the stream of regular payments
3) Find the amount of each regular payment
The present value of a -$4,000 cash flow in 3 years at an annual rate of 12.3% is equal to:
-4,000/1.1233 = -2,824.36
The present value of all cash flows associated with all loan payments is -13,000
If the -4,000 cash flow in 3 years has a present value of -2,824.36, then the present value of the 5
annual fixed cash flows that start in 1 year and end in 5 years is equal to:
-13,000 (-2,824.36) = -10,175.64
Find the payment associated with an annuity with a present value of -10,175.64, a total of 5
payments, and a periodic discount rate of 12.3%
END mode
Enter
5
N
12.3
I%
Solve for
PMT
-2,843.83
10,175.64
PV
0
FV

The regular annual payment would be $2,843.83
Answer: D
$2,843.83 is an amount equal to or greater than $2,835.00 but less than $2,885.00
34

Time
Payment #
Regular Pmt amt
Extra Pmt
Present value
0
0
0
0
-$13,000
1
1
?
0
2
2
?
-4,000
3
3
?
0
4
4
?
0
5
5
?
0
Approach
-4,000/1.1232 = -3,171.76
-13,000 (-3,171.76) = -9,828.24
Find the payment associated with an annuity with a present value of -9,828.24, a total of 5 payments,
and a periodic discount rate of 12.3%
END mode
Enter
5
N
12.3
I%
Solve for
PMT
-2,746.74
9,828.24
PV
0
FV

Answer: B
35

Time
Payment #
Regular Pmt amt
Extra Pmt
Present value
0
0
0
0
-$13,000
1
1
?
0
2
2
?
0
3
3
?
-4,000
4
4
?
0
5
5
?
0
Approach
-4,000/1.1323 = -2,757.53
-13,000 (-2,757.53) = -10,242.47
Find the payment associated with an annuity with a present value of -10,242.47, a total of 5
payments, and a periodic discount rate of 13.2%
END mode
Enter
5
N
13.2
I%
Solve for
PMT
-2,926.31
10,242.47
PV
0
FV

Answer: E
36

Time
Payment #
Regular Pmt amt
Extra Pmt
Present value
0
0
0
0
-$13,000
1
1
?
0
2
2
?
-4,000
3
3
?
0
4
4
?
0
5
5
?
0
Approach
-4,000/1.1322 = -3,121.53
-13,000 (-3,121.53) = -9,878.47
Find the payment associated with an annuity with a present value of -9,878.47, a total of 5 payments,
and a periodic discount rate of 13.2%
END mode
Enter
5
N
13.2
I%
Solve for
PMT
-2,822.31
9,878.47
PV
0
FV

Answer: C
37

Find annuity due value and expected return from fixed perpetuity to compare value & risk
4. Investment A has an expected return of 9.7 percent and is expected to pay $75 per year for a
finite number of years such that its first annual payment is expected later today and its last
annual payment is expected in 5 years from today. Investment B is expected to pay $31 per year
forever, is expected to make its first payment in 1 year from today, and has a value of $325.
Based on the given information, which one of the following assertions is true?
A. Investment A is more valuable than investment B and investment A has more risk than
investment B
B. Investment A is more valuable than investment B and investment B has more risk than
investment A
C. Investment B is more valuable than investment A and investment A has more risk than
investment B
D. Investment B is more valuable than investment A and investment B has more risk than
investment A
E. Investment A is equally as valuable as investment B or investment A has the same amount of
risk as investment B
To answer this question, find the value of each investment and find the expected return of each
investment, since higher expected return is associated with higher risk
Value of each investment
Value of A is the value of an annuity due with 6 payments, a discount rate of 9.7%, and a regular cash
flow of $75
Time
0
1
2
3
4
5
Pmt #
1
2
3
4
5
6
CF
75
75
75
75
75
75
BEGIN Mode
Enter
6
N
Solve for
Value of A = $361.50
Value of B is given as $325
9.7
I%
PV
-361.50
75
PMT
0
FV
Value of A > value of B

Risk of each investment
To compare the risk of the investments, compare their expected returns, since higher risk is
associated with higher expected return
Expected return for investment A is given as 9.7%
Investment B is a fixed perpetuity, so its expected return = r = C / PV
C = 31
PV = 325
r = 31 / 325 = .0954 = 9.54%
Expected return for B = 9.54%
Expected return for A = 9.7% > 9.54% = expected return for B
So A has more risk than B
Putting it all together: Value of A > value of B and A has more risk than B
38

A. Investment A is more valuable than investment B and investment A has more risk than
investment B
B. Investment A is more valuable than investment B and investment B has more risk than
investment A
C. Investment B is more valuable than investment A and investment A has more risk than
investment B
D. Investment B is more valuable than investment A and investment B has more risk than
investment A
flow of $75
Time
0
1
2
3
4
5
6
Pmt #
1
2
3
4
5
6
7
CF
75
75
75
75
75
75
75
BEGIN Mode
Enter
7
N
Solve for
9.7
I%
PV
-404.54
75
PMT
0
FV

C = 37
PV = 375
r = 37 / 375 = .0987 = 9.87%
Expected return for B = 9.87% > 9.7% = expected return for A
So B has more risk than A
Putting it all together: Value of A > value of B and B has more risk than A
39

A. Investment B is more valuable than investment A and investment B has more risk than
investment A
B. Investment B is more valuable than investment A and investment A has more risk than
investment B
C. Investment A is more valuable than investment B and investment B has more risk than
investment A
D. Investment A is more valuable than investment B and investment A has more risk than
investment B
flow of $75
Time
0
1
2
3
4
5
Pmt #
1
2
3
4
5
6
CF
75
75
75
75
75
75
BEGIN Mode
Enter
6
N
Solve for
7.9
I%
PV
-375.24
75
PMT
0
FV

C = 29
PV = 355
r = 29 / 355 = .0954 = 8.17%
Expected return for B = 8.17% > 7.9% = expected return for A
So B has more risk than A
Putting it all together: Value of A > value of B and B has more risk than A
40

A. Investment B is more valuable than investment A and investment B has more risk than
investment A
B. Investment B is more valuable than investment A and investment A has more risk than
investment B
C. Investment A is more valuable than investment B and investment B has more risk than
investment A
D. Investment A is more valuable than investment B and investment A has more risk than
investment B
flow of $75
Time
0
1
2
3
4
5
6
Pmt #
1
2
3
4
5
6
7
CF
75
75
75
75
75
75
75
BEGIN Mode
Enter
7
N
Solve for
7.9
I%
PV
-422.77
75
PMT
0
FV

C = 30
PV = 385
r = 30 / 385 = .0779 = 7.79%
Expected return for A = 7.9% > 7.79% = expected return for B
So A has more risk than B
Putting it all together: Value of A > value of B and A has more risk than B
41

Find missing CF associated with future value of multiple cash flows
The future value of multiple cash flows at different points in time is the sum of the future values of
each individual cash flow, so find the future value of the investment made in 1 year from today, then
find the future value of the investment made in 4 years from today, and then find the actual amount
of the investment made in 4 years from today.
Time
0
1
2
3
4
5
6
Invest
13,400
?
Future value
38,000
Future value of the investment made in 1 year from today
In general, FVt = Ck (1+r)t-k
In this case, r = .051; t = 6; k = 1; t k = 5; Ck = C1 = 13,400;
FV6 = C1 (1+r)5
= 13,400 (1.051)5 = 17,184
Mode is not relevant, since PMT = 0
Enter
5
5.1
N
I%
Solve for
-13,400
PV
0
PMT
FV
17,184
Future value of investment made in 4 years from today

If Georgia expects to have $38,000 in her account in 6 years
And if the investment made in 1 year from today is expected to be worth $17,184 in 6 years
Then the investment made in 4 years from today will be worth $38,000 $17,184 = $20,816 in 6 years
Investment made in 4 years from today
In this case for the investment made in 4 years from today, FV6 = C4 (1+r)6-4 = C4 (1+r)2
We know FV6 = 20,816; r = .051; t = 6; k = 4; and t k = 2
So 20,816 = C4 (1.051)2
So C4 = 20,816 / (1.051)2 = $18,845
Enter
2
5.1
N
I%
Solve for
PV
-18,845
0
PMT
Answer: E
$18,845 is an amount equal to or greater than $18,000 but less than $19,000
42
20,816
FV

Time
0
1
2
3
4
5
6
Invest
15,200
?
Future value
38,000
FV6 = C1 (1+r)5
= 15,200 (1.051)5 = 19,492
Enter
5
5.1
N
I%
Solve for
-15,200
PV
0
PMT
FV
19,492

So 18,508 = C4 (1.051)2
So C4 = 18,508 / (1.051)2 = $16,755
Enter
2
5.1
N
I%
Solve for
PV
-16,755
0
PMT
Answer: C
43
18,508
FV

Time
0
1
2
3
4
5
6
Invest
13,400
?
Future value
38,000
FV6 = C1 (1+r)5
= 13,400 (1.051)5 = 17,184
Enter
5
5.1
N
I%
Solve for
-13,400
PV
0
PMT
FV
17,184

So 20,816 = C2 (1.051)4
So C2 = 20,816 / (1.051)4 = $17,060
Enter
4
5.1
N
I%
Solve for
PV
-17,060
0
PMT
Answer: D
44
20,816
FV

Time
0
1
2
3
4
5
6
Invest
15,200
?
Future value
38,000
FV6 = C1 (1+r)5
= 15,200 (1.051)5 = 19,492
Enter
5
5.1
N
I%
Solve for
-15,200
PV
0
PMT
FV
19,492

So 18,508 = C2 (1.051)4
So C2 = 18,508 / (1.051)4 = $15,169
Enter
4
5.1
N
I%
Solve for
PV
-15,169
0
PMT
Answer: B
45
18,508
FV

Save with annuity and then give a growing perpetuity: what is first perpetuity CF
6. Georgia wants to create a scholarship fund by making annual savings donations to the fund for several
years before the fund starts making annual scholarship payments forever. She plans to save $45,000 per
year in a trust fund for 4 years. Her first savings donation to the trust fund is expected in 1 year from
today. What is the expected amount of the scholarship payment that the trust fund will make in 5 years
from today if the fund is expected to have a return of 8.3 percent per year, make annual scholarship
payments that grow annually by 4.4 percent forever, and make its first annual scholarship payment in 5
years from today?
Step 1: find how much money will be in the trust fund in 4 years (which is one year before the
scholarship payments start)
Step 2: find the amount of the payment that can be produced in 5 years
Time period
Savings #
Savings amount
Future value
Present value
Donation #
Donation amount
1
1
45k
2
2
45k
3
3
45k
4
4
45k
?A
?A
1
?
2
?1.02
3
?1.022
Step 1: find how much money will be in the trust fund in 4 years (denoted by ?A)
If the first savings donation is made in 1 year and the last savings donation is made in 4 years, then
the amount of money accumulated in 4 years can be found by finding the future value of a 4-year
annuity, since the first payment will be made in 1 year, there will be 4 expected payments, and all
expected payments will be equal.
END mode
Enter
4
N
8.3
I%
0
PV
-45,000
PMT
Solve for
In 4 years, the scholarship fund is expected to have $203,676
FV
203,676
The first annual scholarship payment is expected 1 year after the reference point, when the fund is
expected to have $203,676. One year after the reference point of 4 years is in 5 years from today and
we want to know the payment that can be made at that time. To find how much the scholarship
payment in 5 years from today can be for, we need to find the first payment associated with a growing
perpetuity with a present value of $203,676, a growth rate of 4.4%, and a discount rate of 8.3%.
PV4 = C5 / (r g) or resetting the timeline gets PV0 = C1 / (r g)
So $203,676 = C5 / (.083 .044)
= C5 / .039
So C5 = $203,676 .039 = $7,943
The scholarship fund is expected to make a payment of $7,943 in 5 years from today
Answers may differ slightly due to rounding
46

years from today?
Time period
Savings #
Savings amount
Future value
Present value
Donation #
Donation amount
1
1
45k
2
2
45k
3
3
45k
4
4
45k
?A
?A
1
?
2
?1.02
3
?1.022
END mode
Enter
4
N
8.3
I%
0
PV
-45,000
PMT
Solve for
FV
203,676
So $203,676 = C5 / (.083 .039)
= C5 / .044
So C5 = $203,676 .044 = $8,962
47

years from today?
Time period
Savings #
Savings amount
Future value
Present value
Donation #
Donation amount
1
1
54k
2
2
54k
3
3
54k
4
4
54k
?A
?A
1
?
2
?1.02
3
?1.022
END mode
Enter
4
N
8.3
I%
0
PV
-54,000
PMT
Solve for
FV
244,411
So $244,411 = C5 / (.083 .044)
= C5 / .039
So C5 = $244,411 .039 = $9,532
48

years from today?
Time period
Savings #
Savings amount
Future value
Present value
Donation #
Donation amount
1
1
54k
2
2
54k
3
3
54k
4
4
54k
?A
?A
1
?
2
?1.02
3
?1.022
END mode
Enter
4
N
8.3
I%
0
PV
Solve for
-54,000
PMT
FV
244,411
So $244,411 = C5 / (.083 .039)
= C5 / .044
So C5 = $244,411 .044 = $10,754
49

Find R then EAR from FV and payments
To solve:
1) Find the monthly rate that he expects to earn
2) Find the EAR associated with the monthly rate from step 1
If he makes payments for 4 years, then he will make 4 12 = 48 payments, so N = 48
If he has $900 in his account today, then PV = -900
END Mode
Enter
Solve for
48
N
I%
0.71
-900
PV
-47
PMT
0.71 percent is the monthly rate associated with Dats savings

EAR = [(1+periodic rate)number of periods in a year] 1
= [(1+monthly rate)number of months in a year] 1
= [(1.0071)12] 1
= 1.0886 1
= 0.0886 = 8.86%
Answer: D
8.86% is a rate equal to or greater than 8.80% but less than 9.20%
50
3,940.83
FV

To solve:
END Mode
Enter
Solve for
48
N
I%
0.74
-900
PV
-47
PMT

= [(1.0074)12] 1
= 1.0925 1
= 0.0925 = 9.25%
Answer: E
51
3,978.94
FV

To solve:
END Mode
Enter
Solve for
48
N
I%
0.68
-900
PV
-47
PMT

= [(1.0068)12] 1
= 1.0847 1
= 0.0847 = 8.47%
Answer: C
52
3,903.15
FV

To solve:
END Mode
Enter
Solve for
48
N
I%
0.66
-900
PV
-47
PMT

= [(1.0066)12] 1
= 1.0821 1
= 0.0821 = 8.21%
Answer: B
53
3,878.28
FV

Conceptual: identify which bond has higher coupon rate and higher YTM from relative price
bonds C and D have different yields-to-maturity. Which assertion is true if PA > PB > 0, PD >
Bond
Bond Price
Time-to-maturity
Yield-to-maturity
A
PA
T
Y
B
PB
T
Y
Bond
Bond Price
Time-to-maturity
Coupon rate
C
PC
T
C
D
PD
T
C
Bond A and bond B
If two bonds have the same YTM, face value, time to maturity, and coupon payment
schedule, but different coupon rates, then the only difference between the two bonds would
be their regular coupon payments. The one with the higher coupons would be worth more
than the one with the lower coupons. Therefore, the bond with the higher coupon rate
would have the greater value and the bond with the lower coupon rate would have the
lower. Since bonds A and B are alike in all respects except for their coupon rates and since
PA > PB, the coupon rate of bond A is greater than the coupon rate of bond B.
Coupon rate of A > coupon rate of B
Bond C and bond D
If two bonds have the same coupon rate, face value, time to maturity, and coupon payment
schedule, but different YTMs, then the bond with the higher YTM has the lower value and
the bond with the lower YTM has the higher value. Since bonds C and D are alike in all
respects except for their YTMs and since PD > PC, the yield-to-maturity of bond C is
greater than the yield-to-maturity of bond D.
YTM of C > YTM of D
Answer:
54

bonds C and D have different yields-to-maturity. Which assertion is true if PA > PB > 0, PC >
Bond
Bond Price
Time-to-maturity
Yield-to-maturity
A
PA
T
Y
B
PB
T
Y
Bond
Bond Price
Time-to-maturity
Coupon rate
C
PC
T
C
D
PD
T
C
Bond A and bond B
PA > PB, the coupon rate of bond A is greater than the coupon rate of bond B.
Coupon rate of A > coupon rate of B
Bond C and bond D
respects except for their YTMs and since PC > PD, the yield-to-maturity of bond D is
greater than the yield-to-maturity of bond C.
YTM of D > YTM of C
Answer:
55

bonds C and D have different yields-to-maturity. Which assertion is true if PB > PA > 0, PD >
Bond
Bond Price
Time-to-maturity
Yield-to-maturity
A
PA
T
Y
B
PB
T
Y
Bond
Bond Price
Time-to-maturity
Coupon rate
C
PC
T
C
D
PD
T
C
Bond A and bond B
PB > PA, the coupon rate of bond B is greater than the coupon rate of bond A.
Coupon rate of B > coupon rate of A
Bond C and bond D
respects except for their YTMs and since PD > PC, the yield-to-maturity of bond C is
greater than the yield-to-maturity of bond D.
YTM of C > YTM of D
Answer:
56

bonds C and D have different yields-to-maturity. Which assertion is true if PB > PA > 0, PC >
Bond
Bond Price
Time-to-maturity
Yield-to-maturity
A
PA
T
Y
B
PB
T
Y
Bond
Bond Price
Time-to-maturity
Coupon rate
C
PC
T
C
D
PD
T
C
Bond A and bond B
PB > PA, the coupon rate of bond B is greater than the coupon rate of bond A.
Coupon rate of B > coupon rate of A
Bond C and bond D
respects except for their YTMs and since PC > PD, the yield-to-maturity of bond D is
greater than the yield-to-maturity of bond C.
YTM of D > YTM of C
Answer:
57

Find semi-annual coupon from return and then find coupon rate
A. 11.93% (plus or minus 0.03 percentage points)
B. 9.93% (plus or minus 0.03 percentage points)
C. 12.29% (plus or minus 0.03 percentage points)
D. 6.14% (plus or minus 0.03 percentage points)
E. None of the above is within 0.03 percentage points of the correct answer
Coupon rate = annual coupons / par value
Par value is given as $1,000
Find annual coupons as twice the semi-annual coupon
The annual coupons can be found as the semi-annual coupon the number of coupons per
year = the semi-annual coupon 2
The semi-annual coupons on the bond can be found from the percentage return on the bonds
over the past 6 months
Percentage return over the past 6 months
= (cash flow from investment + ending value initial value) / initial value
= (semi-annual coupon + ending value initial value) / initial value
Percentage return over the past 6 months = 5.6% = .056
Initial value = price of bond 6 months ago = $976.00
Ending value = price of bond today = $971.00
Percentage return = (semi-annual coupon + ending value initial value) / initial value
So .056 = (semi-annual coupon + 971.00 976.00) / 976.00
= (semi-annual coupon + (-5.00)) / 976.00
So .056 976.00 = 54.66 = (semi-annual coupon + (-5))
So semi-annual coupon = 54.66 + 5.00 = 59.66
So annual coupons = semi-annual coupon 2 = 59.66 2 = 119.32
= $119.32 / $1,000 = .11932 = 11.93%
58

= $109.72 / $1,000 = .10972 = 10.97%
59

= $136.88 / $1,000 = .13688 = 13.69%
60

= $126.38 / $1,000 = .12638 = 12.64%
61

Find current price from expected dividend and price in quarter with annual expected return
immediately after paying its quarterly dividend in 6 months from today. What is the current
price of Erie Shipping stock if the quarterly dividend in 3 months from today is expected to be
$1.29?
P0 = (D1 + P1) (1 + R)
D1 = 1.29
P1 = 23.68
R = annual expected stock return divided by the number of possible dividends per year
= .132 / 4 = .033 = 3.4%
P0 = (1.29 + 23.68) 1.033
= 24.97 1.033
= $24.17
Answer: B
$24.17 is an amount equal to or greater than $24.00 but less than $26.00
62

$1.92?
P0 = (D1 + P1) (1 + R)
D1 = 1.92
P1 = 23.68
= .132 / 4 = .033 = 3.4%
P0 = (1.92 + 23.68) 1.033
= 25.60 1.033
= $24.78
Answer: B
63

$1.29?
P0 = (D1 + P1) (1 + R)
D1 = 1.29
P1 = 26.38
= .132 / 4 = .033 = 3.4%
P0 = (1.29 + 26.38) 1.033
= 27.67 1.033
= $26.79
Answer: C
64

$1.92?
P0 = (D1 + P1) (1 + R)
D1 = 1.92
P1 = 26.38
= .132 / 4 = .033 = 3.4%
P0 = (1.92 + 26.38) 1.033
= 28.30 1.033
= $27.40
Answer: C
65

Find g from ER, D1, and P0 computed by valuing bond
Since we know the stocks next expected dividend and that it is expected to grow at a
constant rate forever, we can find out that growth rate if we know its price
We know that bond value + stock value = $1,300
If we find the bond value, we can find the stock value, and we can find the dividend growth rate
Finding the bond value
N = 11 years 2 coupons per year = 22
I% = YTM # coupons per year = 8.0 2 = 4.0
PMT = par coupon rate # coupons per year = 1000 9.8% 2 = 49
FV = 1,000 = par
END mode
Enter
22
N
4.0
I%
Solve for
49
PMT
PV
-1,130.06
1000
FV
Finding the stock value

Since bond value + stock value = $1,300, stock value = $1,300 $1,130.06 = $169.94
Finding the dividend growth rate
The annual dividend is expected to grow at a constant rate with the next one expected in
one year, so we can use the constant growth model
P0 = D1 / (R g), so R = (D1 / P0) + g and g = R (D1 / P0)
D1 = $5.61
P0 = $169.94
R is the annual return expected on the stock divided by the number of possible dividends
per year = 11.2% 1 = 11.2% = .112
g = R (D1 / P0)
= .1120 (5.61 / 169.94)
= .1120 .0330
= .0790 = 7.90%
66

FV = 1,000 = par
END mode
Enter
26
N
4.0
I%
Solve for
49
PMT
PV
-1,143.84
1000
FV

D1 = $6.51
P0 = $156.16
per year = 11.2% 1 = 11.2% = .112
g = R (D1 / P0)
= .1120 (6.51 / 156.16)
= .1120 .0417
= .0703 = 7.03%
67

FV = 1,000 = par
END mode
Enter
26
N
4.0
I%
Solve for
49
PMT
PV
-1,143.84
1000
FV

D1 = $5.61
P0 = $156.16
per year = 12.1% 1 = 12.1% = .121
g = R (D1 / P0)
= .1210 (5.61 / 156.16)
= .1210 .0359
= .0851 = 8.51%
68

FV = 1,000 = par
END mode
Enter
22
N
4.0
I%
Solve for
49
PMT
PV
-1,130.06
1000
FV

D1 = $6.51
P0 = $169.94
per year = 12.1% 1 = 12.1% = .121
g = R (D1 / P0)
= .1210 (6.51 / 169.94)
= .1210 .0383
= .0827 = 8.27%
69

Find NPV and payback to decide whether to accept/reject a project
12. The following table presents information on a potential project with conventional cash flows
currently being evaluated by Erie Shipping. Which assertion about statement 1 and statement 2 is
true?
Opportunity
0
1
2
3
4
cost of capital
-76,000
38,000
29,000
19,000
6,000
13.2%
Statement 1: Erie Shipping would accept the project based on the projects net present value
(NPV) and the NPV rule
Statement 2: Erie Shipping would accept the project based on the projects payback period and
the payback rule if the payback threshold is 2.55 years
NPV
NPV = [-76,000] + [38,000 / 1.132] + [29,000 / 1.1322] + [19,000 / 1.1323] + [6,000 / 1.1324] = -$3,048
npv(13.2,-76000,{38000,29000,19000,6000}) -$3,048
The project would be rejected, because it has a negative NPV
Statement 1 is false
Payback
Year
Expected CF Expected CF needed after year-end
0
-76,000
76,000
1
38,000
76,000 38,000 = 38,000
2
29,000
38,000 29,000 = 9,000
3
19,000
9,000 19,000 = -10,000
4
6,000
Payback occurs between 2 and 3 years
After 2 years, 9,000 in expected cash flows are needed
In year 3, the expected cash flow is $19,000
Therefore, it would take ($9,000 / $19,000) = 0.47 of year 3 to reach payback
So payback = 2 + 0.47 = 2.47 years
The project would be accepted using payback, because its payback period is 2.47 years,
which is less than the threshold of 2.55 years
Statement 2 is true
Putting everything together: C. statement 1 is false and statement 2 is true
70

true?
Opportunity
0
1
2
3
4
cost of capital
-76,000
38,000
18,000
35,000
6,000
14.3%
NPV
NPV = [-76,000] + [38,000 / 1.143] + [18,000 / 1.1432] + [35,000 / 1.1433] + [6,000 / 1.1434] = -$2,023
npv(14.3,-76000,{38000,18000,35000,6000}) -$2,023
Payback
Year
0
-76,000
76,000
1
38,000
76,000 38,000 = 38,000
2
18,000
38,000 18,000 = 20,000
3
35,000
20,000 35,000 = -15,000
4
6,000
Statement 2 is true
Putting everything together: B. statement 1 is false and statement 2 is true
71

true?
Opportunity
0
1
2
3
4
cost of capital
-67,000
38,000
24,000
12,000
6,000
12.5%
NPV
NPV = [-67,000] + [38,000 / 1.125] + [24,000 / 1.1252] + [12,000 / 1.1253] + [6,000 / 1.1254] = -$2,086
npv(12.5,-67000,{38000,24000,12000,6000}) -$2,086
Payback
Year
0
-67,000
67,000
1
38,000
67,000 38,000 = 29,000
2
24,000
29,000 24,000 = 5,000
3
12,000
5,000 12,000 = -7,000
4
6,000
Statement 2 is true
Putting everything together: C. statement 1 is false and statement 2 is true
72

true?
Opportunity
0
1
2
3
4
cost of capital
-67,000
38,000
22,000
18,000
6,000
14.4%
NPV
NPV = [-67,000] + [38,000 / 1.144] + [22,000 / 1.1442] + [18,000 / 1.1443] + [6,000 / 1.1444] = -$1,448
npv(14.4,-67000,{38000,22000,18000,6000}) -$1,448
Payback
Year
0
-67,000
67,000
1
38,000
67,000 38,000 = 29,000
2
22,000
29,000 22,000 = 7,000
3
18,000
7,000 18,000 = -11,000
4
6,000
Statement 2 is true
Putting everything together: B. statement 1 is false and statement 2 is true
73

Find NPV with opportunity cost, terminal value, and project sale
13. Erie Shipping is evaluating the turbine project. Today, the project would require an initial
investment in equipment of $65,000. Relevant annual operating cash flows of $41,000 per year
are expected in years 1, 2, and 3, and relevant operating cash flows that are not equal to $0 are
expected in years 4, 5 and 6. In 4 years, the project is expected to have an after-tax terminal
value of $54,000. In 2 years, the project is expected to be sold by Erie Shipping for an after-tax
amount of $45,000. Instead of pursuing the turbine project, Erie Shipping could sell the rights to
the project to Huron Shipping for a $36,000 after-tax payment today from Huron Shipping. The
cost of capital for this project is 11 percent. What is the net present value of the turbine project?
Although there is a terminal value in 4 years, the project is expected to be sold in 2 years, so
we only need to examine cash flow components for up to 2 years.
The terminal value in 4 years is relevant for the firm that buys the project. Once Erie
Shipping sells the project in 2 years, the cash flows to and from them relevant to this
project are complete.
The $36,000 payment that could be received today if the turbine project were not pursued
is an opportunity cost that must be taken into account. Pursuing the turbine project would
result in forgoing the $36,000 today.
All the information needed to find the NPV of the project is given.
OCF
+ Cash flows from NWC
+ CF from capital spending
+ CF from project sale
+ Terminal value
- Opportunity costs
= Relevant CF
0
0
0
-65,000
0
0
36,000
-101,000
Year
1
41,000
0
0
0
0
41,000
2
41,000
0
0
45,000
0
0
86,000
NPV = -101,000 + (41,000 / 1.11) + (86,000 / 1.112) = $5,736

npv(11,-101000,{41000,86000}) 5,736
Answer: B
$5,736 is an amount equal to or greater than $0 but less than or equal to $10,000
74

OCF
+ Terminal value
- Opportunity costs
= Relevant CF
0
0
0
-56,000
0
0
36,000
-92,000
Year
1
41,000
0
0
0
0
41,000
2
41,000
0
0
45,000
0
0
86,000
NPV = -92,000 + (41,000 / 1.11) + (86,000 / 1.112) = $14,736

npv(11,-92000,{41000,86000}) 14,736
Answer: C
$14,736 is an amount equal to or greater than $10,000 but less than or equal to $20,000
75

OCF
+ Terminal value
- Opportunity costs
= Relevant CF
0
0
0
-65,000
0
0
36,000
-101,000
Year
1
41,000
0
0
0
0
41,000
2
41,000
0
0
54,000
0
0
95,000
NPV = -101,000 + (41,000 / 1.11) + (95,000 / 1.112) = $13,041

npv(11,-101000,{41000,95000}) 13,041
Answer: C
76

OCF
+ Terminal value
- Opportunity costs
= Relevant CF
0
0
0
-56,000
0
0
36,000
-92,000
Year
1
41,000
0
0
0
0
41,000
2
41,000
0
0
54,000
0
0
95,000
NPV = -92,000 + (41,000 / 1.11) + (95,000 / 1.112) = $22,041

npv(11,-92000,{41000,95000}) 22,041
Answer: D
77

Find NPV from revs/costs/investment/asset sale
A. $26,257 (plus or minus $100)
B. -$32,295 (plus or minus $100)
C. $27,779 (plus or minus $100)
D. -$120,124 (plus or minus $100)
In a given year, the relevant cash flow for a project
= operating cash flow + cash flow effects from changes in net working capital + cash flow from capital
spending + cash flow from selling project + terminal value opportunity costs
In this case, cash flow effects from changes in net working capital, cash flow from selling project, terminal
value, and opportunity costs are zero in each year.
Therefore, to get relevant cash flow is each year, we need to find operating cash flow and cash flow from capital spending.
Annual SL depreciation = (investment amount asset is depreciated to) / depreciable life
= (270,000 0) / 5 = 54,000 per year
OCF
Year
0
1
2
Revenues
0
144,000
144,000
Costs
0
56,000
56,000
Annual depreciation
0
54,000
54,000
EBIT (revs costs depreciation)
0
34,000
34,000
Tax rate
0.40
0.40
0.40
Taxes
0
13,600
13,600
Net income = EBIT taxes
0
20,400
20,400
OCF = Net income + depreciation
0
74,400
74,400
CF from asset sale
CF from asset sale = sales price of asset taxes paid on sale of asset
Taxes on sale of asset = taxable gain on sale of asset tax rate
Taxable gain on sale of asset = (sales price of asset book value of asset)
Book value = initial price of asset accumulated depreciation
Accumulated depreciation = 0 + 54,000 + 54,000 = 108,000
Book value = 270,000 108,000 = 162,000
Taxable gain on asset sale = 184,000 162,000 = 22,000
Taxes on sale of asset = 22,000 .40 = 8,800
CF from asset sale = 184,000 8,800 = 175,200
Relevant CF
OCF
Cash flow effects from NWC
CF from capital spending
CF from project sale
Terminal value
Opportunity costs
Relevant CF
npv(5.2,-270000,{74400,249600}) 26,257
0
0
0
-270,000
0
0
0
-270,000
78
Year
1
74,400
0
0
0
0
0
74,400
2
74,400
0
175,200
0
0
0
249,600

A. $16,075 (plus or minus $100)
B. -$48,983 (plus or minus $100)
C. $17,767 (plus or minus $100)
D. -$146,570 (plus or minus $100)
= (270,000 0) / 6 = 45,000 per year
OCF
Year
0
1
2
Revenues
0
144,000
144,000
Costs
0
65,000
65,000
Annual depreciation
0
45,000
45,000
0
34,000
34,000
Tax rate
0.40
0.40
0.40
Taxes
0
13,600
13,600
0
20,400
20,400
0
65,400
65,400
CF from asset sale
Book value = 270,000 90,000 = 180,000
Relevant CF
OCF
Terminal value
Opportunity costs
Relevant CF
npv(5.2,-270000,{65400,247800}) 16,075
0
0
0
-270,000
0
0
0
-270,000
79
Year
1
65,400
0
0
0
0
0
65,400
2
65,400
0
182,400
0
0
0
247,800

A. $28,426 (plus or minus $100)
B. -$30,127 (plus or minus $100)
C. $29,948 (plus or minus $100)
D. -$117,955 (plus or minus $100)
= (270,000 0) / 5 = 54,000 per year
OCF
Year
0
1
2
Revenues
0
144,000
144,000
Costs
0
56,000
56,000
Annual depreciation
0
54,000
54,000
0
34,000
34,000
Tax rate
0.40
0.40
0.40
Taxes
0
13,600
13,600
0
20,400
20,400
0
74,400
74,400
CF from asset sale
Book value = 270,000 108,000 = 162,000
Relevant CF
OCF
Terminal value
Opportunity costs
Relevant CF
npv(5.2,-270000,{74400,252000}) 28,426
0
0
0
-270,000
0
0
0
-270,000
80
Year
1
74,400
0
0
0
0
0
74,400
2
74,400
0
177,600
0
0
0
252,000

A. $18,244 (plus or minus $100)
B. -$46,814 (plus or minus $100)
C. $19,936 (plus or minus $100)
D. -$144,401 (plus or minus $100)
= (270,000 0) / 6 = 45,000 per year
OCF
Year
0
1
2
Revenues
0
144,000
144,000
Costs
0
65,000
65,000
Annual depreciation
0
45,000
45,000
0
34,000
34,000
Tax rate
0.40
0.40
0.40
Taxes
0
13,600
13,600
0
20,400
20,400
0
65,400
65,400
CF from asset sale
Book value = 270,000 90,000 = 180,000
Relevant CF
OCF
Terminal value
Opportunity costs
Relevant CF
npv(5.2,-270000,{65400,250200}) 18,244
0
0
0
-270,000
0
0
0
-270,000
81
Year
1
65,400
0
0
0
0
0
65,400
2
65,400
0
184,800
0
0
0
250,200

Find initial CA from initial CL, NWC change, and ending NWC
15. Erie Shipping is evaluating a potential project such that the cash flow effect from the change
in net working capital (NWC) is expected to be -$20 at time 2 and the level of net working
capital is expected to be $80 at time 2. What is the level of current assets for the project
expected to be at time 1 if the level of current liabilities for the project is expected to be $230 at
time 1?
A. $290 (plus or minus $10)
B. $330 (plus or minus $10)
C. $170 (plus or minus $10)
D. $130 (plus or minus $10)
Recall that:
1) Cash flow effects from changes in NWC = -NWC
2) The change in NWC equals NWC at a point in time minus NWC at the previous point in
time, so NWCt = NWCt NWCt-1 and in this case: NWC2 = NWC2 NWC1
3) Net working capital (NWC) is measured as current assets (CA) minus current liabilities
(CL), so NWC = CA CL
To solve:
1) Find NWC from the cash flow effects from changes in NWC
2) Find NWC1 from NWC2 and NWC2
3) Find CL1 from NWC1 and CA1
Cash flow effects from changes in NWC = -NWC
-20 = -NWC2
So NWC2 = 20
Since the cash flow effect from the change in net working capital (NWC) is expected to be
-$20 at time 2, then the change in NWC at time 2 is expected to be $20, which means that
NWC is expected to increase by $20 from time 1 to time 2
NWC2 = NWC2 NWC1
20 = 80 NWC1
So NWC1 = 80 20 = 60
NWC is expected to be $60 at time 1 and $80 at time 2, which means that it is expected to
increase by $20 from time 1 to time 2
3) Find CA1 from NWC1 and CL1
NWC1 = CA1 CL1
60 = CA1 230
So CA1 = 60 + 230 = 290
82

in net working capital (NWC) is expected to be $20 at time 2 and the level of net working capital
is expected to be $80 at time 2. What is the level of current assets for the project expected to be
at time 1 if the level of current liabilities for the project is expected to be $230 at time 1?
Recall that:
To solve:
20 = -NWC2
So NWC2 = -20
$20 at time 2, then the change in NWC at time 2 is expected to be -$20, which means that
NWC is expected to decrease by $20 from time 1 to time 2
NWC2 = NWC2 NWC1
-20 = 80 NWC1
So NWC1 = 80 + 20 = 100
decrease by $20 from time 1 to time 2
NWC1 = CA1 CL1
100 = CA1 230
So CA1 = 100 + 230 = 330
83

in net working capital (NWC) is expected to be -$40 at time 2 and the level of net working
capital is expected to be $80 at time 2. What is the level of current assets for the project
expected to be at time 1 if the level of current liabilities for the project is expected to be $320 at
time 1?
Recall that:
To solve:
-40 = -NWC2
So NWC2 = 40
-$40 at time 2, then the change in NWC at time 2 is expected to be $40, which means that
NWC is expected to increase by $40 from time 1 to time 2
NWC2 = NWC2 NWC1
40 = 80 NWC1
So NWC1 = 80 40 = 40
increase by $40 from time 1 to time 2
NWC1 = CA1 CL1
40 = CA1 320
So CA1 = 40 + 320 = 360
84

in net working capital (NWC) is expected to be $40 at time 2 and the level of net working capital
is expected to be $80 at time 2. What is the level of current assets for the project expected to be
at time 1 if the level of current liabilities for the project is expected to be $320 at time 1?
Recall that:
To solve:
40 = -NWC2
So NWC2 = -40
$40 at time 2, then the change in NWC at time 2 is expected to be -$40, which means that
NWC is expected to decrease by $40 from time 1 to time 2
NWC2 = NWC2 NWC1
-40 = 80 NWC1
So NWC1 = 80 + 40 = 120
decrease by $40 from time 1 to time 2
NWC1 = CA1 CL1
120 = CA1 320
So CA1 = 120 + 320 = 440
85

OCF of 2 years using MACRS
the project?
A. $229,700 (plus or minus $100)
B. -$185,100 (plus or minus $100)
C. $93,940 (plus or minus $100)
D. $307,520 (plus or minus $100)
MACRS rate
Initial investment
Annual depreciation
Year 2
0.4444
800,000
355,520
Year 4
0.0741
800,000
59,280
Revenue
Costs
Annual depreciation
EBIT
Tax rate
Taxes
Net inc = EBIT taxes
OCF = net income + depreciation
158,000
74,000
355,520
-271,520
0.25
-67,880
-203,640
151,880
158,000
74,000
59,280
24,720
0.25
6,180
18,540
77,820
OCF in year 2 + OCF in year 4 = 151,880 + 77,820 = 229,700
86

the project?
A. $307,700 (plus or minus $100)
B. -$107,100 (plus or minus $100)
C. $197,940 (plus or minus $100)
D. $424,520 (plus or minus $100)
MACRS rate
Initial investment
Annual depreciation
Year 2
0.4444
800,000
355,520
Year 4
0.0741
800,000
59,280
Revenue
Costs
Annual depreciation
EBIT
Tax rate
Taxes
185,000
49,000
355,520
-219,520
0.25
-54,880
-164,640
190,880
185,000
49,000
59,280
76,720
0.25
19,180
57,540
116,820
87

the project?
A. $282,200 (plus or minus $100)
B. -$132,600 (plus or minus $100)
C. $163,940 (plus or minus $100)
D. $386,270 (plus or minus $100)
MACRS rate
Initial investment
Annual depreciation
Year 2
0.4444
800,000
355,520
Year 4
0.0741
800,000
59,280
Revenue
Costs
Annual depreciation
EBIT
Tax rate
Taxes
194,000
75,000
355,520
-236,520
0.25
-59,130
-177,390
178,130
194,000
75,000
59,280
59,720
0.25
14,930
44,790
104,070
88

the project?
A. $321,200 (plus or minus $100)
B. -$93,600 (plus or minus $100)
C. $215,940 (plus or minus $100)
D. $444,770 (plus or minus $100)
MACRS rate
Initial investment
Annual depreciation
Year 2
0.4444
800,000
355,520
Year 4
0.0741
800,000
59,280
Revenue
Costs
Annual depreciation
EBIT
Tax rate
Taxes
187,000
42,000
355,520
-210,520
0.25
-52,630
-157,890
197,630
187,000
42,000
59,280
85,720
0.25
21,430
64,290
123,570
89

Get geometric from arithmetic and all but one return
To solve:
1) Find the return from 4 years ago
2) Use the returns from the past four years to get the geometric return
Arithmetic annual return = [(r1) + (r2) + + (rn)] / n
Over the past 4 years, arithmetic annual return = [(r1) + (r2) + (r3) + (r4)] / 4
So .065 = [(.17) + (-.24) + (.13) + (r4)] / 4
So .065 4 = [(.17) + (-.24) + (.13) + (r4)]
So .260 = [(.17) + (-.24) + (.13) + (r4)]
= (.06) + (r4)
So .260 (.060) = r4
r4 = .200 = 20.0%
Geometric annual return = [(1 + r1)(1 + r2) (1 + rn)]1/n 1
Over the past four years, geometric annual return = [(1 + r1)(1 + r2)( 1 + r3)(1 + r4)]1/4 1
= [(1 + .17)(1 + (-.24))(1 + .13)(1 + .20)]1/4 1
= [(1.17)(0.76)(1.13)(1.20)]1/4 1
= [1.2057552]1/4 1
= 1.0479 1
= .0479 = 4.79%
Answer: B
90

To solve:
So .065 = [(.24) + (-.17) + (.13) + (r4)] / 4
So .065 4 = [(.24) + (-.17) + (.13) + (r4)]
So .260 = [(.24) + (-.17) + (.13) + (r4)]
= (.20) + (r4)
So .260 (.200) = r4
r4 = .060 = 6.0%
= [(1 + .24)(1 + (-.17))(1 + .13)(1 + .06)]1/4 1
= [(1.24)(0.83)(1.13)(1.06)]1/4 1
= [1.23277576]1/4 1
= 1.0537 1
= .0537 = 5.37%
Answer: C
91

To solve:
So .085 = [(.17) + (-.24) + (.13) + (r4)] / 4
So .085 4 = [(.17) + (-.24) + (.13) + (r4)]
So .340 = [(.17) + (-.24) + (.13) + (r4)]
= (.06) + (r4)
So .340 (.060) = r4
r4 = .280 = 28.0%
= [(1 + .17)(1 + (-.24))(1 + .13)(1 + .28)]1/4 1
= [(1.17)(0.76)(1.13)(1.28)]1/4 1
= [1.28613888]1/4 1
= 1.0649 1
= .0649 = 6.49%
Answer: D
92

To solve:
So .085 = [(.24) + (-.17) + (.13) + (r4)] / 4
So .085 4 = [(.24) + (-.17) + (.13) + (r4)]
So .340 = [(.24) + (-.17) + (.13) + (r4)]
= (.20) + (r4)
So .340 (.200) = r4
r4 = .140 = 14.0%
= [(1 + .24)(1 + (-.17))(1 + .13)(1 + .14)]1/4 1
= [(1.24)(0.83)(1.13)(1.14)]1/4 1
= [1.32581544]1/4 1
= 1.0731 1
= .0731 = 7.31%
Answer: E
93

Get expected SD from 2 states and P0, D1, and P1 in those states
18. Shares of Erie Shipping are currently priced at $16.00 per share. The following table
indicates what could happen with the Erie Shipping stock price and dividend per share over the
next year. What is the expected standard deviation of Erie Shipping stocks returns?
Probability of
Price of Erie Shipping
Dividend paid by Erie
Outcome
outcome
stock in 1 year
Shipping in 1 year
Good
.2
$25.70
$1.50
Bad
.8
$14.55
$0.25
Find the return for Erie Shipping for each possible outcome
Return = (dividends + ending price initial price) / initial price
Return in good = ($1.50 + $25.70 $16.00) / $16.00 = $11.20 / $16.00 = 0.700
Return in bad = ($0.25 + $14.55 $16.00) / $16.00 = -$1.20 / $16.00 = -0.075
Outcome
R(s)
Good
Bad
Total
0.700
-0.075
Weight
for mean
p(s)
0.20
0.80
E(R) =
p(s)
R(s)
R(s)
E(R)
[R(s)
E(R)]2
0.140
-0.060
0.080
0.620
-0.155
0.384400
0.024025
Weight
for var
p(s)
0.20
0.80
Var(R) =
SD(R) =
Answer: B
94
p(s)
[R(s) E(R)]2
0.07688
0.01922
0.0961
0.310 = 31.0%

Probability of
Outcome
outcome
stock in 1 year
Shipping in 1 year
Good
.2
$26.20
$1.80
Bad
.8
$12.95
$0.25
Return in good = ($1.80 + $26.20 $16.00) / $16.00 = $12.00 / $16.00 = 0.750
Return in bad = ($0.25 + $12.95 $16.00) / $16.00 = -$2.80 / $16.00 = -0.175
Outcome
R(s)
Good
Bad
Total
0.750
-0.175
Weight
for mean
p(s)
0.20
0.80
E(R) =
p(s)
R(s)
R(s)
E(R)
[R(s)
E(R)]2
0.150
-0.140
0.010
0.740
-0.185
0.547600
0.034225
Weight
for var
p(s)
0.20
0.80
Var(R) =
SD(R) =
Answer: D
95
p(s)
[R(s) E(R)]2
0.10952
0.02738
0.1369
0.370 = 37.0%

Probability of
Outcome
outcome
stock in 1 year
Shipping in 1 year
Good
.2
$25.70
$1.50
Bad
.8
$13.75
$0.25
Return in good = ($1.50 + $25.70 $16.00) / $16.00 = $11.20 / $16.00 = 0.700
Return in bad = ($0.25 + $13.75 $16.00) / $16.00 = -$2.00 / $16.00 = -0.125
Outcome
R(s)
Good
Bad
Total
0.700
-0.125
Weight
for mean
p(s)
0.20
0.80
E(R) =
p(s)
R(s)
R(s)
E(R)
[R(s)
E(R)]2
0.140
-0.100
0.040
0.660
-0.165
0.435600
0.027225
Weight
for var
p(s)
0.20
0.80
Var(R) =
SD(R) =
Answer: C
96
p(s)
[R(s) E(R)]2
0.08712
0.02178
0.1089
0.330 = 33.0%

Probability of
Outcome
outcome
stock in 1 year
Shipping in 1 year
Good
.2
$26.20
$1.80
Bad
.8
$14.55
$0.25
Return in good = ($1.80 + $26.20 $16.00) / $16.00 = $12.00 / $16.00 = 0.750
Return in bad = ($0.25 + $14.55 $16.00) / $16.00 = -$1.20 / $16.00 = -0.075
Outcome
R(s)
Good
Bad
Total
0.750
-0.075
Weight
for mean
p(s)
0.20
0.80
E(R) =
p(s)
R(s)
R(s)
E(R)
[R(s)
E(R)]2
0.150
-0.060
0.090
0.660
-0.165
0.435600
0.027225
Weight
for var
p(s)
0.20
0.80
Var(R) =
SD(R) =
Answer: C
97
p(s)
[R(s) E(R)]2
0.08712
0.02178
0.1089
0.330 = 33.0%

Conceptual: insider trading and ethics
19. According to the class overheads and basic ethics, which one of the following assertions
about insider trading, which is against the law, is true?
A. Insider trading is illegal and should not be considered as a potential approach to
investing
B. Insider trading is illegal and should be considered as a potential approach to investing
C. Insider trading is legal and should not be considered as a potential approach to investing
D. Insider trading is legal and should be considered as a potential approach to investing
Answer: A. Insider trading is illegal and should not be considered as a potential approach
to investing
98

Conceptual: portfolio unsystematic and individual stock systematic risk
Statement 1 is true
A well-diversified portfolio with a beta of zero has the same amount of unsystematic risk as
the risk-free asset. A well-diversified portfolio (regardless of its beta) has no unsystematic
risk, because it is well-diversified. The risk-free asset has no unsystematic risk, because
it is risk-free.
Statement 2 is true
The company is more likely to own and operate grocery stores.
0 < Beta < 1 indicates below average, but positive, systematic risk and that an assets price
tends to change in response to news that affects the returns of all or virtually all assets with
changes that are in the same direction as the average asset and below-average in
magnitude. Examples include stocks of firms with performance that tends to vary with
economic conditions, but not by much, such as pharmaceuticals companies like Pfizer and
Merck or grocery stores like Safeway.
Beta > 1 indicates above-average systematic risk and that an assets price tends to change
in response to news that affects the returns of all or virtually all assets with changes that
are in the same direction as the average asset and above-average in magnitude. Examples
would include stocks of firms with performance that tends to vary a lot with economic
conditions such as banks or luxury-goods sellers like Tiffany or Coach.
99

Statement 1 is true
it is risk-free.
100

it is risk-free.
Statement 2 is true
101

it is risk-free.
102

Find value of one portfolio component from value of other and all betas
Approach to solution
1) Get portfolio weights
2) Get value of T-bill holdings
p = xPCPC + xFF
So 0.5 = (xPC 0.8) + (xF 0) = xPC 0.80
So xPC = 0.5 / 0.8 = 0.625
xPC = 0.625
= (value of Erie Shipping) / (value of portfolio)
= (value of Erie Shipping) / [(value of Erie Shipping) + (value of T-bills)]
= (800 $12) / [(800 $12) + value of T-bills]
= 9,600 / [9,600 + value of T-bills] = 0.625
So (9,600 / .625) = 15,360 = [9,600 + value of T-bills]
So value of T-bills = 15,360 9,600 = $5,760
Answer: B
103

p = xPCPC + xFF
So 0.5 = (xPC 0.8) + (xF 0) = xPC 0.80
So xPC = 0.5 / 0.8 = 0.625
xPC = 0.625
= (900 $12) / [(900 $12) + value of T-bills]
= 10,800 / [10,800 + value of T-bills] = 0.625
Answer: C
104

p = xPCPC + xFF
So 0.5 = (xPC 0.8) + (xF 0) = xPC 0.80
So xPC = 0.5 / 0.8 = 0.625
xPC = 0.625
= (800 $16) / [(800 $16) + value of T-bills]
= 12,800 / [12,800 + value of T-bills] = 0.625
Answer: D
105

p = xPCPC + xFF
So 0.5 = (xPC 0.8) + (xF 0) = xPC 0.80
So xPC = 0.5 / 0.8 = 0.625
xPC = 0.625
= (900 $16) / [(900 $16) + value of T-bills]
= 14,400 / [14,400 + value of T-bills] = 0.625
Answer: E
106

Conceptual: expected return is positively related to beta
22. The expected return on the market is greater than the risk-free rate, which is greater than
zero. Based on the information in the table and in this paragraph, which stock is most likely to
have the highest expected return?
Geometric
Arithmetic
average annual
average annual
Standard
return over the
return over the
deviation of
Stock
past 15 years
past 15 years
Share price
Beta
returns
A
21%
29%
$5.65
0.87
12%
B
14%
26%
$4.25
1.28
21%
C
-19%
-12%
$7.25
0.64
32%
D
-11%
-4%
$6.55
1.16
22%
E
-25%
-16%
$3.45
0.72
36%
A. Stock A
B. Stock B
C. Stock C
D. Stock D
E. Stock E
Answer: Stock B is most likely to have the highest expected return
Investors require a higher expected return in exchange for greater risk. Since they can
diversify and eliminate unsystematic risk, only systematic risk is rewarded. Systematic risk
is measured by beta, so higher beta is associated with higher expected return.
The question asks about the stock with the highest expected return. The stock with the
highest beta has the highest expected return. The other information is not relevant.
107

Geometric
Arithmetic
average annual
average annual
Standard
return over the
return over the
deviation of
Stock
past 15 years
past 15 years
Share price
Beta
returns
A
14%
26%
$4.25
1.45
26%
B
-19%
-13%
$5.65
0.66
31%
C
-11%
-3%
$6.55
1.57
22%
D
-25%
-17%
$5.65
0.79
35%
E
23%
29%
$3.45
0.84
13%
A. Stock A
B. Stock B
C. Stock C
D. Stock D
E. Stock E
Answer: Stock C is most likely to have the highest expected return
108

Geometric
Arithmetic
average annual
average annual
Standard
return over the
return over the
deviation of
Stock
past 15 years
past 15 years
Share price
Beta
returns
A
21%
27%
$4.25
0.82
12%
B
14%
26%
$3.45
1.28
17%
C
-19%
-13%
$7.25
0.64
32%
D
-11%
-3%
$5.65
1.45
21%
E
-25%
-17%
$6.55
0.77
36%
A. Stock A
B. Stock B
C. Stock C
D. Stock D
E. Stock E
Answer: Stock D is most likely to have the highest expected return
109

Geometric
Arithmetic
average annual
average annual
Standard
return over the
return over the
deviation of
Stock
past 15 years
past 15 years
Share price
Beta
returns
A
-25%
-17%
$5.65
0.82
21%
B
23%
29%
$6.55
0.99
13%
C
14%
26%
$7.25
1.29
26%
D
-19%
-13%
$3.45
0.57
35%
E
-11%
-3%
$4.25
1.37
19%
A. Stock A
B. Stock B
C. Stock C
D. Stock D
E. Stock E
Answer: Stock E is most likely to have the highest expected return
110

Find P1 from P0 and D1 after finding R from CAPM
A. $25.87 (plus or minus $0.10)
B. $24.23 (plus or minus $0.10)
C. $21.46 (plus or minus $0.10)
D. $25.46 (plus or minus $0.10)
E. None of the above is within $0.10 of the correct answer
P0 = [(D1 + P1) / (1 + R)]
P0 = $23.50
D1 = $1.39
Although R, the annual return expected on the stock divided by the number of possible
dividends per year, is not given, it can be determined with the CAPM.
We used the expression R for expected return in the material on stocks to represent
expected return and E(R) in risk and return, so the expression for the current price can
be restated as: P0 = [(D1 + P1) / (1 + E(R))]
E(RVF) = Rf + (VF [E(RM) Rf])
= .070 + (0.75 [.190 .070])
= .070 + (0.75 .120)
= .070 + .090
= .160 = 16.0%
Note that the CAPM gives us the annual expected return, which is the desired rate, since
dividends are paid annually
P0 = [(D1 + P1) / (1 + E(R))]
23.50 = [(1.39 + P1) / 1.160]
23.50 1.160 = 1.39 + P1
So 27.26 = 1.39 + P1
So P1 = 27.26 1.39 = $25.87
111

A. $27.84 (plus or minus $0.10)
B. $26.08 (plus or minus $0.10)
C. $22.92 (plus or minus $0.10)
D. $27.40 (plus or minus $0.10)
P0 = [(D1 + P1) / (1 + R)]
P0 = $25.20
D1 = $1.39
= .070 + (0.75 [.190 .070])
= .070 + (0.75 .120)
= .070 + .090
= .160 = 16.0%
P0 = [(D1 + P1) / (1 + E(R))]
25.20 = [(1.39 + P1) / 1.160]
25.20 1.160 = 1.39 + P1
So 29.23 = 1.39 + P1
So P1 = 29.23 1.39 = $27.84
112

A. $24.86 (plus or minus $0.10)
B. $23.69 (plus or minus $0.10)
C. $22.31 (plus or minus $0.10)
D. $24.57 (plus or minus $0.10)
P0 = [(D1 + P1) / (1 + R)]
P0 = $23.50
D1 = $1.93
= .050 + (0.75 [.170 .050])
= .050 + (0.75 .120)
= .050 + .090
= .140 = 14.0%
P0 = [(D1 + P1) / (1 + E(R))]
23.50 = [(1.93 + P1) / 1.140]
23.50 1.140 = 1.93 + P1
So 26.79 = 1.93 + P1
So P1 = 26.79 1.93 = $24.86
113

A. $26.80 (plus or minus $0.10)
B. $25.54 (plus or minus $0.10)
C. $23.80 (plus or minus $0.10)
D. $26.48 (plus or minus $0.10)
P0 = [(D1 + P1) / (1 + R)]
P0 = $25.20
D1 = $1.93
= .050 + (0.75 [.170 .050])
= .050 + (0.75 .120)
= .050 + .090
= .140 = 14.0%
P0 = [(D1 + P1) / (1 + E(R))]
25.20 = [(1.93 + P1) / 1.140]
25.20 1.140 = 1.93 + P1
So 28.73 = 1.93 + P1
So P1 = 28.73 1.93 = $26.80
114

Compute WACC with 2 items after finding YTM
24. Erie Shipping has 3,000,000 shares of common equity outstanding that have an expected
return of 15.40% and a current price of $15.00 each. Erie Shipping has issued 100,000 bonds
with a face value of $1,000, a market value of $850.00 each, an annual coupon rate of 8.60%, a
current yield of 10.12%, and that pay annual coupons with the next one due in 1 year. The bonds
mature in 12 years. If the tax rate is 40%, what is the weighted-average cost of capital for Erie
Shipping?
WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
V=E+D
Expected returns
RE = .1540 = 15.40%
RD = YTM = r the number of coupon payments per year
N = 12 1 = 12
PMT = .0860 $1,000 = $86
END mode
Enter
12
-850.00
86
1000
N
I%
PV
PMT
FV
Solve for
10.90
Since I% = 10.90 is an annual rate, RD = YTM = 1 10.90% = 10.90%
Values
E = number of shares market price (value) per share = 3,000,000 $15.00 = $45,000,000
D = number of bonds market price (value) per bond = 100,000 $850.00 = $85,000,000
V = E + D = $45,000,000 + $85,000,000 = $130,000,000
Taxes
Tc = 0.40
WACC
WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
= [(45m/130m) .1540] + [(85m/130m) .1090 (1 .40)]
= .0533 + .0428
= .0961 = 9.61%
115

Shipping?
WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
V=E+D
Expected returns
RE = .1460 = 14.60%
N = 12 1 = 12
PMT = .0860 $1,000 = $86
END mode
Enter
12
-850.00
86
1000
N
I%
PV
PMT
FV
Solve for
10.90
Values
V = E + D = $45,000,000 + $85,000,000 = $130,000,000
Taxes
Tc = 0.40
WACC
WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
= [(45m/130m) .1460] + [(85m/130m) .1090 (1 .40)]
= .0505 + .0428
= .0933 = 9.33%
116

Shipping?
WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
V=E+D
Expected returns
RE = .1540 = 15.40%
N = 12 1 = 12
PMT = .0640 $1,000 = $64
END mode
Enter
12
-850.00
64
1000
N
I%
PV
PMT
FV
Solve for
8.44
Values
V = E + D = $45,000,000 + $85,000,000 = $130,000,000
Taxes
Tc = 0.40
WACC
WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
= [(45m/130m) .1540] + [(85m/130m) .0844 (1 .40)]
= .0533 + .0331
= .0864 = 8.64%
117

Shipping?
WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
V=E+D
Expected returns
RE = .1460 = 14.60%
N = 12 1 = 12
PMT = .0640 $1,000 = $64
END mode
Enter
12
-850.00
64
1000
N
I%
PV
PMT
FV
Solve for
8.44
Values
V = E + D = $45,000,000 + $85,000,000 = $130,000,000
Taxes
Tc = 0.40
WACC
WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
= [(45m/130m) .1460] + [(85m/130m) .0844 (1 .40)]
= .0505 + .0331
= .0836 = 8.36%
118

Conceptual: appropriate project cost of capital from pure play and subjective approaches
Statement 1: If Erie Shipping has a weighted-average cost of capital of 11.1% and is evaluating
project Z, which is a potential project that is more risky than the average-risk project at Erie
Shipping, then 12.4% could be the appropriate cost of capital for Erie Shipping to use to evaluate
project Z.
Statement 2: Based on the information in the following table and applying the pure play
approach to determining a projects cost of capital, 9.1% is more appropriate than both 11.1%
and 13.1% for Erie Shipping, which is a company that transports goods in ships across oceans, to
use as the cost of capital for evaluating project X, which is a potential project that would involve
transporting goods in trains over railroad tracks. Note that this statement is true if 9.1% is a
more appropriate cost of capital for project X than 11.1% and if 9.1% is also a more appropriate
cost of capital for project X than 13.1%. The statement is not true if 11.1% is a more appropriate
cost of capital for project X than 9.1% or if 13.1% is a more appropriate cost of capital for
project X than 9.1% or if both 11.1% and 13.1% are more appropriate costs of capital for project
X than 9.1%.
Firm
Line of business
WACC
Erie Shipping
11.1 percent
Thomas Shipping
9.1 percent
Diversified Shipping Transports goods in ships, trains, trucks, and airplanes
13.1 percent
Statement 1 is true
The appropriate cost of capital used to compute the NPV of project Z could be 12.4%. The
appropriate cost of capital for a project that is average-risk for a firm is the firms WACC, and
the appropriate cost of capital for a project that is more risky than average-risk for a firm
would be greater than the firms WACC. Therefore, the appropriate cost of capital for the
project described in the problem would be greater than the Erie Shippings WACC of 11.1%,
and 12.4% is greater than 11.1%, so the appropriate cost of capital used to compute the NPV
of the project could be 12.4%
Statement 2 is true
The appropriate opportunity cost of capital for any project is based on the risk of the
project. Therefore, the appropriate cost of capital in this case would be the cost of capital
associated with the risk of transporting goods in trains over railroad tracks.
Recall that with the pure play approach to setting the cost of capital for a given project, the
WACCs of other firms engaged in same line of business as a potential project are used to
determine the cost of capital. In this case, Thomas Shipping, which transports goods in
trains over railroad tracks, is in the same line of business as the potential project, so
Thomas Shippings WACC of 9.1 percent is the most appropriate cost of capital for Erie
Shipping to use for project X.
119

X than 11.1%.
Firm
Line of business
WACC
Erie Shipping
9.1 percent
Thomas Shipping
11.1 percent
13.1 percent
project Z.
Statement 1 is true
Statement 2 is true
The appropriate cost of capital used to compute the NPV of project Z could be 10.7%. The
and 10.7% is greater than 9.1%, so the appropriate cost of capital used to compute the NPV of
the project could be 10.7%
120

project Z.
X than 11.1%.
Firm
Line of business
WACC
Erie Shipping
13.1 percent
Thomas Shipping
11.1 percent
9.1 percent
The appropriate cost of capital used to compute the NPV of project Z could not be 12.4%. The
and 12.4% is not greater than 13.1%, so the appropriate cost of capital used to compute the
NPV of the project could not be 12.4%
Statement 2 is true
121

transporting goods in trains over railroad tracks. . Note that this statement is true if 13.1% is a
X than 13.1%.
Firm
Line of business
WACC
Erie Shipping
11.1 percent
Thomas Shipping
13.1 percent
9.1 percent
project Z.
Statement 1 is true
The appropriate cost of capital used to compute the NPV of project Z could not be 10.7%. The
and 10.7% is not greater than 11.1%, so the appropriate cost of capital used to compute the
NPV of the project could not be 10.7%
122
123

Final Exam Solutions 2012 1 Spring

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Final Exam Solutions 2012 1 Spring

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FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

25. Which assertion about statement 1 and statement 2 is true?

FNAN 301, Spring 2012, final, solutions

25. Which assertion about statement 1 and statement 2 is true?

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

3) Find the amount of each regular payment

FNAN 301, Spring 2012, final, solutions

3) Find the amount of each regular payment

FNAN 301, Spring 2012, final, solutions

3) Find the amount of each regular payment

FNAN 301, Spring 2012, final, solutions

3) Find the amount of each regular payment

FNAN 301, Spring 2012, final, solutions

Value of A > value of B

FNAN 301, Spring 2012, final, solutions

Value of A > value of B

FNAN 301, Spring 2012, final, solutions

Value of A > value of B

FNAN 301, Spring 2012, final, solutions

Value of A > value of B

FNAN 301, Spring 2012, final, solutions

Future value of investment made in 4 years from today

FNAN 301, Spring 2012, final, solutions

Future value of investment made in 4 years from today

FNAN 301, Spring 2012, final, solutions

Future value of investment made in 2 years from today

FNAN 301, Spring 2012, final, solutions

Future value of investment made in 2 years from today

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions

FNAN 301, Spring 2012, final, solutions