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UNIVERSITY OF TORONTO

Joseph L. Rotman School of Management


Oct. 17, 2014 Babaoglu/Huggins
RSM332 MID-TERM EXAMINATION Yang/Yung

DURATION - 2 hours
Aid Allowed: Silent electronic calculator and one 1-sided 8 12 11 crib sheet

Name: Student Number:


Circle the section that you are registered in:
Babaoglu (Mon. 57p.m.) Huggins (Mon. 11a.m.1p.m.) Huggins (Tue. 2p.m.4p.m.)
Huggins (Thu. 13p.m.) Huggins (Thu 68p.m.) Yang (Wed. 11a.m.1p.m.)
Yang (Wed. 35p.m.) Yung (Mon. 24p.m.) Yung (Tue. 911a.m.)

Instructions
1. Write all your answers on the examination paper.
2. Answer five out of six questions. Each question is worth 20 marks. Do not answer all
six questions! In the table below, cross out the question that you choose not to answer.

Question Marks

1
2
3
4
5
6

Total

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1. Suppose Jasons utility function is

U (C0 , C1 ) = min(C0 , C1 ),

where C0 is todays consumption and C1 is tomorrows consumption. He is endowed


with money Y0 = 120 today and Y1 = 100 tomorrow. He also has two real projects
available:
Project A: invest 50 today and receive 50 tomorrow;
Project B: invest 50 today and receive 100 tomorrow.
(a) Assume that Jason does not have access to capital markets. How much should
Jason invest? Explain. (5 marks)
For parts (b)(d), suppose that there is a perfect capital market for borrowing and
lending at the market interest rate of 10%.
(b) In the presence of the financial market, how much should Jason invest? Explain.
(5 marks)
(c) What is Jasons optimal consumption plan? How much will Jason borrow or lend?
(6 marks)
(d) Suppose Tom has the same investment opportunities
as Jason, but he has a different
utility function U (C0 , C1 ) = log (C0 ) + 1000 C1 . How much should Tom invest? (4
marks)

2. Suppose you have the utility function,

U (C0 , C1 ) = C0 C11 ,

where 0 < < 1, C0 is todays consumption and C1 is tomorrows consumption. You


are endowed with a wealth of W0 today and nothing tomorrow. There is a production
function that if I is invested today, then the output tomorrow would be

f (I) = I,

where > 0. There is also a capital market where lending and borrowing rate of
interest is r, i.e., if you borrow (or lend) 1 unit of good today, you will pay (or be paid)
1 + r units of good tomorrow.
You optimally choose your consumption, investment, and savings. As a result, you
decide to consume the same amount today and tomorrow (i.e., C0 = C1 ), and to
invest 2,500 in the production opportunity (i.e., I = 2,500). In order to earn interest
in the capital market, you decide to make a deposit of 2,000 at date 0 and you will get
2,500 at date 1.
(a) What is the interest rate r in this economy? (4 marks)
(b) What is the value of ? (3 marks) What is the output tomorrow? (1 mark)

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(c) What is the net present value of the chosen investment activity I = 2,500? (4
marks)
(d) What is the value of ? (4 marks)
(e) What is your endowment today, W0 ? (4 marks)
3. (a) Suppose you have $1000 for a fixed deposit in a bank for three years. The bank
offers you a rate of 5% per year, compounded annually.
(i) Relative to the original account, do you prefer an account with a rate of 4.9% per
year, compounded semi-annually? (2 marks)
(ii) Relative to the original account, do you prefer an account with a rate of 4.9% per
year, compounded continuously? (2 marks)
(b) You borrow $10,000 to buy a motorcycle at a quoted rate of 10.99% interest with
daily compounding (using the convention that one year has 365 days). If you plan to
pay off the entire loan in 3 years with a series of bi-weekly payments (i.e. 26 payments
per year), what is the size of each payment? (5 marks)
(c) Suppose today is your 20th birthday. You are considering a project that costs
$10,000 and want to save money to fund this project. Starting from today, you decide
to deposit $1,000 every birthday to an account which offers a rate of 6%/year, com-
pounded quarterly. Suppose the cost of the project does not change so that it is fixed
at $10,000. At least how many deposits do you need to make in order to be able to
start the project? (5 marks)
(d) Suppose you are given the following award plan: for the first two years, it pays you
$100 at the end of the first and second year; starting from the third year, it pays $300
at the end of every year that is an odd number, and pays $100 for every year that is an
even number, and the pattern continues forever. For example, the cash flows for the
first 10 year-ends are (100, 100, 300, 100, 300, 100, 300, 100, 300, 100, and so on). The
quoted annual interest rate is 6%/year, compounded annually. Calculate the present
value of this award plan. (6 marks)
4. Assume that you have the following information:
(i) A 2-year zero coupon bond with the face value of $1,000 trades at $892.52;
(ii) A 4-year zero coupon bond with the face value of $1,000 trades at $777.32;
(iii) A 6-year zero coupon bond with the face value of $1,000 trades at $657.08;
(iv) A 3-year coupon bond with the face value of $1,000 and the annual coupon rate
of 8% trades at $1,050.22, where coupons are paid annually;
(v) The 1-year forward rate (a 1 year loan starting in one year from now, f2 ) is 6.25%.
(a) What are the yields-to-maturity for the three zero coupon bonds? (3 marks)
(b) What should the price be for a 2-year coupon bond with a face value of $1,000 and
an annual coupon rate of 5%, where coupons are paid annually? (4 marks)

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(c) What should the price be for a 4-year annual coupon bond with a face value of
$1,000 and an annual coupon rate of 6%, where coupons are paid annually? (4 marks)
(d) Assume that the 3-year zero coupon bond with the face value of $1,000 is traded
at $850. If you are restricted to using only the securities (i)-(v) listed at the beginning
of the question, is there an arbitrage opportunity? If yes, show the exact transactions
that you need to make in order to obtain an arbitrage profit. (9 marks)

5. Suppose the current forward rates for the second year and third year are 3% and 4%,
respectively (i.e. f2 = 3% and f3 = 4%). In addition, the three-year spot rate is 5%
(i.e. r3 = 5%).
(a) Find the 1-year and 2-year spot rates (r1 and r2 ) implied by the forward rates. (2
marks)
(b) Find the price of 1-year, 2-year, and 3-year zero coupon bonds (each with a face
value of $1,000). What are the yields-to-maturities for these bonds? (6 marks)
(c) Suppose today, a financial institution (FI) offers a forward rate of 3.80% over the
third year. If you are only allowed to use the zero-coupon bonds from part (b) and
the rate offered by the FI, is there an arbitrage opportunity? If yes, show the exact
transactions that you need to make in order to obtain an arbitrage profit. (6 marks)
(d) Suppose one year later, a one-year zero coupon bond with a face value of $1,000
can take two possible values: $952.38 and $X, with equal probabilities. Suppose that
the expectation hypothesis holds. What is the value of X? (6 marks)

6. A company has just announced that its current EPS (earnings per share) is $10. The
company has a constant dividend payout ratio of 20%. When the company reinvests
its earnings, it expects to earn a return (ROE) of 10% on them. Given the riskiness of
the company, the appropriate discount rate is 15%.
(a) The company will pay out a dividend from its current earnings. How much will
the dividend per share be? (2 marks)
(b) How much will be next years expected dividend per share? (4 marks)
(c) Use the Gordon growth model to compute the price per share of this company. (4
marks)
(d) Suppose we define the price-dividend ratio as the current share price over its current
dividend. What is the price-dividend ratio of the company? If the expected return on
this company were instead 10%, what would the price-dividend ratio be? (5 marks)
(e) Suppose that two companies, A and B, have identical dividend growth rates. Also
suppose that company A has a higher price-dividend ratio than company B. Which
company has a higher expected return? (5 marks)