University of California

Walter A. Haas School of Business

UGBA 103
Introduction to Finance
Prof. Dmitry Livdan 5 October 2015

Solutions to the MIDTERM 1

1. (6.5 points) Four years ago you have bought Citi Corp. stock for $50. You have used growing
perpetuity formula to value it
E1
P0 = ,
r−g
where you have assumed a constant annual growth rate of earnings, g, which you have esti-
P−4
mated to be equal to 5%. Citi’s P/E ratio four years ago (i.e. E−3
) was equal to 5. Assuming
that Citi’s growth has not changed (i.e. g is the same today as it was 4 years ago) and using
the same growing perpetuity formula, at what price should you sell your Citi stock today if
you plan to earn the same rate of return as you’ve expected four years ago?
The price of Citi stock today is:
E1
P0 = .
r0 − g
Therefore in order to find P0 we need to know r0 and E1 . Since we are given that r0 = r−4
we can find r0 from the valuation done four years ago
E−3 P−4 1 1
P−4 = ⇒ = ⇒5= ⇒ r0 = r−4 = 25
r−4 − g E−3 r−4 − g r−4 − 0.05

Now we can calculate E1 since we know g:

E1 = E−3 ∗ (1 + g)4 = E−1 ∗ 1.054 .

We still do not know E1 but we can find it from the 4-year old P/E ratio:

P−4 P−5 $50

= 5 ⇒ E−1 = = = $10.
E−3 5 5

Therefore E1 = E−1 ∗ 1.054 = $10 ∗ 1.216 = $12.16. Finally we find

E1 $12.16
P0 = = = $60.80.
r0 − g 0.25 − 0.05

2. (4.5 points) You plan to buy a 2-year bond with a face value of $1000 and an annual coupon
of 5%. You observe that two other bonds, A and B, are traded. Bonds A is a 2-year bond
with a face values of $400 paying a 4% annual coupon. B is a 1 or 2 year zero coupon bond
with a face value of $600. Bond A is priced at par while bond B is priced at $578. If bonds
UGBA 103 MIDTERM 1 – Solutions 2

A and B are fairly priced, i.e. discount factors D1 and D2 and bond yields are correct, then
what is the price of the bond you want to buy?
We need to find discount factors D1 and D2 form prices of bonds A and B. From bond B we
have:

$578
$578 = D2 × $600 ⇒ D2 = = 0.963
$600
We can find D1 from the price of bond A:

$400 = D1 × $16 + D2 × $416 = D1 × $16 + $400.75.

Solving for D1 we find

$400 − $400.75
D1 = = −0.047.
$16
The price is equal to:

P = D1 × $50 + D2 × $1050 = −0.047 × $50 + 0.963 × $1050 = $1008.80.

If bond B is 1-year bond then the solution is:

D1 = 0.963,

$400 − 0.963 ∗ $16

D2 = = 0.9245,
$416
P = 0.963 × $50 + 0.9245 × $1050 = $1018.88

3. (7.5 points) You are considering between two projects both costing $6,000. The first one
runs for 3 years and produces $10,000 in revenues (given in nominal terms), and costs $5,000
(given in nominal terms) to run. Revenues of this project are fixed in real terms while costs
are fixed in nominal terms. The second one runs for 4 years and produces $7,500 in revenues
(given in nominal terms), and costs $3,500 (given in nominal terms) to run. Revenues of this
project are fixed in real terms for the first 3 years and they are fixed in nominal terms for the
last year, i.e. between years 3 and 4. Costs of the second project are fixed in nominal terms.
Book values of both projects of both projects are recorded in nominal terms and depreciate
on a straight line to zero. The resale value of each project at the end of its lifespan is equal to
zero, i.e. they cannot be sold. The nominal APR is 14% and the inflation is 4%. Corporate
tax rate is 34%. Which project would you choose?
We calculate the real APR first

R = 14% − 4% = 10%.

We can calculate NPV as:

N P V = −$6, 000 + (P V (Revenues) − P V (Costs) + P V (ResaleP rof it))(1 − tc ) + P V (DT S)

Project 1:
UGBA 103 MIDTERM 1 – Solutions 3

PV(Revenues) is equal to (calculated in real terms):

$10,000
1.04 1
P V (Revenues) = (1 − ) = $23, 912.04.
0.1 1.13
PV(Costs) is equal to (in nominal terms):
$5, 000 1
P V (Costs) = (1 − ) = $11, 608.16.
0.14 1.143
Finally, PV(DTS) is equal to (in nominal terms):
$2, 000 1
P V (DT S) = 0.34 × (1 − ) = $1, 578.71.
0.14 1.143
NPV is equal to
N P V = −$6, 000 + 0.66($23, 912.04 − $11, 608.16) + $1, 578.71 = $3, 699.27.
Since we are comparing two projects of different duration we are going to convert the NPV
of each project into equal lease payments and then compare annual payments.
$3, 699.27
C1 = 1 1 = $1, 593.39,
0.14 (1 − 1.143)

in nominal terms and

$3, 699.27
C1 = 1 = $1, 487.53,
0.1 (1 − 1.11 3 )
in real terms. Now we are going to do the same for project two.
Project 2:
PV(Revenues) is equal to (calculated in real terms):
$7,500
1.04 1 $7, 500(1.04)2
P V (Revenues) = (1 − ) + = $22, 736.98.
0.1 1.13 1.144
PV(Costs) is equal to (in nominal terms):
$3, 500 1
P V (Costs) = (1 − ) = $10, 197.99.
0.14 1.144
Finally, PV(DTS) is equal to (in nominal terms):
$1, 500 1
P V (DT S) = 0.34 × (1 − ) = $1, 485.99.
0.14 1.143
NPV is equal to
N P V = −$6, 000 + 0.66($22, 736.98 − $10, 197.99) + $1, 485.99 = $3, 761.73.
Since we are comparing two projects of different duration we are going to convert the NPV
of each project into equal lease payments and then compare annual payments.
$3, 761.73
C2 = 1 1 = $1, 291.04,
0.14 (1 − 1.144)

in nominal terms and

$3, 761.73
C2 = 1 = $1, 186.72,
0.1 (1 − 1.11 4 )
in real terms. Since C1 > C2 we pick the first project.