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Midterm Examination

MGMT E-2700 –Corporate Finance


Professor Efraim Benmelech, Spring 2010

The exam has 2 parts in 4 pages and 100 total points. Allocate your time wisely and
answer all questions. Please spread your work over 4 bluebooks as indicated in the
exam. You have to show your calculations in all the quantitative questions. You
have 85 minutes to complete this exam. Please write your name below and submit
this questionnaire with your blue books. We will not read an exam unless this
questionnaire with your name on it is submitted with the blue books.

Name:

Part I. (60 points)

Use Bluebook #1 for Questions 1-2.

Question 1: Credit Risk, CAPM and Capital budgeting (15 points)

Assume that the probability the Patriots will win the Superbowl is 25%. A souvenir shop
outside the stadium will earn net profits of $1.8 million if the Patriots win, and $0.7
million if they lose. You are the loan officer of the bank to whom the shop applied for a
loan. You can assume that your bank is risk-neutral and that the bank can invest in safe
projects that offer an expected rate of return of 6%.

a. What interest rate would you quote if the owner asked you for a loan for
700,000 today? What interest rate would you quote if the owner asked you
for a loan for $1,000,000 today?

Now assume that the bank is risk averse and follows the Capital Asset Pricing Model to
determine its expected rate of return. The risk free rate is 3% and the return on the market
is 8%. The bank is financed with 30% risk-less debt and 70% equity. The beta of the
bank’s equity is 1.5.

b. What interest rate would you quote now if the owner asked you for a loan
for 700,000 today? What interest rate would you quote if the owner asked
you for a loan for $1,000,000 today?
Question 2: Term Structure and Bond Pricing (15 points)

Assume that the following data on U.S. Treasuries is current:


Years to maturity Yield to maturity
1 4.00%
2 5.50%
3 7.00%
4 7.00%
5 7.50%

a) What is the forward rate for a 1-year bond issued 2 years from now?
b) What is the yield on a 3-year coupon bond issued at par today? (Hint a coupon
bond issued at par today has a price equal to its face value).
c) After two years, the yield curve is unchanged. Calculate the price and the
yield of the bond in part (b). (You can assume a face value of $1,000).
d) A consultant tells you that you should take advantage of the upward sloping
yield curve by borrowing at one year rate and lending at the five year rate. He
tells you that since you are borrowing at 4% and lending at 7.5%, your
expected revenue will be 3.5%. Is he correct? Why or why not?

Use Bluebook #2 for Questions 3-4

Question 3: Bonds and Duration (15 points)

The formula for Macaulay duration is: where is the

bond’s market price which represents the present value of the bond’s future payments.
a) Show the relation between Macaulay duration and the discount-rate elasticity
of the bond price, where the discount-rate elasticity of the bond price is
defined as .

b) What is the duration of zero coupon bond that matures in 7 years if it trades at
par today?
c) Your portfolio is composed of a $70,000 invested in a consol that pays a
constant $1,000 annually forever (starting a year from now), and $30,000 in
cash deposited in the bank. The discount rate is 11% per year, what is the
duration of your portfolio?

Question 4 Advanced Capital Budgeting (15 points)


The Chocolate Store currently produces high-end chocolates. The management team
wants to diversify the business, and has identified a flower company called Rose
Boutique (currently owned by Private Equity Firm ABC Partners who financed their
acquisition of Rose with 50% debt and 50% equity – a capital structure that is still in
place). Rose has an equity beta of 1.50. Its debt trades at par and has a coupon of 5%.
The market equity premium is 7% and the risk free rate is 5%. The Chocolate Factory
has no debt and an equity beta of 2.50. Chocolate Factory believes that Rose will
generate $30 of cash flows forever, if acquired. However, the acquisition will require the
Chocolate Store to allocate store space to flowers, which will decrease high-end
chocolate sales by $100 in year 1, $125 in year 2 and $150 in year 3 (no further impact
after year 3).

Should The Chocolate Store acquire Rose Boutique, and if so what is the maximum
amount they would be willing to pay?

Part II. (40 points)

Use Bluebook #3 for Questions 5-8.

Question 5: Default Risk (5 points)

You are applying for a loan from a risk-neutral bank. You want to borrow $350 for one
year. The bank knows that borrowers with the same default risk as you go bankrupt in 5
out of 100 cases and pay $20. A time-equivalent otherwise identical risk-less government
bond promises a 6% interest rate. Both the loan and the bond have no coupons. What is
the default (or credit) spread of the loan in basis points?

Question 6: Perpetuity (5 points)


What is the present value of a perpetuity that pays $75 annually forever assuming that the
first payment is received today (immediately) and that the annual discount rate is 5% (per
year).

Question 7: Future value (5 points)


You are investing today $200 in a continuously compounded annual rate of 5.6%. How
long would it take for your investment to quadruple in value?

Question 8: Capital Budgeting (5 points)


You are a consultant to an oil exploration company. Your firm has a capital structure of
40% riskless debt (that has zero beta) and 60% of equity. Since oil is a very pro-cyclical
commodity, the beta the equity of your firm is 2.2. Your firm owns an oil field and you
are currently conducting a survey of the oil reserves in the field. Despite the uncertainty
you were able to sell the entire oil production schedule in the forward market to the U.S
government for $300 million. However, your firm remains liable for environmental
pollution in the first 5 years of the project. There is a 10% chance that the firm will be
liable for pollution damages of $170 million five years from now. What is the value of
the oil field to your firm if the risk free rate is 3% and the market expected return is 9%?

Use Bluebook #4 for Questions 9-12.

Question 9: Annuities and Mortgages (5 points)


Calculate the monthly payment due on a 30-year, fixed-rate, $80,000 mortgage if the
quoted interest rate is 6%.

Question 10: Default Risk (5 points)


A risk-free investment of $10,000 will return 8%. A risky $10,000 investment promises a
rate of return of 12%, and has a 50% chance of defaulting and returning only $3,000.
What is the expected rate of return on the risky investment? Assume risk-neutrality in
your answer.

Question 11: CAPM (5 points)


The expected return on the market portfolio is 15%, with a standard deviation of 17%.
The risk-free rate of return is 6%. You want to design a portfolio with an expected return
of 12%. Calculate the weights that must be invested in the market portfolio and in the
risk-free asset in order to accomplish this.

Question 12: Growing Perpetuity (5 points)


A security will provide you a cash flow, which grows at 6% forever, beginning with $55
a year from now. You believe that the appropriate discount rate for a security of that type
is 11%. How much would you be willing to pay for such a security?