Very Important (READ THIS):

All students with seven digit ID numbers must add “2” in front of their ID number to make it eight digit.
For example:
ID # 6770177 should be made 26770177
You should put the eight-digit ID (26770177 in the above example) on both the exam and the bubble sheet.
Examination Cover Sheet
Print Family Name: Print Given Name: ID Number:
  
COURSE NUMBER SECTIONS: AA, AB, AC
FINANCE COMM 308
EXAMINATION DATE TIME: 3 hours # OF PAGES 16
Final Exam June 21, 2018 09:00 to 12:00 Including this cover
VERSION BLUE (morning)

INSTRUCTOR: Circle your Professor DIVISION

Rahul Ravi Sonal Kumar John Molson School of Business
Chunrong Wang Concordia University

INSTRUCTIONS: Please read these carefully

1. Please ensure you have 16 pages (including this cover page and Formula sheet) in this exam.
2. For Part I of this exam (Multiple Choice Questions): All answers must be recorded IN PENCIL on
the computer sheet. Only the computer sheet will be graded.
3. For Part II: Show your calculations to earn part marks. Label clearly.
4. For Part II: All answers must be recorded IN INK within this exam.
5. In the event the exact answer is not provided, choose the CLOSEST response.

MATERIALS ALLOWED:
1. You must submit a BLUE computer answer sheet.
2. You are allowed to bring one or more calculators (ENCS sticker not necessary)
3. You are allowed to bring one language dictionary (no finance/ mathematics/economics etc.
dictionary)

MCQ Q1 Q2 Q3 Q4 Total
Max marks: 75 6 9 5 5 100

Marks awarded

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Part I: Multiple Choice Questions (30 Questions, 75 Points Total):
Only MCQ answers IN PENCIL on the computer answer sheet (scantron) will be graded.

1. Assume that all other factors are held constant and that the interest rate is greater than zero.
Increasing the number of periods (i.e., n) will cause the present value of a lump sum to be
received in the future to _________ and the present value of an annuity to _______.
a. Increase; Increase
b. Increase; Decrease
c. Decrease; Decrease
d. Decrease; Increase
e. It depends on whether the annuity is an annuity due or an ordinary annuity

2. Congratulations! You have just won a small lottery. It will pay you either 5 annual payments
of $15,000 each (with the first payment to be received two years from today), or a single lump
sum to be received today. If you can invest at a 6% annual rate of interest, what is the least you
should accept as the lump sum payout amount?
a. $75,000.00
b. $66,976.58
c. $63,185.46
d. $59,608.92
e. $89,629.78

3. Which of the following accounts would pay you the highest effective annual rate?
a. Stated annual rate of 6.05%, compounded annually
b. Stated annual rate of 6.01%, compounded semi-annually
c. Stated annual rate of 5.95%, compounded quarterly
d. Stated annual rate of 5.90%, compounded monthly
e. Stated annual rate of 5.85%, compounded daily (assuming 365 days a year)

4. You are attempting to reconstruct a project analysis of a co-worker who was fired for flunking
FI 3300. You have found the following information:
 The IRR is 14%.
 The project life is 6 years.
 The initial cost is $16,000.
 In years 1, 2, 3 and 4 you will receive cash inflows of $3,000.
 You know the cash flows in years 5 and 6 are equivalent, but the amount is not on file.
 The appropriate discount rate is 10%.
What is the NPV of the project?

a. $2,335.25
b. $5,750.35
c. ($1,250)
d. $2,000
e. None of the above

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5. You have just invested $3,000 into an account that will earn a 9% annual interest rate. You
want to have exactly $8,000 in the account at the end of 5 years. The account allows you to
make one deposit at the end of the 3rd year. In order to have exactly $8,000 at the end of year
5, how much must you deposit at the end of the 3rd year?
a. $2,848.35
b. $2,613.17
c. $2,397.40
d. $3,384.13
e. None of the above answers is within $50 of the correct amount

6. Suppose there is a financial security that promises to give you $5,000 eight years from today.
All else constant, for a given nominal interest rate, a change from monthly compounding to
annual compounding will cause the current price of this security to ___________________ .
a. Increase.
b. Decrease.
c. Remain the same.
d. Either increase or decrease depending on the number of years until the money is to be
received.
e. None of the above.

7. A 10-year annual coupon bond was issued four years ago at par. Since then the bond’s yield to
maturity (YTM) has decreased from 9% to 7%. Which of the following statements is true about
the current market price of the bond?
a. The bond is selling at a discount
b. The bond is selling at par
c. The bond is selling at a premium
d. The bond is selling at book value
e. Insufficient information

8. What should be the price of a $1,000 par value, 10% coupon rate (coupon interest paid semi-
annually) bond with 30 years remaining to maturity, assuming a discount rate of 9%?
a. $1,101.88
b. $1,102.44
c. $1,103.19
d. $1,104.48
e. $1,105.72

9. You have just discovered a $1,000 par value corporate bond with a maturity of 10 years. The
bond’s yield to maturity is 9% and the bond is currently selling for $743.29. What is the bond’s
annual coupon rate (the bond pays coupon payments annually)?
a. 5%
b. 6%
c. 7%
d. 8%
e. 9%

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10. What is the quoted yield to maturity of a $1,000 par value bond with a coupon rate of 10%
(semi-annual coupon payments) that matures in 30 years assuming the bond is currently selling
for $838.13?
a. 6.0%
b. 6.2%
c. 10.0%
d. 12.0%
e. 12.4%

11. XYZ, Inc. just paid a dividend of $3 per share. The industry analysts predict that XYZ’s
dividends will grow at a constant rate of 4% forever. If the stock is currently trading at $25 per
share, what is the required rate of return on this stock?
a. 8.48%
b. 12.00%
c. 12.48%
d. 16.00%
e. 16.48%

12. Unitongue Talk, Inc. just paid a $2.00 annual dividend. Investors believe that the dividends
will grow at a rate of 20% per year for each of the next two years and 5% per year thereafter.
Assuming a discount rate of 10%, what should the current price of the stock be?
a. $60.50
b. $57.60
c. $54.55
d. $49.87
e. $43.56

13. Consider a project with an initial outflow at time 0 and positive cash flows in all subsequent
years. As the discount rate is increased the _____________.
a. IRR remains constant while the NPV increases.
b. IRR decreases while the NPV remains constant.
c. IRR increases while the NPV remains constant.
d. IRR remains constant while the NPV decreases.
e. IRR decreases while the NPV decreases.

14. Milson Company is considering the purchase of MiHe Company at a price of $190,000. If
Milson makes the acquisition, its after-tax net cash flows will increase by $30,000 per year and
remain at this new level forever. If the appropriate cost of capital is 15 percent, should Milson
buy MiHe?
a. Yes, because the NPV = $30,000
b. Yes, because the NPV = $200,000
c. Yes, because the NPV = $10,000
d. No, because NPV < 0.
e. There is not enough information given to answer this question.

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15. Which of the following statements is CORRECT?
a. Diversifiable risk can be reduced by forming a large portfolio, but normally even highly-
diversified portfolios are subject to market (or systematic) risk.
b. A large portfolio of randomly selected stocks will have a standard deviation of returns that
is greater than the standard deviation of a 1-stock portfolio if that one stock has a beta less
than 1.0.
c. A large portfolio of stocks whose betas are greater than 1.0 will have less market risk than
a single stock with a beta = 0.8.
d. If you add enough randomly selected stocks to a portfolio, you can completely eliminate
all of the market risk from the portfolio.
e. A large portfolio of randomly selected stocks will always have a standard deviation of
returns that is less than the standard deviation of a portfolio with fewer stocks, regardless
of how the stocks in the smaller portfolio are selected.

16. The expected return of the market portfolio is rm=12%, the Std of the return on that portfolio
is σm=18% and the return of the risk-free asset is rf=6%. There are two risky assets in this
market with the following parameters:

Asset The (market) Expected Return σ - The Std of the Return β

A 15% 22% 1.5
B 10% 20% 0.4

Assuming that the CAPM model should hold, which of the following statements is correct?
a. The market is in equilibrium (CAPM).
b. B is overpriced (by the market relative to the CAPM), since it’s expected return is lower
than the expected return of the market portfolio and it’s Std of return is higher than the Std
of return of the market portfolio.
c. In equilibrium (CAPM), we expect asset A to have a lower price than its current market
price.
d. In equilibrium (CAPM), we expect asset B to have a higher price than its current market
price.
e. None of the above.

17. The Seattle Corporation has been presented with an investment opportunity that will yield cash
flows of $30,000 per year in Years 1 through 4, $35,000 per year in years 5 through 9, and
$40,000 in Year 10. This investment will cost the firm $150,000 today, and the firm's cost of
capital is 10 percent. Assume cash flows occur evenly during the year, 1/365th each day. What
is the regular payback period (not the discounted payback) for this investment?
a. 5.23 years
b. 4.86 years
c. 4.00 years
d. 6.12 years
e. 4.35 years

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18. Which of the following statements is most correct?
a. Since depreciation is not a cash expense, it does not affect operating cash flows
b. Corporations should include sunk costs when making investment decisions.
c. Corporations should include opportunity costs when making investment decisions.
d. All of the answers above are correct.
e. Answers (a) and (c) are correct.

19. Consider three investment alternatives: a perpetuity, an ordinary annuity and an annuity due.
All three have the SAME payment amount. The annuity due and the ordinary annuity have the
same number of payments (e.g., 6 payments). The interest rate is positive and the same for all
three investments. Given this information, which of the following statements is correct?
a. The present value of the ordinary annuity is greater than the present value of the annuity
due.
b. The perpetuity and the annuity due have the same present value.
c. The future value of the ordinary annuity is less than future value of the annuity due.
d. The present value of the ordinary annuity is greater than the present value of the perpetuity.
e. None of the above is the correct answer.

20. The common stock of Darkover Inc just paid a dividend of $2.00 per share. The dividend is
expected to grow at a constant rate forever. The required rate of return for this stock is 10%.
If the current price is $30.00 then the expected growth rate is ____%.
a. 3.125
b. 5.000
c. 7.125
d. 9
e. None of the above

21. Which of the following statements regarding Information Asymmetry is false:

a. Information Asymmetry hampers the proper operation of markets.
b. Two types of Information Asymmetry are adverse selection and moral hazard.
c. Information Asymmetry can be combated in market environments through full disclosure.
d. Information Asymmetry alone may cause a market to collapse in extreme cases.
e. None of the above.

22. Nicholas Manufacturing just announced yesterday that its fourth quarter earnings will be 10%
higher than last year's fourth quarter. You observe that Nicholas had an abnormal return of
−1.2% yesterday. This suggests that
a. the market is not efficient.
b. Nicholas' stock will probably rise in value tomorrow.
c. investors expected the earnings increase to be larger than what was actually announced.
d. investors expected the earnings increase to be smaller than what was actually announced.
e. earnings are expected to decrease next quarter.

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23. The slope of the Security Market Line will increase if
a. the risk free rate increases
b. the required return from the market portfolio increases
c. the average beta increases
d. if the risk premium decreases.
e. None of the above

24. You write one JNJ put with strike price $70, for a premium of $5. Ignoring transactions costs,
what is the breakeven price of this position?
a. $65
b. $75
c. $5
d. $70
e. None of these is correct

25. A firm is expected to pay dividends of $1.00, $1.50 and $2.00 over the next three years. After
that dividends are expected to grow at 5%. The cost of equity is 10%. The stock should sell
for $______.
a. 40.25
b. 30.00
c. 38.45
d. 35.21
e. Insufficient information

26. According to the Capital Asset Pricing Model (CAPM),

a. a security with a positive alpha is considered overpriced.
b. a security with a zero alpha is considered to be a good buy.
c. a security with a negative alpha is considered to be a good buy.
d. a security with a positive alpha is considered to be underpriced.
e. a security with a positive beta is considered to be underpriced.

27. Which of the following could explain why a business might choose to organize as a corporation
rather than as a sole proprietorship or a partnership?
a. Corporations generally face fewer regulations.
b. Corporations generally face lower taxes.
c. Corporations generally find it easier to raise capital.
d. Corporations enjoy unlimited liability.
e. Statements c and d are correct.

28. Capital asset pricing model asserts that expected returns are best explained by:
a. Economic factors
b. Specific risk
c. Systematic risk
d. Diversification
e. Total risk

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29. Which of the following is most likely to be true for a portfolio of 40 randomly selected stocks?
a. The riskiness of the portfolio is the same as the riskiness of each stock if it was held in
isolation.
b. The beta of the portfolio is less than the average of the betas of the individual stocks.
c. The beta of the portfolio is equal to the average of the betas of the individual stocks.
d. The beta of the portfolio is larger than the average of the betas of the individual stocks.
e. The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was
held in isolation.

30. Stocks A and B are quite similar: Each has an expected return of 12%, a beta of 1.2, and a
standard deviation of 25%. The returns on the two stocks have a correlation of 0.6. Portfolio P
has 50% in Stock A and 50% in Stock B. Which of the following statements is CORRECT?
a. Portfolio P has a standard deviation that is greater than 25%.
b. Portfolio P has an expected return that is less than 12%.
c. Portfolio P has a standard deviation that is less than 25%.
d. Portfolio P has a beta that is less than 1.2.
e. Portfolio P has a beta that is greater than 1.2.

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Part II: Problems (25 Points Total)
 Answer on this document, in the space provided. Use the back of the sheet if you need
additional space. Any work not labeled clearly will not be graded.
 Show all your work. Unsupported statements or numbers will not receive any grade.

Q1: Option portfolio payoff: Suppose that the price of a share of stock in ABC Corporation is
currently trading at $30/share. Consider selling the following two options on one share of ABC:
a. A Call option with a strike price of $35
b. A Put option with a strike price of $25
(i): (4 points) Draw a payoff diagram of this portfolio.
Note: Clearly label both axes as well as the location of each important point on the diagram.
Show which portion of the payoff is a result of which corresponding option.
Payoff Table [Students were not asked for this, thus no marks allocated]
P=0 P=25 P=30 P=35 P=50
Short Call (X=$35) 0 0 0 0 -15
Short Put (X=$25) -25 0 0 0 0
Total Payoff -25 0 0 0 -15

Payoff Diagram (Students must clearly illustrate a PORTFOLIO payoff diagram; students drawing
separate payoffs for each individual option should not be allocated marks)
Payoff

Option Payoff Diagram

25$ 35$
0$ Stock Price

-5$

-10$

-15$

-20$

-25$

Marking: 0.5 points per axis (1 point total), 1 point for identifying each corresponding option (2 Points
total), 1 point overall appropriateness. If student draws separate diagrams, 1 point total for question.
(ii):(2 points) What is the holder of this portfolio betting on (i.e. hoping for)? What is the
minimum cost of this portfolio?
Betting on stock price being between 25$ and 35$. Minimum cost = 0$.

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Q2: (9 points) The following cash flows are estimated for two mutually exclusive projects:
Project A Project B
Year Cash Flow Cash Flow
0 -$100,000 -$100,000
1 60,000 30,000
2 40,000 40,000
3 20,000 20,000
4 10,000 50,000
You have also estimated that the IRR of project A is 15.86% and the IRR of project B is 14.1%.
The payback period of Project A is 2 years, while the payback period of project B is 3.2 years.
When is Project B more lucrative than Project A? That is, over what range of discount rate (k)
does Project B have a higher NPV than Project A?

Step 1: Crossover Cash Flows [2 Points]

Year Difference between A and B
0 0
1 $30,000
2 0
3 0
4 $40,000

Step 2: Crossover Rate Calculation [4 Points]

30,000 40,000
0= −
(1 + 𝑘) (1 + 𝑘)4
30,000 40,000
=
(1 + 𝑘) (1 + 𝑘)4
30,000(1 + 𝑘)4
= 40,000
(1 + 𝑘)
40,000
(1 + 𝑘)3 =
30,000
40,000 1/3
(1 + 𝑘) = ( )
30,000
𝑘 = 10.064% - represents the rate at which both NPVs are equal.

Step 3: Conclusion [3 Points – 1.5 Points per conclusion]

Accept project A if “k” is between 10.064% and 15.86%.
Accept project B if “k” is between 0% and 10.064%.

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Q3: (5 points) ABC Inc.’s first quarterly dividend of $2 per share is expected to be paid 6
months from today. From then on, dividends will grow by 2% per quarter for three years. After
three years, the dividends will start declining by 1% per quarter in perpetuity. Assume that
ABC’s required rate of return is 15% (Effective annual rate). What is the price of a share of ABC
today?
Step 1: Conversion from EAR to EQR [1 Point]

𝑬𝑸𝑹 = (𝟏 + 𝟎. 𝟏𝟓)𝟏/𝟒 − 𝟏 = 𝟎. 𝟎𝟑𝟓𝟓𝟓𝟖 = 𝟑. 𝟓𝟓𝟓𝟖%

Step 2: Present Value of Annuity [2 Points]

𝟐 𝟏.𝟎𝟐 𝟏𝟑
𝑷𝑽𝑸𝒖𝒂𝒓𝒕𝒆𝒓 𝑶𝒏𝒆 = (𝟏 − ( ) ) = $22.9641
𝟎.𝟎𝟑𝟓𝟓𝟓𝟖−𝟎.𝟎𝟐 𝟏.𝟎𝟑𝟓𝟓𝟓𝟖

Note on step 2: The dividend payment begins at the end of quarter 2. Using this dividend as D1 implies
the PV is at quarter 1. N = 13 because the formula provides for n+1 (i.e: (3 years x 4 quarters) + 1).

Step 3: Present Value of Perpetuity [1 Point]

𝟐 𝒙 𝟏.𝟎𝟐𝟏𝟐 𝒙 (𝟏−𝟎.𝟎𝟏)
𝑷𝑽𝑸𝒖𝒂𝒓𝒕𝒆𝒓 𝑭𝒐𝒖𝒓𝒕𝒆𝒆𝒏 = = $55.1192
𝟎.𝟎𝟑𝟓𝟓𝟓𝟖−(−𝟎.𝟎𝟏)

Note on step 3: The dividend payment with declining growth begins as at payment 15 (i.e: first dividend
paid in quarter 2, so declining growth occurs 3 years + 1 period after that = 2 + 12 + 1 = 15).

Step 4: Present Value at Time=0 [1 Point]

𝑷𝑽 𝑸𝟏 (𝒊. 𝒆: 𝑺𝒕𝒆𝒑 𝟐) 𝑷𝑽 𝑸𝟏𝟒 (𝒊. 𝒆: 𝑺𝒕𝒆𝒑 𝟑)
𝑷𝑽𝟎 = +
𝟏. 𝟎𝟑𝟓𝟓𝟓𝟖 (𝟏. 𝟎𝟑𝟓𝟓𝟓𝟖)𝟏𝟒
𝟐𝟐. 𝟗𝟔𝟒𝟏 𝟓𝟓. 𝟏𝟏𝟗𝟐
𝑷𝑽𝟎 = +
𝟏. 𝟎𝟑𝟓𝟓𝟓𝟖 (𝟏. 𝟎𝟑𝟓𝟓𝟓𝟖)𝟏𝟒
𝑷𝑽𝟎 = $𝟓𝟓. 𝟗𝟕𝟏𝟐

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Q.4: (5 Points) It is given that assets A and B are priced in the market by the CAPM, with the
following data:

Stock Expected Return Beta

A 25% 1.5
B -10% -1
*Expected returns are based on CAPM
Assets C and D are priced in the market by the dividend growth model, with the
following data:
Stock Expected Return Beta
C 28.6% 2
D 16.8% 0.75
**Expected returns are based on the dividend growth model
Assume that the correct asset-pricing model is the CAPM. Based on the above data, show that
Asset C and D are Overpriced/Underpriced/correctly priced.

Step 1: Determine Information Missing [No Points allocated]

Looking for what CAPM predicts stocks C and D to earn in return, thus:
𝐶 = 𝑅𝑓 + 2(𝑅𝑚 − 𝑅𝑓)
𝐷 = 𝑅𝑓 + 0.75(𝑅𝑚 − 𝑅𝑓)
We are missing the risk free rate and the market risk premium. Must solve for these before proceeding.

Step 2: Solve for Rf and Rm via Substitution [2 Points]

0.25 = 𝑅𝑓 + 1.5(𝑅𝑚 − 𝑅𝑓)

Less: −0.1 = 𝑅𝑓 − 1(𝑅𝑚 − 𝑅𝑓)

0.35 = 0 + 2.5(𝑅𝑚 − 𝑅𝑓)

Thus,
0.35
(𝑅𝑚 − 𝑅𝑓) =
2.5
To solve for the risk free rate, substitute (Rm-Rf) in either of the A or B expressions (given they are said to
BOTH be correctly priced via the CAPM). See as follows:

0.25 = 𝑅𝑓 + 1.5(𝑅𝑚 − 𝑅𝑓)

0.25 = 𝑅𝑓 + 1.5(0.14)

0.25 = 𝑅𝑓 + 0.21

𝑅𝑓 = 0.04

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Step 3: Determine returns for C and D predicted by CAPM [2 Points – 1 Point Each]

𝐶 = 𝑅𝑓 + 2(𝑅𝑚 − 𝑅𝑓)
𝐶 = 0.04 + 2(0.14)
𝐶 = 0.32 = 32%

𝐷 = 𝑅𝑓 + 0.75(𝑅𝑚 − 𝑅𝑓)
𝐷 = 0.04 + 0.75(0.14)
𝐷 = 0.145 = 14.5%

Step 4: Conclusion [1 Point – 0.5 Points Each]

Asset C is overpriced as CAPM predicts 32% return, yet the quoted return is lower than this value (at
only 28.6%).

Asset D is underpriced as CAPM predicts 14.5% return, yet the quoted return is greater than this value
(at 16.8%).

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