PRACTICE QUESTIONS FOR THE MIDTERM

Q1 A given rate is quoted as 9% APR, but has an EAR of 9.3807%. What is the rate of
compounding during the year?

a. Biannually
b. Annually
c. Semiannually
d. Monthly
e. Continuously
12
 0.09 
1 +  = 1 + 0.093807
 12 

Q2 Mary has just obtained a 20-year $50,000 loan from her bank at 10%. The loan
requires equal annual payments over the next 19 years and a final payment of
5,000 in year 20. Calculate the amount that Mary must pay during each of the
next 19 years.

a. $ 5,879.61
b. $ 5,888.49
c. $ 5,379.61
d. $ 5,285.68
e. $ 5,872.98

C  1  5,000
50,000 = 1 − 19  +  C = $5888.49
0.1  1.1  1.120

Page 1 of 56
Q3 You have just got married and can't wait to buy a new house. In order to be able to
buy the house, you take a $277,000 loan from the bank. As per the loan covenants,
you are expected to make constant monthly payments to the bank for the next 40
years. The APR is 18% compounded monthly. If you want to liquidate the loan
after 25 years, what will be the balloon payment?

a. $ 4,158
b. $ 277,000
c. $ 258,210
d. $ 250,460
e. $ 254,205
277,000 0.18
C=  = $4,158
1 12
1− 480
 0.18 
1 + 
 12 

 
 
4158  1 
Balloon =  1− 180 
= $258,210
(0.18 / 12) 
 1 + 0.18 
  
  12  

Q4 You are 40 years away from retirement and expect to live for 25 years after
retirement. Currently, a nursery home costs $20,000 per year, payable at the
beginning of the year. You expect annual costs to continually increase at an
average of 5% per year. Assuming that the interest rate is 5% and that you plan to
move to a nursery home immediately after retirement, how much do you need to
have in the bank when you retire (just before the first year payment) to cover the
25 years that you expect to live in the nursery home?

a. $ 1,984,424
b. $ 140,800
c. $ 500,000
d. $ 281,879
e. $ 3,519,994

Amount = 20,000  1.0540  25 = 3,519,994

Page 2 of 56
 Comments
\

• The annual cost of the nursery home in 40 years will

be 20,000 x (1.05)40.
• Since the annual cost growth rate is equal to the
interest rate (5%) you would need to have 25 times
the annual cost in the bank, 25 x 20,000 x (1.05)40,
when you retire to pay for the 25 years that you
expect to live.

Q5 You have just won the lotto and as a prize you will be receiving 20 equal
payments of $2 million each. The first payment will be received in 2 years and
thereafter, the other 19 payments will be received every three years (that is, in
year 5, 8, 11, etc.). The current annual interest rate of 10% will remain stable for
next 3 years and then it will increase to 20%. How much should you willing to
pay for the winning ticket?

a. $ 7.718 million
b. $ 9.739 million
c. $ 2.747 million
d. $ 4.130 million
e. $ 3.022 million

Three Year Effective Rate = (1 + 0.2)3 − 1 = 72.8%

2 2 1 2  1 
PV = + 3 + 3 1 −  = $4.130M
1.1 1.1  1.2 1.1  1.2 0.728  1.72818 
2 2 2

Q6 A cheque-cashing store is in the business of making personal loans to walk-in

customers. The store makes only one-week loans at 5 percent interest per week.
What annual percentage rate (APR) must the store report to its customers? What is
the effective annual rate (EAR) that the customers are actually paying?

a. APR=6.84% ; EAR=55.98%
b. APR=7.67% ; EAR=92.90%
c. APR=8.29% ; EAR=45.98%
d. APR=125.00% ; EAR=45.98%
e. APR=260.00% ; EAR=1,164.28%

APR = 52  5 = 260%
EAR = (1 + .Page
05) 523−of1 =
561,164.28%
Q7 Your father promises to pay you a lump sum of money today or an annual amount
at the end of each of the next ten years. At today's interest rates the present values
of the two options are identical. You should:

I. choose the lump sum if you expect interest rates to rise in the near future. (TRUE)

II. choose the annuity if you expect interest rates to rise in the near future. (FALSE)

III. choose the lump sum if you expect interest rates to fall in the near future. (FALSE)

IV. choose the annuity if you expect interest rates to fall in the near future. (TRUE)

Q8 Your father deposited $224 in a bank account 25 years ago. It turns out that today
she has $469 in the account. What annual interest has she earned?

a. 2%
b. 3%
c. 4%
d. 5%
e. 6%
469 = (1 + 0.03) 25  224

Q9 The bonds of AGI carry a 9% coupon rate, have a $1,000 face value, pay one
coupon per year, and mature in five years. If the bond YTM is 5%, what is the
market value of AGI's bonds?

a. $842
b. $1,000
c. $1,142
d. $1,173
e. $1,193

1,000  .09  1  1,000

P0 = 1 − +
 (1 + .05)  (1 + .05)5 = $1,173
5
.05  

Page 4 of 56
Q10 The bonds of IGA carry a 12% coupon rate, have a $1,000 face value, pay two
coupons per year, and mature in 10 years. If currently IGA’s bonds trade at
$601.83 what is the bond YTM (quoted as an APR with semi-annual
compounding)?

a. 11%
b. 12%
c. 22%
d. 24%
e. 26%

 
1  
(1,000  0.12)  
1 1,000
P0 = 2  1 − 20 
+ = $601.83
 0.22   1 +  0.22      0.22  
20
      1 +  
 2      
  2    2

Q11 Suppose you are trying to price a bond. Which ONE of the following is TRUE?

a. The lower the discount rate, the less valuable the coupon payments are today.
b. Bonds with high coupon payments are generally (all else the same) more
sensitive to changes in interest rates than bonds with lower coupon payments.
c. When market interest rates rise, bond prices will increase, all else the same.
d. Bonds with long maturities are generally (all else the same) more
sensitive to changes in interest rates than bonds with shorter maturities.
e. All else the same, bonds with larger coupon payments will have a lower price
today.

Page 5 of 56
Q12 A given rate is quoted as 24% APR, but has an EAR of 25.44%. What is the
frequency of compounding?

a. Annually
b. Semiannually
c. Quarterly
d. Monthly
e. Continuously
2
 0.24 
1 +  = 1 + 0.2544
 2 

Q13 Peter has just obtained a 10-year $100,000 loan from his bank. The loan requires
equal annual payments of $18,962 over the next 9 years and a final payment of
$6,555 in year 10. Calculate the interest rate on the loan.

a. 9.20%
b. 10.50%
c. 11.60%
d. 12.80%
e. 15.00%

18,962  1  6,555
100,000 = 1 − +
0.128  1.1289  1.12810

Page 6 of 56
Q14 A corporate bond is currently trading at $2,184.72. The bond, which pays two
coupons per year, matures in 9 years, has a coupon rate of 10%, and YTM of 12%
(APR with semi-annual compounding). Calculate the face value of the bond.

a. $1,825
b. $2,030
c. $2,108
d. $2,450
e. $2,600

2,184.72 =
(FV  0.1) / 2 1 − 1 
+
FV
 FV = 2,450
 18 
0.06  1.06  1.0618

Q15 In order to buy a car, you take a $66,000 loan from the bank. As per the loan
covenants, you are expected to make constant monthly payments to the bank for the
next 5 years. The APR is 6% compounded monthly. If you want to liquidate the
loan after 3 years, what will be the balloon payment?

a. $ 66,000
b. $ 1,276
c. $ 28,789
d. $ 41,942
e. $ 1,468

66,000 0.06
C=  = $1,276
1 12
1− 60
 0.06 
1 + 
 12 

 
 
1276  1 
Balloon = 1− 24 
= $28,789
 0.06   0.06 
   1 +  
 12    12  

Page 7 of 56
Q16 In order to buy a house, you take a $250,000 loan from the bank. As per the loan
covenants, you are expected to make constant annual payments to the bank for the
next 25 years. If the EAR is 12%, how much principal is amortized in the 21st
payment?
a. $ 13,788
b. $ 18,087
c. $ 22,815
d. $ 41,942
e. $ 31,875

250,000  0.12
Annual Payment = = $31,874
1
1−
(1 + 0.12)25

31,875  1 
Principal Outstanding in Year 20 = 1 −  = $114,902
5 
0.12  (1 + .12) 

Interest Payment in Year 21 = 114,902  0.12 = $13,788

Principal Payment in Year 21 = 31,874 − 13,788 = $18,087

Q17 In order to buy a Ferrari, you take a $150,000 loan from the bank. As per the loan
covenants you are expected to amortize a constant fraction of the principal in each
of the 15 annual payments of the loan. If the EAR is 8%, how much should you pay
in the 7th year?

a. $ 8,320
b. $ 7,200
c. $ 16,400
d. $ 17,200
e. $ 17,524
150,000
Principal Outstanding in Year 6 = 150,000 − 6  = $90,000
15

Interest Payment in Year 7 = 90,000  0.08 = $7,200

Payment in Year 7 = 7,200 + 10,000 = $17,200

Page 8 of 56
Q18 Mary is 20 years away from retirement and by the time she retires Mary would like
to have $1 million in the bank. Assuming that the interest rate is 15% per year
(EAR) how much does Mary need to deposit each month in her bank account?

a. $ 50,000
b. $ 4,167
c. $ 2,325
d. $ 762
e. $ 668

EMR = (1 + 0.15)1/12 − 1 = 1.1715%

MonthlyPayment = 1 million  0.011715 / ((1 + 0.011715) 2012 − 1) = $762

Q19 You have just received an inheritance and as a result you will be getting 15 equal
payments of $1 million each. The first payment will be received in 1 year and
thereafter, the other 14 payments will be received every three years (that is, in year
4, 7, 10, etc.). The current annual interest rate of 10% will remain stable for the next
4 years and then it will increase to 15%. Calculate the present value of your
inheritance.

a. $ 3.218 million
b. $ 3.116 million
c. $ 2.898 million
d. $ 2.395 million
e. $ 2.265 million

Three Year Effective Rate = (1 + 0.15) 3 − 1 = 52.09%

1 1 1 1  1 
PV = + 4+ 4 1 − 13 
= $2.898M
1.1 1.1 1.1 0.5209  1.5209 

Page 9 of 56
Q20 Consider the following statements:

I. All else equal, bonds with longer maturities have more interest rate risk.
(TRUE)
II. All else equal, bonds with shorter maturities have more interest rate risk.
(FALSE)
III. All else equal, bonds with higher coupon payments have more interest rate
risk. (FALSE)
IV. All else equal, bonds with lower coupon payments have more interest rate risk.
(TRUE)
V. Bond ratings measure a bond’s exposure to interest rate risk. (FALSE)

Q21 Consider the following statements:

I. The law of one price will cause investors to demand discount bonds until these
bonds trade at par value. (FALSE)
II. A consol is a risk-free zero-coupon government bond. (FALSE)
III. All else equal, bonds with a higher probability of default have a higher yield to
maturity. (TRUE)
IV. Treasury bills are long-term government bonds with a maturity of up to 10 years.
(FALSE)

V. The prices of bonds with lower coupon rates are less sensitive to changes in
interest rates. (FALSE)

Q22 A loan has a 20% APR and an EAR of 22.140%. What is the frequency of
compounding of the APR rate?

a. Annually
b. Semiannually
c. Quarterly
d. Continuously
e. Biannually

EAR = e0.2 − 1 = 22.140%

Page 10 of 56
Q23 Justin has just obtained a 20-year $200,000 loan to open a business. The loan
requires Justin to make annual payments of $17,564.53 over the next 20 years.
Calculate the interest rate on the loan.

a. 12% Effective Annual Rate

b. 3% Effective Annual Rate
c. 6% APR with semiannual compounding
d. 4% APR with semiannual compounding
e. 3% APR with semiannual compounding

A 6% APR with semiannual compounding corresponds to the following EAR:

2
 0.06 
EAR = 1 +  − 1 = 6.09%
 2 

If we use 6.09% to discount the 20 year annuity we get $200,000:

17564.53  1 
1 − 20 
= 200,000
0.0609  1.0609 

Q24 Mary deposited $1,000 in a bank account 20 years ago. She withdrew $300 from
the bank account 10 years ago. If the annual interest is 12%, how much does she
have in the bank account today?

a. $ 2,174
b. $ 6,752
c. $ 9,646
d. $ 8,715
e. $ 10,578

(1 + 0.12) 20  1000 − (1 + 0.12)10  300 = $8,715

Page 11 of 56
Q25 Consider a bond with a 9% annual coupon rate, a $1,000 face value, and that pays
monthly coupons. The bond has just paid a coupon, matures in 20 years, and
currently trades at $514.03. What is the bond YTM (quoted as an APR with
monthly compounding)?
a. 9%
b. 18%
c. 24%
d. 12%
e. 6%
 
1  
(1,000  0.09)  
1 1,000
P0 = 12 1 − 240 
+ = $514.03
 0.18     0.18      0.18  
240
 
 12   1 +  12    1 +  12  
     

Q26 Consider the following statements:

I. A risk-free zero-coupon bond with a face value of $1,000 that matures in one year
sells today for $972. If the risk-free interest rate is 4% per year, you can make
money by borrowing at the risk-free rate and buying the zero-coupon bond.
(FALSE)

II. A 20-year, risk-free coupon bond with a face value of $1,000 pays one coupon of
$45 each year, has just paid a coupon, and has a YTM of 3.2% (APR with annual
compounding). Currently, the yield curve is upward slopping, and hence, bonds
will be expected to yield a higher interest rate in the future. Therefore, the 20-
year, risk-free coupon bond must be currently trading at a discount. (FALSE)

Q27 Consider the following statements:

I. A premium bond has its price increasing overtime to provide a premium return
that makes up for the low coupon rate. (FALSE)
II. High yield bonds are bonds in the top four categories of creditworthiness with a
low risk of default. (FALSE)
III. A T-bill is a zero coupon bond with a maturity longer than ten years and a consol
is a zero coupon bond with a maturity shorter than one year. (FALSE)

Page 12 of 56
Q28 Marisa has just obtained a 30-year $1,000,000 loan to buy a condo. The loan
requires Marisa to make annual payments of $210,691.97 over the next 30 years.
Calculate the interest rate on the loan.

a. 20% APR with semiannual compounding

b. 22% APR with semiannual compounding
c. 10% APR with semiannual compounding
d. 11% APR with semiannual compounding
e. 24 % APR with semiannual compounding

Solution

A 20% APR with semiannual compounding corresponds to the following EAR:

2
 0.20 
EAR = 1 +  − 1 = 21%
 2 

If we use 21% to discount the 30-year annuity we get $1,000,000:

210,691.97  1 
1 −  = 1,000,000
0.21  1.2130 

Q29 Pierre deposited $5,000 in a bank account 20 years ago at an interest rate of 8% per
year. Pierre withdrew some amount from the bank account 12 years ago. If Pierre
has $20,912.52 in the bank account today, how much did Peter withdraw 12 years
ago?

a. $192
b. $2,025
c. $825
d. $950
e. $1,352

Solution
(1 + 0.08)20  5000 − (1 + 0.08)12  950 = $20,912.52

Page 13 of 56
Q30 You have just graduated and want to buy a new boat. In order to buy the boat, you
take a $150,000 loan from the bank. As per the loan covenants, you are expected
to make constant monthly payments to the bank for the next 10 years. The APR
is 6% compounded monthly. You have just made a payment and still owe the
bank $37,574. (That is, if you were to liquidate the loan today, you would need
to pay the bank $37,574.) How much time is there left on the loan?

a. 18 months
b. 48 months
c. 24 months
d. 28 months
e. 12 months

Solution

A 6% APR with monthly compounding corresponds to the following effective

monthly rate:
6
EMR = = 0.5%
12
The monthly payment on the loan is:
150,000
Monthly Payment = = $1,665.31
1  1 
1 − 
0.005  1.005120 

The amount owed to the bank when there are n months left in the loan is:

1,665.31  1 
1 − 
0.005  1.005n 

Plugging in n = 24 months we get that the amount still owed to the bank:

1,665.31  1 
1 −  = 37,574
0.005  1.00524 

Page 14 of 56
Q31 Juan took a $500,000 loan from CIBC. As per the loan covenants, he is expected to
make constant annual payments to CIBC for the next 32 years. If the EAR is 4%,
how much interest is paid in the 22nd payment?
a. $8,202
b. $12,625
c. $27,974
d. $9,803
e. $28,887

Solution
500,000  0.04
Annual Payment = = $27,974.29
1
1−
(1 + 0.04)32
27,974.29  1 
Principal Outstanding in Year 21 = 1 −  = $245,068.12
11 
0.04  (1 + 0.04) 

Interest Paid in Year 22 = 245,068.12  0.04 = $9,803

Q32 Consider a bond with a YTM of 18% (quoted as an APR with monthly
compounding), a $1,000 face value, and that pays monthly coupons. The bond has
just paid a coupon, matures in 10 years, and currently trades at $815.01. What is the
bond’s coupon rate?

a. 18%
b. 16%
c. 14%
d. 12%
e. 10%

Solution

Plugging the 14% coupon rate (i.e., 0.14) into the bond price formula:

 
1  
 1,000  0.14  
1 1,000
P0 = 12  1− 120 
+ = $815.01
 0.18     0.18      0.18  
120
 
 12   1 +  12    1 +  12  
     

Page 15 of 56
Q33 An economy has an annual risk-free rate of 5% that is certain to remain constant.
Consider a risk-free bond with a 10% coupon rate, a $1,000 face value, and that
pays one coupon per year. The bond has just paid a coupon, and currently trades at
$1,386.09. Calculate the price of the bond two years from now (just after paying the
coupon for that year).

a. $1,428.16
b. $1,290.84
c. $1,323.16
d. $1,372.19
e. $1,528.16

Solution

Because the bond is risk free and the risk-free rate is constant at 5% per year:

1,000  0.1 1,000  0.1 + P2

P0 = 1,386.09 = +  P2 = 1,323.16
1 + 0.05 (1 + 0.05)2

Q34 Taylor Swift has just signed a new contract with Emi Records. According to the
contract, Taylor Swift will be receiving 15 equal payments of $5 million each. The
first payment will be received in year 1, and thereafter, the other 14 payments will
be received every two years (that is, in years 3, 5, 7, 9 etc.). The current annual
interest rate of 4% will remain stable for the next 4 years and then it will increase
to 7%. How much is the contract worth today?

a. $42.12 M
b. $44.97 M
c. $39.19 M
d. $35.38 M
e. $31.42 M

Solution

Two Year Effe ctive Rate = (1 + 0.07)2 − 1 = 14.49%

5 5 5 1 5  1 
PV = + + + 1 − 12 
= $35.38M
1.04 1.04 1.04  1.07 1.04  1.07 0.1449  1.1449 
3 4 4

Page 16 of 56
Q35 A silver mine will produce for the next 12 years (i.e., from year 1 to year 12), but
its production of silver will decline by 7% per year. Silver prices, however, will
grow by 4% per year. Next year, the mine is expected to produce 1,000 kilos of
silver and the price of silver is expected to be $2,000 per kilo. Assuming that the
appropriate discount rate is 8%, calculate today’s value of the mine’s future
revenues, that is, the present value of the mine’s revenues from year 1 to 12.

a. $15,250,409
b. $13,011,700
c. $13,320,020
d. $15,072,156
e. $17,352,429

Solution

Growth in Revenues = (1 − 0.07)  (1 + 0.04) − 1 = −3.28%

1,000  2,000   1 − 0.0328  

12

PV = 1−   = $13,011,700
0.08 − ( −0.0328)   1 + 0.08  

Page 17 of 56
Q36 A risk-free zero-coupon bond with a face value of $1,000 maturing in one year
trades today at a price of $890. A risk-free bond with a coupon rate of 10%, that
pays one coupon per year, has a face value of $1,000, matures in 2 years, and that
has just paid a coupon trades today at $995. Calculate the current price of a risk-
free zero-coupon bond with a face value of $1,000 that matures in 2 years.

a. $823.64
b. $704.93
c. $105.00
d. $792.09
e. $942.50

Solution

The coupon bond pays $100 in one year (i.e., 1000 x 0.1) and $1,100 in two years
(i.e., coupon + FV =1000 x 0.1 + 1000). Therefore, the coupon bond is equivalent
to 0.1 one-year zero-coupon bond plus 1.1 two-year zero-coupon bonds. Hence
the law of one price (i.e., securities or portfolios with the same cash- flows must
have the same price) implies that:

Price of coupon bond =

= 0.1 x Price of one-year zero-coupon + 1.1 x Price of two-year zero-coupon

Plugging in the prices:

995 = 0.1 x 890 + 1.1 x Price of 2-year zero-coupon

Solving: Price of two-year zero-coupon = $823.64

Page 18 of 56
Q37 John is celebrating his 40th birthday today and wants to start saving for his
retirement at age 65. John plans to make equal annual deposits in a savings
account starting on his 41st birthday and with the last deposit being on his 65th
birthday. In addition, he expects an inheritance on his 55th birthday of $40,000,
which he will also deposit in the savings account. John wants to withdraw
$25,000 from his savings account on each birthday for 20 years following
retirement (the first withdrawal will be on his 66th birthday). If the savings
account offers a 10% interest per year, what is the minimum amount that John
must deposit annually to be able to make the desired withdrawals during
retirement?

Solution

Step 1: Money needed in the bank when John retires in 25 years (when he turns 65):

25,000  1 
PV65−birthday = 1 − 20  = $212,839.09
0.1  1.1 

Step 2: Money needed in the bank when John retires in 25 years (when he turns 65)
after subtracting the future value of the $40,000 inheritance deposited on Jonh’s 55th
birthday

V65−birthday = 212,839.09 − 40,000  (1 + 0.1)10 = 212,839.09 − 103,749.70 = $109,089.39

Step 3: Present value (John is now 40) of the $109,089.39 :

109,089.39
PV40−birthday = = $10,068.51
(1 + 0.1) 25

Step 4: Equal annual deposits in the savings account starting on the 41st needed:

10,068.51
C= = $1,109.23
1  1 
1 − 
0.1  1.125 

Note: Steps 3 and 4 can be combined into one using the FV of

an annuity:

109,089.39 =
C
0.1
( )
1.125 − 1  C = $1,109.23

Page 19 of 56
Q38 The mortgage on your house in Montreal is 10 years old. It requires semi-annual
payments of $30,000, has an original term of 25 years, and has an interest of 18%
(APR with semi-annual compounding). You decided to sell your Montreal house
for $375,000, liquidate your loan with part of the $375,000, and use the remaining
amount towards a down payment for a beach house in Hawaii. You plan to finance
the rest of the beach house with a new mortgage. This new mortgage requires semi-
annual payments and has an interest rate of 12% (APR with semi-annual
compounding). Suppose that you are willing to continue making semi-annual
payments of $30,000 and want to pay the new mortgage in 20 years. How much can
you afford to pay for the new beach house in Hawaii?

Solution

Step 1: Amount needed to repay the old loan:

 
 
30,000  1 
PV =  1− 30 
= $308,209.62
(0.18 / 2) 
 1 +
0.18 
 
  2  

Step 2: Amount remaining from selling the old house after repaying the old loan:

Remaining = $375,0000 − $308,209.62 = $66,790.38

Step 3: Amount available to buy the new house (i.e., remaining from selling the
house plus new mortgage):

 
 
30,000  1 
Total Available = 66,790.38 + 1− =
(0.12 / 2)   0.12  40 
 1 +  
  2  

= 66,790.38 + 451,388.91 = $518,179.28

Page 20 of 56
Consider the following term structure of risk-free Canadian interest rates for
January 2004, 2008, 2009, and 2010.

Using the information from the above table answer the following three questions

Page 21 of 56
Q39 On January 2004, Mary bought a risk-free zero-coupon bond with a face value of
$1,000 maturing in 15 years. If Mary sold this bond on January 2010, calculate the
annual return on her six-year investment.

Solution

Step 1

1,000
Purchase Price Jan − 04 = = $465.07
(1 + 0.052363)15

Step 2
1,000
Sale Price Jan − 10 = = $724.15
(1 + 0.036513)9

Step 3

724.15 − 465.07
6 - year return = = 55.7079%
465.07

Per year return = (1 + 0.557079)1 / 6 − 1 = 7.6594%

Q40 On January 2010, a zero-coupon bond with a face value of $1,000 maturing in one
year had a YTM of 10%. On January 2010, it was also already known that the bond
was certain to default and that would only pay $X at maturity (instead of its $1,000
face value). Calculate $X.

Solution

Step 1
1,000
Price Jan − 10 = = $909.09
1 + 0.1

Step 2

X
Price Jan − 10 = 909.09 =  X = $915.80
1 + 0.007381

Page 22 of 56
Q41 Calculate the YTM on January 2004 of a risk-free coupon bond that pays one
coupon per year, has a coupon rate of 30% and a face value of $1,000, and that
matures in three years (the next coupon is exactly one year from now January
2004). IN THIS PROBLEM, YOU DO NOT ACTUALLY NEED TO SOLVE FOR THE
YTM, YOU JUST NEED TO SET UP THE EQUATION THAT ONE WOULD NEED TO
SOLVE TO FIND THE YTM.

Solution
Step 1

1,000  30 1,000  30 1,000  30 + 1,000

Price Jan − 04 = + + = $1,748.30
1 + 0.025875 (1 + 0.030484) 2
(1 + 0.034756)3

Step 2
The YTM would solve:

1,000  0.3 1,000  0.3 1,000  0.3 + 1,000

$1,748.30 = + +
1 + YTM (1 + YTM ) 2 (1 + YTM )3
or
1,000  0.3  1  1,000
$1,748.30 = 1 − +
3
YTM  (1 + YTM )  (1 + YTM )3

Q42 Massey, a tractor manufacturer, has just announced earnings of $1 million for year
0. Massey’s earnings will grow at a rate of 20% per year for the next 3 years. After
that, earnings will grow at a rate of 5% per year forever. What is the present value
of all future earnings if the interest rate is 10%?

Solution

1.2 1.2 2 1.23 1 1.23  1.05

PV = + 2 + 3 + 3 = $30.84M
1.1 1.1 1.1 1.1 0.1 − 0.05

Page 23 of 56
Q43 Olivia took a 30-year loan from her bank. As per the loan covenants, she is expected
to amortize a constant fraction of the original amount borrowed in each of the 30
annual payments of the loan. [In other words, in each annual payment, Olivia will
amortize 1/30 of the original amount borrowed.] The EAR on the loan is 5%, and
Olivia will need to make a payment of $42,625 in year 20 (i.e., the 20th payment).
How much did Olivia originally borrow from the bank?

a. $825,000
b. $700,000
c. $950,000
d. $875,000
e. $975,000

Solution

 19  11
Principal Outstanding Year 19 = 1 −   Amount Borrowed =  Amount Borrowed
 30  30

11
Interest Paid in Year 20 = 0.05   Amount Borrowed
30

11 Amount Borrowed
Payment in Year 20 = 0.05   Amount Borrowed + = 42,625
30   30 
Interest Paid in Year 20 Principal Repaid in Year 20

Solving for the amount borrowed:

42,625  30
Amount Borrowed = = $825,000
0.05 11 + 1

Page 24 of 56
Q44 You are 5 years away from retirement and expect to live for 20 years after
retirement. Currently, a nursery home costs $30,000 per year, payable at the
beginning of the year. You expect annual costs to continually increase at an
average of 5% per year. The interest rate is 8% and you plan to move to a nursery
home immediately after retirement. How much do you need to have in the bank
when you retire (just before paying for the first year at the nursery home) to cover
the 20 years that you expect to live in the nursery home?

Solution

Cost of Nursery at Retirement = 30,000 1.055 = 38,288.45

38,288.45  1.05   1.05  

19
PV = 38,288.45 + 1−    = $593,724
0.08 − 0.05   1.08  


Comment
The nursery is payable at the beginning of the year, so
the first payment is due right away after retirement.

Q45 Consider a risk-free bond. The bond pays one coupon of $100 each year, has just
made a coupon payment, and is trading for $950. The current one-year risk-free
interest rate is 2%. It is also known with certainty that the one-year risk-free interest
rate will be 6% the following year, and 3% the year after. (Hence there is no
uncertainty about future interest rates.) Calculate the price of the bond three years
from now just after the coupon payment for that year.

Solution

100 100 100 + P3

950 = + +  P3 = $745.77
1.02 1.02  1.06 1.02  1.06  1.03

Page 25 of 56
Q46 Suppose Toy, Inc. has a zero-coupon bond that will pay $1,000 at maturity on
March 2, 2012. Today is March 2, 2008, and the bond is selling for $790.09. What
is the bond’s YTM (quoted as an APR with annual compounding)?

a. 9.00%
b. 5.02%
c. 6.99%9
d. 7.82%
e. 6.06%

Solution

 1
  1

      
 − 1 = 6.06%
FV FV n 1,000 4
P=  YT M n =   −1 = 
(1 + YTM n )n  P 

  790.09 
 



YTM is 6.06% compounded annually.

Q47 Mary took a 20-year loan of $300,000 from the bank. As per the loan covenants
she is expected to amortize a constant fraction of the original amount borrowed in
each of the 20 annual payments of the loan. (In other words, in each annual
payment, she will amortize 1/20 of the original amount borrowed.) If EAR on the
loan is 10%, how much does Mary need to pay in year 5?

a. $36,000
b. $37,800
c. $38,500
d. $39,000
e. $39,500

Solution

20 - 4
Principal Outstanding in Year 4 =  300,000 = $240,000
20

Interest Paid in Year 5 = 10%  240,000 = $24,000

300,000
Payment in Year 5 = 24,000 + = $39,000
20

Page 26 of 56
Q48 Assume that the interest rate is 10% per year. You are planning to retire in 40 years
and hope to live for 25 years in retirement. You estimate that in retirement you will
need to withdraw $40,000 per year (starting one year after retirement) so that you
will just exhaust your savings with the 25th withdrawal. You plan to deposit in the
bank a constant amount each year starting in one year and retire immediately after
making the 40th deposit. What amount will you need to deposit in the bank account
each year?

a. 1,250
b. 1,330
c. $630
d. $945
e. $820

Solution

Money needed in the bank when you retire in 40 years:

Step 1:
40,000  1 
PV40 = 1 − 25  = $363,081.60
0.1  1.1 

Money need to deposit in each of the next 40 years:

Step 2:
363,081.60
PV0 = = $8,022.26
1.140
Step 3:

8,022.26
C= = $820.35
1  1 
1 − 
0.1  1.140 

Page 27 of 56
Q49 Michael Jordan has just signed a new contract with Nike Inc. In particular, M.
Jordan will be receiving 10 equal payments of $2.5 million each. The first payment
will be received in 2 years, and thereafter, the other 9 payments will be received
every three years (that is, in years 5, 8, 11, 14 etc.). The current annual interest rate
of 10% will remain stable for next 6 years and then it will decrease to 5%. How
much is the contract worth today?

a. $12.3
b. $6.1M
c. $10.1M
d. $8.7M
e. $9.2M

Solution

Three Year Effective Rate = (1 + 0.5) 3 − 1 = 15.76%

2.5 2.5 2.5 1 2.5  1 

PV = + 5+ 6 + 6 1 − 7 
= $10.1M
1.1 1.1 1.1  1.05 1.1  1.05 0.1576  1.1576 
2 2 2

Q50 A bond has annual coupon payments of $200 and a face value of $1,000. If the
yield to maturity of the bond is 15%, this bond should:

a. Sell at a discount
b. Sell at premium
c. Sell for par value
d. Sell for the same price as the similar bond regardless of their respective
maturities.
e. Sell at a premium or at discount depending on frequency of the coupon
payments.

Comment

The coupon rate 20% (=200/1000) is larger than the YTM.

Page 28 of 56
Q51 John took a $300,000 loan from RBC. As per the loan covenants, he is expected
to make constant annual payments to RBC for the next 30 years. If the EAR is
10%, how much principal is amortized in the 22nd payment?

a. $32,500
b. $13,496
c. $19,425
d. $17,201
e. $7,321

Solution
300,000  0.1
Annual Payment = = $31,823.77
1
1−
(1 + 0.1)30
31,823.77  1 
Principal Outstanding in Year 21 = 1 −  = $183,273.88
0.1  (1 + 0.1)9 

Interest Payment in Year 22 = 183,273.88  0.1 = $18,327.39

Principal Payment in Year 22 = 31,823.77 − 18,327.39 = $13,496

Q52 Capital One is advertising a 60-month, 5.99% APR compounded monthly

motorcycle loan. If you need to borrow $8,000 to purchase your dream Harley
Davidson, what will your monthly payment be?

Solution

Timeline:

0 1 2 3 4 60

–8,000 C C C C C

Page 29 of 56
 5.99
✓ 5.99 APR monthly implies a = 0.499167% monthly effective rate.
12
✓ Using the formula for computing a loan payment we calculate the monthly
payment:

8, 000
C= = $154.63
1  1 
1 − 60 
0.00499167  (1.00499167 ) 

Q53 You have credit card debt of $25.000 that has an APR (monthly compounding) of
15%. Each month you pay the minimum monthly payment only and you are
required to pay only the outstanding interest. You have received an offer in the
mail for an otherwise identical credit card with an APR (monthly compounding)
of 12%. After considering all your alternatives, you decide to switch cards, roll
over the outstanding balance on the old card into the new card and borrow
additional money as well. How much can you borrow today on the new card
without changing the minimum monthly payment that you will be required to
pay?

Solution
15
✓ The discount rate on the original card is = 1.25%
12

✓ Assuming that your current monthly payment is the interest that accrues, it equals:

0.15
$25, 000  = $312.50
12
✓ Timeline:

0 1 2

312.50 312.50

This is a perpetuity so the amount you can borrow at the new interest rate is this cash
12
flow discounted at the new discount rate. The new discount rate is = 1% and
12

Page 30 of 56
 312.50
hence, PV = = $31, 250
0.01
In other words, switching credit cards allows you to spend an extra

31, 250 − 25, 000 = $6, 250

Q54 You have just graduated and can't wait to buy a new car. In order to be able to
buy the car, you take a loan of $17,000 from the bank. As per the loan covenants,
you are expected to make constant monthly payments to the bank for the next 25
years. The APR is 10% APR (monthly compounding).

a) Calculate the monthly payment.

b) If you want to liquidate the loan after 5 years, what will be the balloon
payment?

Solution

a) Notice that the loan is an annuity with 300 monthly payments (i.e., 25 years),
an effective monthly rate of (0.1 / 12), and a present value of $17,000. Solving
for the monthly payment:

17,000 0.1
C=  = $154.48
  12
 
 1 
1 − 300 
 1 + 0.1  
 
  12  

b) The balloon payment after five years is the PV in year five of the remaining
payment (which is a 20-year annuity with monthly payments of $154.48):

 
 
154.48  1 
Balloon =  1− 240 
= $16,007.83
(0.1 / 12) 
 1 + 0.1 
  
  12  

Page 31 of 56
Q55 Mr. Wise is collecting money for his children's education. Suppose he deposits
$10,000 in his bank account every two years, with the first deposit starting in one
year. If the annual rate of return is 8% and it is compounded continuously, how
much money will he have accumulated after 25 years?

Solution

0 1 3 5 25

10K 10K 10K 10K

This stream of payments can be considered as annuity starting at year 1.

( ) 2
( )
2
Effective 2-Year Rate = er − 1 = e0.08 − 1 = 0.1735

We first compute the present value of the payments at year “-1”, and then find the
future value at the end of year 25.

10000  1 
PV−1 = 1 −  = 50435.43
 13 
0.1735  (1.1735) 

FV25 = 50435.43 x 1.173513 = $403,660.22

Alternatively, we can calculate the future value of 10,000 for 13 periods

@17.35% every period:

FV25 =
10,000
0.1735
( )
1.173513 − 1 = $40,3660.23

Page 32 of 56
Q56 In three years, you will receive the first of nine annual $300 payments. The
current interest rate is 14% and will stay constant for the next three years. After
year 3, the interest rate will drop to 12%. What is the present value of this cash
stream?

Solution
You can view the cash-flow from year 4 on as an 8-year annuity with a 12%
discount rate. Then you can sum to the PV in year 3 of this 8-year annuity to the
cash-flow in year 3, and discount everything to the present at 14%:

1  300  1  
PV =  1 −  + 300 = $1,208.39
 
1.14 3  0.12  (1.12) 
8


Q57 Suppose that a young couple has just had their first baby and they wish to ensure
that enough money will be available to pay for their child's college education.
Currently, college tuition, books, fees, and other costs, average $12,500 per year.
On average, tuition and other costs have historically increased at a rate of 4% per
year. Assuming that college costs continue to increase an average of 4% per year
and that all her college savings are invested in an account paying 7% interest, then
what is the amount of money she will need to have available at age 18 to pay for
all four years of her undergraduate education? [Note: The first tuition payment
will be at age 18, when she starts college.]

Solution

First, determine the cost of the first year of college:

FV = 12,5001.0418 = $25,322.71

Second, find the value for four years of college:

C  1+ g   25,322.71   1 + 0.04  

n 4
PV = 1 −     (1 + r ) = 1 −     (1 + 0.07) = $97,110.01
r − g   1 + r   0.07 − 0.04   1 + 0.07  

Note: The first payment is due when she starts college in 18 years, and the
annuity formula gives the PV one period before the first payment (i.e., in year 17
in this case). Hence to calculate the present value in year 18, you will need to
multiply by (1+r).

Page 33 of 56
Q58 Your son is about to start kindergarten in a private school. Currently, the tuition
is $12,000 per year, payable at the start of the school year. You expect annual
tuition increases to average 6% per year over the next 13 years. Assuming that
your son remains in this private school through high school and that your current
interest rate is 6%, then what is the present value of your son's private school
education?

Solution
Notice that this is a growing annuity but with the first payment at time 0. The PV
of a growing annuity formula is undefined since r = g. But since r = g, the growth
in the payments is exactly offset by the current interest rate, the answer is 12,000
× 13 = $156,000.

Note: You could also individually discount each of the 13 payments and arrive at the same
answer.

Q59 Assume that you are 30 years old today, and that you are planning on retiring at
age 65. Your salary from the next years is $45,000 and you expect your salary to
increase at a rate of 5% per year as long as you work. To save for your
retirement, you plan on making annual contributions to a retirement account.
Your first contribution will be made on your 31st birthday and will be 8% of the
year's salary, i.e., $45,000. Likewise, you expect to deposit 8% of your salary
each year until you reach age 65. At age 66 you will begin withdrawing equal
annual payments until your 101st birthday. If the annual rate of return is 7%, then
how much money will you have to spend in each of your golden years of
retirement?

Solution

• First Deposit = 0.08 × $45,000 = $3,600

• The money available at retirement is the future value of a 35-year (that is,
from age 31 to age 65) growing annuity:

C  1+ g   3,600   1 + 0.05  

n 35
FVAge−65 = 1 −     (1 + r ) =
n
1 −     (1 + 0.07) = $928,895
35
r − g   1 + r   0.07 − 0.05   1 + 0.07  

Page 34 of 56
 • The value spent each year from age 66 to age 101 is calculated as the constant
payment of a 36-year annuity with discount rate 7% and present value of
$928,895:

C  1 
928,895 = 1−  C = 71,260

0.07  1.0736 

Q60 If you pay back a three-year loan of $10,000 at 12% per year with equal annual
payments, how much interest is paid in the third year?

Solution

First we need to find the annual payment:

Payment  1 
10,000 = 1 −  → Payment = 4,136.49
0.12  1.123 

Beginning Total Interest Principal Ending

Year Balance Payment Paid Paid Balance
1 $10,000 4,163.49 1,200 2,963.49 7,036.51
2 7,036.51 4,163.49 844.38 3,319.11 3,717.40
3 3,717.40 4,163.49 446.09 3,717.40 0.00

Interest paid each period= Beginning balance x 12%

Page 35 of 56
Q61 Suppose you owe a principal amount of $10,000 bearing an interest rate of 10%
per annum. Prepare an amortization schedule showing the annual payment, on the
basis that you want to amortize 1/10th of the $10,000 original principal every year.

Solution

Principal Principal Interest Total

Period outstanding paid paid payment
0 10000
1 9000 1000 1000 2000
2 8000 1000 900 1900
3 7000 1000 800 1800
4 6000 1000 700 1700
5 5000 1000 600 1600
6 4000 1000 500 1500
7 3000 1000 400 1400
8 2000 1000 300 1300
9 1000 1000 200 1200
10 0 1000 100 1100

Q62 You have just won the lotto and as a prize you will be receiving 20 equal
payments of $2 million each. The first payment will be received in 2 years and
thereafter, the other 19 payments will be received every three years (that is, in
year 5, 8, 11, etc.). The current annual interest rate of 10% will remain stable for
next 3 years and then it will increase to 20%. How much should you willing to
pay for the winning ticket?

Solution

Three Year Effective Rate = (1 + 0.2)3 − 1 = 72.8%

2 2 1 2  1 
PV = + 3 + 3 1 −  = $4.130M
1.1 1.1  1.2 1.1  1.2 0.728  1.72818 
2 2 2

Page 36 of 56
Q63 A bond with a coupon rate of 15% and a face value of $1,000 is priced today at
$1,500. As per the terms of the prospectus, the bond makes coupon payments on
a monthly basis. The bond matures 8 years from today and has just paid a
coupon. What is the YTM of the bond?

Solution

CPN  1  FV
P= 1 − +
n 

YTM n  (1 + YTM n )  (1 + YTM n ) n

0.15 1,000
 1  1,000
1,500 = 12 1 − +
96 
YTM 96  (1 + YTM 96 )  (1 + YTM 96 )96

where YTM 96 is the yield to maturity of the bond expressed as a per effective
monthly rate for holding the bond from today until maturity in 96 months. Solving
with excel, a financial calculator or by trial and error we get: YTM 96 =0.572% and
hence the YTM (expressed as an APR with monthly compounding) is:

YTM = 0. 572 x 12 = 6.8%

Q64 A risk-free zero-coupon bond with a face value of $1,000 maturing in 1 year
trades today at a price of $909.09. A risk-free zero-coupon bond with a face value
of $1,000 maturing in 2 years trades today at price of $790.51. Calculate the
current price of a risk-free coupon bond with a coupon rate of 10% that pays one
coupon per year, has a face value of $10,000, and matures in 2 years.

Solution

The coupon bond pays $1,000 in one year (i.e., 10,000 x 0.1) and $11,000 at
maturity in two years (i.e., coupon + FV =10,000 x 0.1 + 10,000). Therefore, the
coupon bond is equivalent to one 1-year zero-coupon bond plus eleven 2-year
zero-coupon bonds. Hence the law of one price (i.e., securities or portfolios with
the same cash- flows must have the same price) implies that:

Price of coupon bond = 1 x 909.09 + 11 x 709.51 = $9,604.7

Page 37 of 56
Q65 Consider a bond, with a $1,000 face value, a coupon rate of 5%, and that pays one
coupon per year. The bond has just paid a coupon, matures in 2 years, and
currently is trading at $900. The bond is certain to pay the next coupon in one
year but it may default in two years. In particular, in two years, with probability
0.12, the bond will default and pay nothing and, with probability 0.88, the bond
will not default and pay the promised coupon plus the face value. Calculate the
bonds YTM (quoted as an APR with annual compounding).

a. 1.325%
b. 6.321%
c. 5.000%
d. 12.463%
e. 10.826%

Solution

The YTM is given by the following equation:

0.05  1000 0.05  1000 + 1000

P = 900 = +
1 + YTM (1 + YTM )2

Plugging in 10.826% the number:

0.05  1000 0.05  1000 + 1000

P= + = 900
1 + 0.10826 (1 + 0.10826)2

Note: The YTM are calculated using the promised cash-

flows rather than the expected cash-flows.

Page 38 of 56
Q66 Consider a bond with a face value of $1000, that matures in three years, pays one
coupon of $50 each year, and that has just made a coupon payment. The current
one-year risk-free interest rate is 4%. It is also known with certainty that the one-
year risk-free interest rate will be 6% the following year and thereafter. Find the
(a) the bond the current price of the bond, the price of the bond in one year, and
the price of the bond in two years. (b) Find the YTM of the bond in year 0, in year
1, and in year 2. (c) Find the return from holding the bond during the first year
(from t=0 to t=1), from holding the bond during the second year (from t=1 to t=2),
and from holding the bond during the third year (from t=2 to t=3).

Solution

a)
50 50 50 + 1,000
P0 = + + = $991.9866
1 + 0.04 (1 + 0.04)(1 + 0.06) (1 + 0.04)(1 + 0.06) 2

50 50 + 100
P1 = + = 981.6661
(1 + 0.06) (1 + 0.06) 2

50 + 100
P2 = = 990.5660
(1 + 0.06)
b)
50 50 50 + 1,000
P0 = 991.9866 = + +  YTM t = 0 = 5.2959%
1 + YTM t = 0 (1 + YTM t = 0 ) 2
(1 + YTM t = 0 )3

50 50 + 1,000
P1 = 981.6661 = +  YTM t =1 = 6%
(1 + YTM t =1 ) (1 + YTM t =1 ) 2

50 + 1,000
P2 = 990.5660 =  YTM t = 2 = 6%
(1 + YTM t = 2 )
c)
50 + P1 − P0 50 + 981.6661 − 991.98660
Returnt = 0 to t =1 = = = 4%
P0 991.9866

50 + P2 − P1 50 + 990.5660 − 981.6661
Returnt =1 to t = 2 = = = 6%
P1 981.6661

50 + 1,000 − P2 50 + 1,000 − 990.5660

Return t = 2 to t =3 = = = 6%
P2 990.5660

Page 39 of 56
Q67 An investor has two bonds in his portfolio. Both bonds mature in 4 years, have a
face value of $1,000, and their yield to maturity equals 9.6 percent per year. One
bond, Bond C, pays one coupon per year and has a coupon rate of 10 percent, the
other bond, Bond Z, is a zero coupon bond. Assuming that the yield to maturity of
each bond remains at 9.6 percent per year over the next 4 years, what will be the
price of each of the bonds at the following time periods? Fill in the following
table:

Time Price of Bond C Price of Bond Z

0 1,012.79 693.04
2 1,006.98 832.49
4 1,000 1,000

Solution

The Value of Bond Z increases as it nears maturity, while the value of Bond C,
which is currently selling at a premium, decreases as it approaches its maturity.
The values of the two bonds converge on maturity date and are equal to $1000.

Q68 Evaluate the following statements:

I. Firm’s debt-holders are the residual claimants to the firm’s cash flows.
(FALSE)
II. All else equal, a firm’s P/E ratio is decreasing in the dividend payout
ratio. (FALSE)
III. If a project has an IRR of 15 % and a required cost of capital of 8%
then it must have a positive NPV. (FALSE)
IV. Shareholders are corporation’s residual claimants. (TRUE)

Q69 Consider the following statements:

I. Debt-holders are corporation’s residual claimants. (FALSE)

II. Debt-holders are entitled to vote for the board of directors. (FALSE)
III. Shareholders are corporation’s residual claimants. (TRUE)
IV. Zero coupon bonds sell at a premium. (FALSE)

Page 40 of 56
Q70 The rate at which the stock price is expected to appreciate (or depreciate) is the:

a. The risk-free rate.

b. Total yield.
c. Dividend yield.
d. Capital gains yield.
e. The coupon rate

Q71 Dot.com Technologies’ dividend has been growing at a rate of 10% per year in
recent years. This growth rate is expected to last for another nine years. After
these nine years dividend is expected to grow at a 7% annually. If the equity cost
of capital is 12%. Calculate the capital gains yield between years 14 and 15.

a. 10%
b. 7%
c. 5%
d. 12%
e. 2%

Solution

Div15 Div16 (1 + g ) Div15

P14 = and P15 = = = (1 + g ) P14 . Therefore:
r−g r−g r−g

P15 − P14
Capital GainsYield = = g = 7%
P14
Comment
• By year 14 the future dividends behave like in the
constant dividend growth model (i.e., in year 15 and
thereafter, future dividends behave like a growing
perpetuity). In the constant dividend growth model the
capital gains yield is equal to the dividend growth rate.

Page 41 of 56
Q72 The following are the FCF for Dot.com in year 1. These cash flows depend on the
state of the economy (i.e. poor, normal, good, and super good). The probability of
these economic states is given below.

State Probability FCF ($)

Bad 1/4 1,000
Normal 1/2 3,000
Good 1/8 6,000
Super Good 1/8 7,000

Dot.com. closes down at the end of period 1 and has no assets other than the FCF
generated in the period. The company has the following stakeholders: senior debt-
holders with a claim of $4,000, junior debt-holders with a claim of $2,000 and
shareholders. Assuming a 0% discount rate for all financial assets, calculate the
current value of Dot.com’s junior debt.

a. $ 500
b. $ 2,000
c. $ 1,000
d. $ 125
e. $ 1,750

Solution

1 1 1 1
Value( Junior Debt ) =  0 +  0 +  2,000 +  2,000 = $500
4 2 8 8
Comment

• The value of the different securities is as follows:

State Probability FCF ($) Senior Debt Junior Debt Equity

Bad 1/4 1,000 1,000 0 0
Normal 1/2 3,000 3,000 0 0
Good 1/8 6,000 4,000 2,000 0
Super Good 1/8 7,000 4,000 2,000 1,000
3,375 2,750 500 125

Page 42 of 56
Q73 Dot.Com has just paid a $5 dividend and the required return on its equity is 10%.
The dividend is expected to grow at 25% per year during the first year, at 9% per
year during the following eight years, and at 2% per year thereafter. Calculate the
current share price.

a. $ 86
b. $ 106
c. $ 117
d. $ 123
e. $ 100

Solution
5 1.25   1.09   1 5 1.25 1.098 1.02
9

P= 1−   + = $117
0.1 − 0.09   1.1   1.19 0.1 − 0.02

Q74 Consider a firm with a cost of equity of 8% and 5 million shares outstanding. In
year one the firm will not pay any dividends but it will repurchase $10 million
worth of shares. After year one, the firm will pay a total dividend of $25 million
each year forever. Calculate the price per share in year zero.

a. $ 60
b. $ 20
c. $ 80
d. $ 40
e. $ 90

Solution
25
10 +
Equity 0 = PV (Future Dividends & Repurchases) = 0.08 = $298.611M
1.08

Equity 0 298.611
P 0= = = $60 per share
Number of Shares0 5

Page 43 of 56
Q75 Consider a firm with a cost of equity of 10%. The firm will only start paying
dividends in three years but it plans to repurchase shares during the next two years.
If the current price per share is $77, calculate the price per share in year one (after
the shares have been repurchased).

a. $ 84.7
b. $ 68.2
c. $ 70.3
d. $ 77.0
e. $ 770.0

Solution
Capital Gains Yield 0 = re − Dividend Yield 0 = 10% − 0% = 10%

P1 − P0 P1 − 77 Solving
10% = Capital Gains Yield 0 = = ⎯⎯⎯→ P1 = $84.7
P0 77

Q76 Evaluate the following statements:

I. The declaration of dividend is at the discretion of the board of directors.

(TRUE)

II. The payment of dividends by the corporation is a tax-deductible business

expense. (FALSE)

III. A dividend on common stock, whether declared or no by the board of

directors, is not a legal liability of the firm. (FALSE)

Q77 Evaluate the following statements:

I. The IRR is insensitive to the scale of the project. (TRUE)

II. The profitability index is insensitive to the scale of the project. (TRUE)

III. The IRR and the profitability index methods are both insensitive to the
scale of the project, therefore, for the case of independent projects the
two methods are equivalent. (FALSE)

Page 44 of 56
Q78 Dot.com must install a machine that costs $700,000. The machine will require
$50,000 of maintenance each year and it must be replaced every 25 years. The
appropriate discount rate is 10%. Calculate the equivalent annual annuity, i.e.,
EAA, of the machine. (Notice that some of the magnitudes below, that is, options b
to e below, are negative.)

a. $ 27,118
b. $ -246,148
c. $ -27,118
d. $ -1,153,852
e. $ -127,118

1  1 
PV = −700,000 − 50,000 1 −  = −$1,153,852
25 
0.1  (1 + 0.1) 

- 1,153,852
EAA = = −$127,118
1  1 
1 − 
0.1  (1 + 0.1) 25 

Q79 Punto.com must decide whether to install machine A or machine B. Both machines
cost $100,000. Machine A generates $50,000 each year and it must be replaced
every 17 years. Machine B generates $45,000 each year and it must be replaced
every 27 years. The appropriate discount rate is 10%. Which machine should
Punto.com install?

a. Machine B because it has an NPV of $315,675

b. Machine A because it has an NPV of $301,077
c. Machine B because it has an EAA of $34,174
d. Machine A because it has an EAA of $37,534
e. Machine B because it has an EAA of $38,255

1  1 
NPVA = −100,000 + 50,000 1 −  = $301,078
17 
0.1  (1 + 0.1) 

301,077
EAAA = = $37,534
1  1 
1 − 
0.1  (1 + 0.1)17 

Page 45 of 56
 1  1 
NPVB = −100,000 + 45,000 1 −  = $315,675
27 
0.1  (1 + 0.1) 

315,675
EAAB = = $34,174
1  1 
1 − 
0.1  (1 + 0.1) 27 

Q80 Dot.com is considering investing in a project with the following expected free cash
flows:

Year 1 Year 2 Year 3

37,500 -86,250 49,500

Which of the following statements is correct?

a. The IRR of the project is 2% and if the cost of capital is 3% the project
should be undertaken because it creates value.

b. The IRR of the project is 20% and if the cost of capital is 19% the
project should be undertaken because it creates value.

c. The IRR of the project is 6% and if the cost of capital is 5% the project
should be undertaken because it creates value.

d. The IRR of the project is 10% and if the cost of capital is 11% the
project should be undertaken because it creates value.

e. The IRR of the project is 10% and if the cost of capital is 9% the
project should be undertaken because it creates value.

• There are two IRR (10% and 20%) but if the cost of
capital is 19% or 11% the project destroys value (NPV <
0) while if the cost of capital is 9% the project creates
value (NPV > 0).

Page 46 of 56
Q81 BestBuy must decide whether to install vending machine A or vending machine B.
Machine A costs $200,000, generates a revenue of $28,000 per year, and it must be
replaced every 20 years. Machine B costs $100,000, generates a revenue of
$14,000 per year and it must be replaced every 10 years. The appropriate discount
rate is 12%. Which machine should BestBuy install?

a. Machine A because it has an EAA of $9,144.42

b. Machine A because it has an EAA of $1,224.24
c. Machine B because it has an EAA of $3,698.42
d. Machine B because it has an EAA of $1,320.33
e. BestBuy is indifferent between installing machine A or B.

1  1 
` PVA = −200,000 + 28,000 1 −  = $9,144.42
20 
0.12  (1 + 0.12) 

9,144.42
EAA A = = $1,224.24
1  1 
1 − 
0.12  (1 + 0.12) 20 

1  1 
PVB = −100,000 + 14,000 1 −  = −$20,896.88  0
10 
0.12  (1 + 0.12) 

- 20,896.88
EAAB = = −$3,698.42  0
1  1 
1 − 
0.12  (1 + 0.12)10 

[Note: Installing machine B is negative NPV.]

Page 47 of 56
Q82 Dixon Inc. is considering investing in a project with the following expected free
cash flows:
Year 0 Year 1 Year 2
10,000 -22,000 12,084

Which of the following statements is correct?

a. The IRR of the project is 17% and if the cost of capital is 14% the project
should be undertaken because it creates value.
b. The IRR of the project is 14% and if the cost of capital is 11% the project
should be undertaken because it creates value.
c. The IRR of the project is 11% and if the cost of capital is 6% the project
should be undertaken because it creates value.
d. The IRR of the project is 6% and if the cost of capital is 3% the project
should be undertaken because it creates value.
e. The IRR of the project is 3% and if the cost of capital is 0% the project
should be undertaken because it creates value.

Comment
There are two IRR (6% and 14%) but if the cost of capital
is 11% the project destroys value (NPV < 0) while if the
cost of capital is 3% the project creates value (NPV > 0).

Q83 Apple must decide whether to install vending machine A or vending machine B in
the Airport. Machine A costs $300,000, generates a revenue of $45,000 per year,
and it must be replaced every 15 years. Machine B costs $100,000, generates a
revenue of $24,000 per year, and it must be replaced every 10 years. The
appropriate discount rate is 10%. Which machine should Apple install and what is
the EAA of installing this machine?

a. Apple is indifferent between installing machine A or B.

b. Should install Machine A, which generates an EAA of $9,244.42
c. Should install Machine A, which generates an EAA of $5,557.87
d. Should install Machine B, which generates an EAA of $3,223.32
e. Should install Machine B, which generates an EAA of $7,725.46

Page 48 of 56
Solution
45,000  1 
` NPVA = −300,000 + 1 −  = $42,273.58
15 
0.1  (1 + 0.1) 

42,273.58
EAAA = = $5,557.87
1  1 
1 − 
0.1  (1 + 0.1)15 

24,000  1 
NPVB = −100,000 + 1 −  = $47,469.61
10 
0.1  (1 + 0.1) 

47,469.61
EAAB = = $7,725.46
1  1 
1 − 
0.1  (1 + 0.1)10 

Q84 Becks Inc. is considering investing in a project with the following expected free
cash flows:
Year 0 Year 1 Year 2

10,000 -39,000 30,629

Which of the following statements is correct?

a. The IRR of the project is 5% and if the cost of capital is 12% the project
should be undertaken because it has a positive NPV.
b. The IRR of the project is 12% and if the cost of capital is 10% the
project should be undertaken because it has a positive NPV.
c. The IRR of the project is 5% and if the cost of capital is 9% the project
should be undertaken because it has a positive NPV.
d. The IRR of the project is 9% and if the cost of capital is 3% the project
should be undertaken because it has a positive NPV.
e. The IRR of the project is 4% and if the cost of capital is 6% the project
should be undertaken because it has a positive NPV.

Solution

The Project has an IRR of 9% and if the cost of capital is 3% it is NPV

positive. (Note: 4%, 5%, and 12% are not IRR).

Page 49 of 56
Q85 Dot.com Technologies’ dividend has been growing at a rate of 20% per year in
recent years. This growth rate is expected to last for another 2 years. After these
two years dividend is expected to grow at a 6% per annum. If the dividend per
share in year 1 is expected to be $1.60 and the equity cost of capital is 10%.
Calculate the price per share in year 0 and 1, and the dividend and the capital gains
yield between year 0 and 1.

Solution

0 1 2 3 4 ……

1.6 1.6 x 1.2 1.6 x 1.2 x 1.06 1.6 x 1.2 x 1.062 ..…

1.6 1 1.6  1.2

P 0= + = $45.09 per share
1.1 1.1 0.1 − 0.06

1.6  1.2
P 1= = $48 per share
0.1 − 0.06

Div1 1.6
Dividend Yield 0 = = = 3.55%
P0 45.09

P1 − P 0 48 − 45.09
Capital Gains Yield 0 = = = 6.45%
P0 45.09

Notice that the dividend plus the capital gains yield equal to 10%, which is the required
return on the equity.

Page 50 of 56
Q86 Consider two “identical” firms X and Y with a cost of equity of 10% and 2 million
shares outstanding. These companies only differ in how they will distribute cash
next year:

• Firm X will pay $10 million dividend in year 1

• Firm Y will repurchase $10 million in outstanding shares in year 1

After year 1, the two firms will be identical thereafter, that is, they will pay an
annual total dividend of $5 million. Calculate the price per share at the end of year
one, P1 (after the dividend has been paid or the shares have been repurchased), the
price per share in year 0, P0, and the dividend and capital gains yield between year 0
and 1 for Firm X and Firm Y. How many shares does Firm Y repurchase?

Solution

Firm X:
*Value of equity at t=1 (after the dividend at t=1):

Total Dividend 5
Equity 1= = = $50M
r 0.1

* Share Price at t=1 (after the dividend at t=1):

Equity1 50M
P 1= = = $25 per share
Number of Shares 1 2M

*Share Price at t=0:

10M
+ 25
Div1 + P1 2 M
P 0= = = $27.27 per share
(1 + r) 1 + 0.1

10M
Div1
* Dividend Yield 0 = = 2M = 18.33%
P0 27.27

P1 − P 0 25 − 27.27
* Capital Gains Yield 0 = = = −8.33%
P0 27.27

Page 51 of 56
Firm Y:

*Value of equity at t=1 (after the repurchase at t=1):

Total Dividend 5
Equity 1= = = $50M
r 0.1

*Value of equity at t=0:

10 1 5
Equity 0 = PV (Future Dividends & Repurchases) = + = $54.54M
1.1 1.1 0.1

* Share price at t=0:

Equity 0 54.54 M
P 0= = = $27.27 per share
Number of Shares 0 2M

✓ Notice that the price per share P0 in year 0 is the same for Firm X and Firm Y (i.e.,
$27.27). Hence the current share price is not affected by whether the $10M in year 1
are returned to shareholders in the form of a dividend or a share repurchase.

Div1 0
* Dividend Yield 0 = = = 0%
P0 27.27

* Capital Gains Yield 0 = r − Dividend Yield 0 = 10% − 0% = 10%

✓ Notice that for Firm X’s and Firm Y’s shareholders both get a 10% return between 0
and 1 but for the shareholders of Firm Y this return comes entirely in the form of a
capital gain.

* Share price at t=1:

P1 − P0 P1 − 27.27 Solving
10% = Capital Gains Yield 0 = = ⎯⎯⎯→ P1 = $30
P0 27.27
✓ Notice that the price per share (after the dividend has been paid or the shares has been
repurchased) P1 in year 1 is higher for Firm Y (i.e., $30) than for Firm X i.e., $25)
which reflects the higher dividend per share in year 2 onwards (i.e., Firm Y will have
fewer shares after the share repurchase). Notice also that the price difference $5 is just

Page 52 of 56
 the dividend per share that shareholders of Firm X have already obtained in year 1, a
$5 value that the shareholders of Firm Y will obtain in the form of higher future
dividends per share.

* Number of Shares at t=1 (after the repurchase at t=1):

Equity1 50M
Number of Shares 1 = = = 1,666,667 shares
P1 30

* Number of Shares repurchased at t=1:

Shares Repurchased1 = 2,000,000 − 1,666,667 = 333,333 shares

✓ Notice that you could also have calculated the amount of shares repurchased by
dividing $10M by the price per share at t=1:

10M 10M
Shares Repurchased1 = = = 333,333 shares
P1 30

Q87 Laval Construction must choose between two pieces of equipment. Tamper A
costs $600,000 and it needs to be replaced every five years. This tamper will
require $110,000 of maintenance each year. Tamper B costs $750,000, but it will
last seven years. Maintenance costs for Tamper B are $90,000 per year. Laval
incurs all maintenance costs at the end of the year. The appropriate discount rate
for Laval Construction is 12 percent. Which machine should Laval purchase?

Solution

Tamper A:

1  1 
PV = −600,000 − 110,000 1 −  = −$996,525.38
5
0.12  (1 + 0.12) 

- 996,525.38
EAA = = −$276,445.84
1  1 
1 − 
0.12  (1 + 0.12) 5 

Tamper B:

Page 53 of 56
 1  1 
PV = − 750,000 − 90,000 1 −  = $1,160,738.09
7 
0.12  (1 + 0.12) 

− 1,160,738.09
EAA = = −$254,338.30
1  1 
1 − 
0.12  (1 + 0.12) 7 

Choose Tamper B (Note: The problem assumes that the company needs one
machine, Tamper A or B, in order to implement “some other positive NPV
project”.)

Q88 Assume you are considering taking one of two mutually exclusive projects:

Project A:
Year 0 1 2 3

FCF -100 100 10 10

Project B:
Year 0 1 2 3

FCF -100 10 10 120

a) Calculate the IRR for these projects.

b) For which discount rates is the NPV of project A greater than the NPV of
project B:

Solution

a) Calculate the IRR for these projects.

100 10 10
− 100 + + + = 0  IRR A = 16.04%
1 + IRR A (1 + IRR A ) (1 + IRR A )3
2

10 10 120
− 100 + + + = 0  IRRB = 12.94%
1 + IRRB (1 + IRRB ) (1 + IRRB )3
2

Page 54 of 56
b) For which discount rates is the NPV of project A greater than the NPV of project B:

100 10 10
NPV A = −100 + + +
1 + r (1 + r ) (1 + r )3
2

10 10 120
NPVB = −100 + + +
1 + r (1 + r ) (1 + r )3
2

Hence:
100 − 10 10 − 120 1  110 
NPV A − NPVB = + = 
 90 − 
2 
1+ r (1 + r )3
1 + r  (1 + r ) 
Therefore:
110
NPV A − NPVB  0  90 −  0  r  10.55%
(1 + r )2

NPV
PROJECT B

PROJECT A

10.55 12.94 16.04 Rate (%)

Page 55 of 56
Q89 Dot.com is considering investing in a project with the following expected free cash
flows:

Year 1 Year 2 Year 3

-15,000 34,500 -19,800

Which of the following statements is correct?

a. The IRR of the project is 2% and if the cost of capital is 3% the project
should be undertaken because it creates value.
b. The IRR of the project is 5% and if the cost of capital is 7% the project
should be undertaken because it creates value.
c. The IRR of the project is 20% and if the cost of capital is 21% the project
should be undertaken because it creates value.
d. The IRR of the project is 30% and if the cost of capital is 41% the project
should be undertaken because it creates value.
e. The IRR of the project is 10% and if the cost of capital is 11% the project
should be undertaken because it creates value.

Comments
• There are two IRR (10% and 20%) but if the cost of
capital is 21% the project destroys value (NPV < 0) while
if the cost of capital is 11% the project creates value
(NPV > 0):

Two IRR (i.e., 10% and 20%):

− 15,000 34,500 − 19,800
+ + =0
1.1 1.12 1.13

− 15,000 34,500 − 19,800

+ + =0
1.2 1.22 1.23

NPV with cost of capital 21% < 0:

− 15,000 34,500 − 19,800
NPV (21%) = + + 0
1.21 1.212 1.213

NPV with cost of capital 11% > 0:

− 15,000 34,500 − 19,800
NPV (11%) = + + 0
1.11 1.112 1.113

Page 56 of 56