UNIVERSITY OF TORONTO

Joseph L. Rotman School of Management

Nov. 11, 2003 Aldridge/Derrien/Doidge/

MGT337Y MID-TERM EXAMINATION #1 Fournier/Predescu

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

Name: Student Number:

Circle the section that you are registered in:
Aldridge Derrien (Mon.) Derrien (Tue. morning)
Derrien (Tue. afternoon) Doidge Fournier Predescu

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

Question Marks

1
2
3
4
5
6

Total

1
1. You observe the following yields-to-maturities on three different zero coupon bonds:

Effective Annual
Maturity Yield to Maturity
1 4%
2 4.20%
3 4.40%

(a) What is the price of a 3-year annual coupon bond with face value $1,000 and a
coupon rate of 6%? (5 marks)
(b) What are the forward rates over the first, second and third year? (5 marks)
(c) Under the expectations hypothesis, what price does the market expect to observe on
the 3-year 6% coupon bond in two years from now after the coupon is paid? (5 marks)
(d) If in one year from now the term structure will be flat at 5%, what is the one-year
holding period return on the 3-year 6% coupon bond? (5 marks)

2. (a) As a financial consultant, you are helping a client who just won a fortune at Las Ve-
gas. The two of you are planning her retirement. Today is January 1, 2003. Your client
will make a deposit on December 31, 2003 in an account that pays 8% compounded
semi-annually. She will retire 25 years (on December 31, 2028) after she makes the
deposit and she expects to live for another 30 years after she retires (until December
31, 2058). She wants an income of $30,000 per year during her retirement years, paid
on December 31 of each year. The first payment will be received on December 31, 2029
and the last on December 31, 2058 (30 payments total). Further, your client expects
her husband to live for an additional five years. Her husband will need an income of
$20,000 per year, paid on each December 31 from 2059 to 2063.
Your client wants to start spending her winnings today, but she wants to make sure
she will have enough money to realize her retirement goals. How much money does
she have to deposit into her account on December 31, 2003? (8 marks)
(b) Would your client prefer an account that pays 7.9% compounded continuously or
the account that pays 8% compounded semi-annually? Why? (3 marks)
(c) Suppose that everything is the same as in part (a), except now assume that your
client wants to take a trip to Saturn from January 1, 2035 to January 1, 2037. There-
fore, she wants $90,000 on December 31, 2034 and nothing on December 31, 2035 and
2036. How much money does she have to put into her account on December 31, 2003?
(9 marks)

3. (a) An investment under consideration costs $70,000. It has a payback period of 7

years. If the required rate of return is 16%, what is the worst-case NPV of the project,
assuming all the future cashflows are positive? (5 marks)

2
 (b) A project costs $I, has perpetual cash flows of $C per period where both I and C
are positive, and the required rate of return is r. What is the relationship between the
project’s payback period and its IRR? (5 marks)
(c) TunnelDig has a contract to build a tunnel connecting two cities separated by a
lake. The contract calls for TunnelDig to complete the tunnel in a maximum of 3 years.
Under the contract, TunnelDig has two choices, A and B. Under choice A, TunnelDig
will have to spend $100 million at the end of years 1 and 2 and at the end of the
third year it will receive payment of $260 million. Under choice B, TunnelDig can
sub-contract out some of the work and complete the tunnel in two years. TunnelDig
will have to spend $220 million at the end of year 1 and it will receive $260 million
at the end of year 2. Assume that TunnelDig’s cost of capital is 15%. What is the
incremental NPV of choice B over choice A? Should TunnelDig sub-contract the work?
(7 points)
(d) Suppose that TunnelDig decides to use the IRR rule to make the decision in part
(c). Can TunnelDig be confident that it is making the correct decision? Explain briefly.
(3 marks)

4. (a) The dividend valuation model tells us that the value of a company’s stock is the
present value of its expected future dividends. Still, some companies never pay divi-
dends. Does the fact that these companies have positive stock values contradict the
dividend discount model? (5 marks)
(b) Company ABC paid a dividend of $2 per share yesterday. This company pays
dividends quarterly, and historically, its dividends have grown by 1% per quarter.
We can reasonably assume that this growth rate will persist forever. Comparable
companies have an annual effective required rate of return on equity of 12%. What is
the market price of one share of ABC? (5 marks)
(c) What will be the expected price of ABC in exactly three months, after the dividend
is paid? (3 marks)
(d) Assume the company decides to change its dividend policy. For the next two years,
it will pay dividends quarterly (with the dividends grow by 1% per quarter), then it
expects to pay dividends semi-annually forever, and dividends will grow at a rate of
2% every six months. What is the market price of one share of ABC? (7 marks)

5. The stock market comprises two stocks, A and B. The table below gives next year’s
returns of the two stocks, rA and rB , depending on the state of the world, and the
probability of each state of the world.

State of the world rA rB Probability

Good 20% 8% 0.3
Normal 12% −5% 0.3
Bad −10% 5% 0.4

3
 (a) Calculate the expected returns of stocks A and B next year, and the standard
deviations of these returns? (4 marks)
(b) Calculate the covariance between A and B’s returns, Cov[rA , rB ], and their corre-
lation coefficient, ρAB . (4 marks)
(c) What is the variance of a portfolio combining A and B and offering an expected
return of 5%? (4 marks)
(d) What proportions of your wealth should you invest in A and B if you want to
minimize the variance of your portfolio? (4 marks)
(e) Now assume that in addition to stocks A and B, there exists a risk-free asset with
a 2% return. A rational investor has constructed his portfolio the following way. In
addition to his $1,000 initial wealth, he borrowed $550, and invested $1,550 in the
market portfolio. The expected return of his portfolio is 5%. What is the composition
of the market portfolio? (4 marks)

6. You are considering the following project and you must decide whether you accept
it or not. The project involves buying a machine to launch a new line of products.
The equipment costs $80,000 and you are considering a time horizon of 4 years. This
acquisition would allow you to use some spare parts you already own. If the project is
not taken, the spare parts can be sold for $5,000. You paid $2,500 to a marketing firm
to estimate the demand for this kind of product. With these estimates, you plan to
sell 10,000 units during the first year, at a price of $16 each. The number of units sold
will increase by 4% per year and the price by 2% per year. For the first year, each unit
requires $9 of raw material and $2 of labor. You estimate the cost of the raw material
to increase by 3% per year and the cost of labor by 9% per year. You must also take
into account fixed costs of $20,000 per year. Finally, you will need an increase in net
working capital of $10,000 at the beginning of the project, but you will recuperate it
at the end of the project. The equipment belongs to the class 8, 20% category, and
you estimate a salvage value of $35,000 at the end of the fourth year (assume the pool
remains open after you sell the asset). The corporate tax rate is 35% and the discount
rate is 10%. For simplicity, assume revenues and expenses are received and paid at the
end of each year.
(a) What’s the present value of the tax shield on Capital Cost Allowance offered by
this project? (5 marks)
(b) Compute the NPV of this project. Do you accept the project? (15 marks)