UNIVERSITY OF TORONTO

Joseph L. Rotman School of Management

Nov. 16, 2004 Aldridge/Brean/Florence

MGT337Y MID-TERM EXAMINATION #1 /Fulop/Kan

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 Brean (morning) Brean (afternoon)
Florence (Mon.) Florence (Tue.) Fulop Kan

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

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1. Consider an entrepreneur who can choose one of the following three different investment
levels at time 0.

Investment at 0 Output at 1
0 0
20 30
40 55

His preferences over consumption at date 0 (C0 ) and consumption at date 1 (C1 ) are
described by the utility function

U (C0 , C1 ) = min(C0 , C1 )

The endowment of the entrepreneur at date 0 is 100. He has an additional endowment

of 60 at date 1.
(a) Assume that the entrepreneur does not have access to capital markets. What will
be his optimal investment and consumption plan? (6 marks)
(b) Assume that he does have access to capital markets and he can borrow and lend at
an interest rate of 10 %. What will be his optimal investment and consumption plan?
(7 marks)
(c) The entrepreneur dies before a decision is made on the investment and his son takes
over the firm, who is more impatient. The utility function of the son is

U (C0 , C1 ) = min(C0 , 2C1 )

Will the investment decision of the firm change in situation (a) (without capital mar-
kets) and (b) (with capital markets)? Does the investment decision depend on the
preferences of the owner in the two cases? (7 marks)
2. (a) Suppose a project requiring an investment of $125,000 now is expected to provide
future cash flows as follows: The first cash flow is expected to be $20,000 at the end of
year 5. The second cash flow is expected to be $30,000 at the end of year 6. The third
cash flow is expected to be $50,000 at the end of year 7. Cash flows after year 7 are
expected to decrease at a rate of −5% per year compounded annually for 7 more years,
with the last payment at the end of year 14. Find the net present value of this project
if the appropriate discount rate is 11%. Should the project be undertaken? (6 marks)
(b) A bank offers two savings accounts with interests as follows:
Account A: a nominal annual rate of 15.00% with monthly compounding,
Account B: a nominal annual rate of 14.75% with continuous compounding.
(i) What is the equivalent effective annual rate for each account? (ii) How much will
$5,000 deposited into each account now grow to in 3 years? (iii) Suppose you make

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 four deposits of $5,000 each into the saving accounts for years 0, 1, 2 and 3. How much
money will you have in each account 25 years from now? (6 marks)
(c) Project A requires an investment of $15,000 and pays off with a single cash flow
of $35,000 in 3 years. Project B requires an investment of $30,000 and pays off with a
single cash flow of $60,000 in 3 years.
Find the IRR for project A and project B. For which discount rates do we prefer
project A, and for which discount rates do we prefer project B? Are there rates at
which we would accept both projects? Neither project? One project only? Use a
diagram if necessary. (8 marks)

3. A riskless pure discount (i.e., zero coupon) Government of Canada bond that retires
on 16 November 2006, i.e., a 2-year bond, traded today at 90. A similar Government
of Canada that retires on 16 November 2007 traded today at 86. In dealing with the
following questions, you may assume that the Expectations Hypothesis holds.
(a) What is the yield-to-maturity (expressed in annual terms) on the 2-year bond?
(3 marks)
(b) What is the expected spot rate over year 3? (4 marks)
(c) If the expected one-year spot rate over year 4 (16 November 2007 to 16 November
2008) is 4 percent, what is the price today of a pure discount bond that retires on 16
November 2008, i.e., a 4-year bond ? (4 marks)
(d) Assume the Government announces a scheme to pay one dollar per 100 dollars
of face value on its heretofore pure discount bonds. These additional “one dollar per
hundred” payments would be made every year that the bond is outstanding with the
final payment of “one dollar per hundred” paid at the time of maturity of the bond.
The first payments under this scheme would be made on 16 November 2006 (2 years
from today). What would be the effect on the price of the 3-year bond? (4 marks)
(e) In view of the term structure of the interest rates that you have calculated in (a)–(c),
would you expect a 3-year bond or a 4-year bond to have the higher yield-to-maturity
after the announcement of the additional “one dollar per hundred” payments. Explain
your answer without calculating the yields-to-maturity of the 3-year and 4-year bonds.
(5 marks)

4. (a) Microsoft paid a dividend of $0.15 a month ago. Suppose you believe Microsoft
will continue to pay a dividend of $0.15/quarter indefinitely, with the next dividend
arriving in 2 months. What is the theoretical price of Microsoft if the effective annual
discount rate is 6%/year? (5 marks)
(b) The current annual earnings of Amazon.com is $0.75/share. Its stock price is
$40/share. Assuming a discount rate of 10%/year, what is the net present value per
share of the growth opportunity (NPVGO) of Amazon.com? (5 marks)

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 (c) PEG Ratio: A company’s price-earnings-growth (PEG) ratio is calculated by
dividing the P/E ratio by the percentage growth rate in earnings. For example, a
company with a P/E ratio of 100 and an earnings growth rate of 25% has a PEG ratio
of 4.
Trent Enterprises just reported earnings of $2/share. It plans to retain 40% of its
earnings for investments and pays out 60% of the earnings as dividends. The historical
return on equity (ROE) was 15%/year, a figure that is expected to continue into the
future. The appropriate discount rate for its stock is 12%. Suppose the stock price is
obtained by using the Gordon model (i.e., dividend growth model), what is the PEG
ratio of Trent Enterprises? (6 marks)
(d) Suppose Microsoft has a PEG ratio of 3.9 and Amazon.com has a PEG ratio of 2.5.
Does that mean Amazon.com is a better buy than Microsoft? Explain your answer.
(4 marks)
5. (a) A firm contemplates the purchase of a $10,000 machine that would save labour costs
of $5,000 in each of years 1 and 2, and $6,000 in each of years 3 and 4. The machine
lasts for four years and requires an additional stock of raw materials of $3,000 during
its four years of operation. The extra raw materials will be released at the end of the
fourth year. The machine is expected to have a salvage value of $2,916 at the end of
the four-year life of the machine. Operation of the machine requires additional space.
If this space is not needed, it can be rented out for $1,000/year. Capital cost allowance
on a declining balance may be claimed at a rate of 30%. If the company’s tax rate
is 40% and the appropriate discount rate is 8%. Should the machine be purchased?
(14 marks)
(b) What is the maximum price that the firm is willing to pay for this machine?
(6 marks)
6. Today, stock price of company A is $40 and stock price of company B is $30. You
estimate that the two stocks will have the following prices at the end of next year,
conditional on the state of economy:
Stock Price Stock Price
State of Economy Probability of Company A of Company B
Good 0.3 $50 $32
So-so 0.5 $38 $35
Bad 0.2 $35 $40
(a) Calculate the expected return and variance of each stock. (4 marks)
(b) Calculate the covariance between returns on stocks A and B. (4 marks)
(c) A portfolio p of stocks A and B has an expected return of 10%. Calculate the
variance of portfolio p. (6 marks)
(d) Find the minimum variance portfolio composed of stocks A and B. (6 marks)