2FA3 midterm by ab1W51


									                                              Name: ________________________________

                                           Student Number: _______________________

                Commerce 2FA3: Introduction to Finance
Mid term exam, summer session 2001         Instructor: K. Brewer
Time allowed for this test: 3 hours.       July 17, 7 - 10 p. m.
   a) This exam has 13 pages, including this one. Please check that you are not
      missing any pages and bring any problems to the attention of the
   b) Each multiple-choice question has only one right answer. Circle the letter
      of the most appropriate answer on the exam page. Right answers will be
      worth 2 marks and wrong or missing answers will be worth zero. There is
      no correction factor.
   c) Long answer questions are to be answered on the question paper. All
      work must be shown to receive full marks. If you are running short of
      space and decide to continue the answer on another page, indicate where
      the rest of the answer is located. The marker cannot give you marks for an
      answer that they cannot find.
   d) A formula sheet will be distributed with this exam, no other references are
   e) Use of a standard scientific or financial calculator is allowed for this exam.

                  Multiple choice                       /50
                  Problem 1                             /10
                  Problem 2                             /10
                  Problem 3                             /10
                  Problem 4                             /10
                  Problem 5                             /10
                  Total                                 /100
Commerce 2FA3                   Mid term exam                        July 17, 2002

Multiple choice questions: 2 marks each.
1)   The primary objective of the financial manager should be to;
        a) maximize net income for the current year
        b) maximize revenue the revenue of the company
        c) maximize the wealth of the current shareholders
        d) increase the size of the company because growth is important
        e) ensure that the accounting statements are accurate and complete
2)   Purchasing a corporate bond with 3 years to maturity from a securities
     dealer is best characterized as what type of transaction?
        a) A primary market transaction in the money market
        b) A primary market transaction in the capital market
        c) A secondary market transaction in the money market
        d) A secondary market transaction in the capital market
        e) An over the counter transaction in an auction market
3)   Which of the following is not a feature of the form of business organization?
        a) A partnership has the most limited life
        b) Limited partners have unlimited liability
        c) Corporations are subject to double taxation
        d) It is easier to raise capital and transfer ownership with a corporation
        e) A sole proprietorship requires the least amount of paperwork to set
4)   The process of accumulating interest on an investment over time to earn
     more interest is called ___________.
        a) growth
        b) aggregation
        c) accumulation
        d) compounding
        e) simple interest

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Commerce 2FA3                    Mid term exam                      July 17, 2002

5)   If you put $700 into a bank account that earns interest at an interest rate of
     6% APR with semi-annual compounding, what will the account balance be
     at the end of 30 months?
        a) $809.77
        b) $811.49
        c) $812.98
        d) $4,020.44
        e) none of the above
6)   Which of the following stated interest rates is the highest?
        a) 8.00% effective annual rate
        b) 7.95% APR with semi-annual compounding
        c) 7.90% APR with monthly compounding
        d) 7.85% APR with continuous compounding
        e) the rates are the same
7)   You have decided to buy furniture worth $5,000. You can pay it off with 36
     equal monthly installments. The first payment is due today. The interest rate
     is 18% APR with monthly compounding. What are your monthly payments
     to the nearest dollar?
        a) $178
        b) $181
        c) $228
        d) $237
        e) none of the above

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Commerce 2FA3                   Mid term exam                      July 17, 2002

8)   You've been quoted an interest rate of 6% annual simple interest for 3 years.
     What would this be if converted to an effective annual rate?
        a) 5.00%
        b) 5.53%
        c) 5.67%
        d) 6.00%
        e) none of the above
9)   To settle a debt of $5,000, a friend of yours has offered to pay you $300 per
     month for 18-months. What is the implied EAR in these terms?
        a) 5.3%
        b) 8.0%
        c) 9.9%
        d) 10.3%
        e) none of the above
10) If the terms of a loan agreement call for you to make periodic payments that
    are equal to the accumulated interest, and a balloon payment at the end of
    the term equal to the amount borrowed, this type of a loan is a(n)
        a) consol
        b) amortized loan
        c) interest only loan
        d) pure discount loan
        e) partial amortization loan

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Commerce 2FA3                   Mid term exam                      July 17, 2002

11) If the current YTM of a bond is 6.5% and it has a coupon rate of 8% the
    bond will be selling at
        a) a premium
        b) a discount
        c) par
        d) it would depend on the time to maturity
        e) it would depend on the default risk of the issuer
12) If a $1,000 face value, 9% coupon bond, with 6 years to maturity is trading
    at $1,075, what is it's YTM?
        a) 7% or less
        b) between 7% and 8%
        c) less than 9% but more than 8%
        d) exactly 9%
        e) over 9%
13) Which of the following features will usually decrease the value of a bond
        a) retractable
        b) extendable
        c) convertible
        d) subordinated
        e) all of the above will increase the value of the bond
14) Assume you have two $1,000 face value bonds, with the same coupon rate,
    from the same company. One will mature in 7 years, the other in 5 years.
    Which bond will decrease more in price if market interest rates increase?
        a) the price decrease will be the same
        b) the 5 year bond will decease more in price
        c) the 7 year bond will decease more in price
        d) it would depend on the coupon rate
        e) the bond prices will actually increase

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Commerce 2FA3                    Mid term exam                        July 17, 2002

15) When a bond is issued with a maturity greater than 10 years and no specific
    assets are pledged as collateral, the issue is a
         a) note
         b) debenture
         c) mortgage bond
         d) preferred share
         e) none of the above
16) At what discount rate is a bond that pays $100 per year forever worth
         a) 8%
         b) 9%
         c) 10%
         d) 12.5%
         e) It depends on who issued the bond
17) Duration is
         a) A measure of default risk
         b) A measure of interest rate risk
         c) A measure of reinvestment risk
         d) A measure of unsystematic risk
         e) The same as time to maturity for a high coupon paying bond
18) A bond that pays a variable coupon, set in relation to a measure of
    prevailing interest rates in the market (e.g. T-bill rate) is called a(n) _______
         a) LYON
         b) income bond
         c) real return bond
         d) floating rate bond
         e) deep discount bond

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Commerce 2FA3                  Mid term exam                      July 17, 2002

19) Currently available interest rates are 5% for a 4-year term deposit and 6.5%
    for a 5-year term deposit. What is the implied forward rate for the fifth
        a) 5.0%
        b) 5.75%
        c) 6.5%
        d) 8.0%
        e) 12.7%
20) XYZ Inc. is expected to pay an annual dividend of $1.00 one year from now.
    Dividends have been growing at an annual rate of 5% and this is expected
    to continue indefinitely. What price should XYZ Inc.’s common stock trade
    at if investors demand an expected return of 12% to buy XYZ shares?
        a) $8.33
        b) $14.29
        c) $15.00
        d) $20.00
        e) cannot be determined from the information given
21) Fun Tech Inc. has never paid a dividend. The company's EPS is currently
    $1.30 and is growing at a rate of 15% annually. This growth rate is expected
    to continue for 5 years. After that time they are expected to start paying
    dividends. The first dividend, six years from today, is expected to be $2.25
    and is expected to grow at 4% indefinitely. At what price should Fun Tech's
    share be trading today if the required rate of return is 14%?
        a) $10.25
        b) $11.69
        c) $22.50
        d) $23.40
        e) There is not enough information to find the price

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Commerce 2FA3                     Mid term exam                    July 17, 2002

22) BSB Inc. is has a dividend yield of 7.5% and cost of capital of 17.5%. If the
    current price of BSB's shares is $23.00, what price should you expect BSB's
    shares to be trading at one year from now?
        a) $23.00
        b) $23.92
        c) $25.30
        d) $26.22
        e) none of the above
23) A preferred share feature that means that any missed dividends have to be
    paid to the preferred shareholders before the common shareholders can
    receive dividends is called
        a) senior
        b) retractable
        c) cumulative
        d) convertible
        e) participating
24) AMW Inc. is considering two conventional investment projects that are not
    mutually exclusive. Project A has an IRR of 17.5% and project B has an IRR
    of 20%. AMW has a cost of capital of 14%. What is the appropriate
    decision for the management of AMW?
        a) Accept project A
        b) Accept project B
        c) Reject both projects
        d) Accept both projects
        e) further information is required before any decision can be made

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Commerce 2FA3                    Mid term exam                     July 17, 2002

25) For a conventional investment project, if the NPV > 0, then the
        a) the PI is greater than 1
        b) the AAR exceeds the IRR
        c) the IRR is less than the firm's cost of capital
        d) the project does not pay back on a discounted basis
        e) the payback period is shorter than the firm's required cutoff point

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Commerce 2FA3                  Mid term exam                     July 17, 2002

Problem 1
Six months ago Larry paid $1,075 for a $1,000 face value, 8% coupon bond with
6.5 years to maturity. The bond has just paid its semi-annual coupon and is
trading at $1,065. What was Larry's holding period return? Convert this holding
period return to an effective annual rate, to an APR with semi-annual
compounding, and also to a stated rate with continuous compounding. Keep at
least 2 decimal places.

Step 1: the holding period return is simply the final value of the investment
divided by the cost of the investment - one.
      r = ($40 + $1065)/$1075 - 1 = 2.79% per six months.

Step 2: convert to EAR, APR, and CC
      EAR = (1 + r)2 -1 = 5.66%
      APR = r x 2 = 5.58%
      CC = 2 x ln(1 + r) = 5.50%
             from  FVIF = ($40 + $1065)/$1075 = PV x ert
                     t=2, six month periods per year

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Commerce 2FA3                        Mid term exam               July 17, 2002

Problem 2
You are planning for your retirement. You want your investment account to be
worth $1,000,000 when you retire 40 years from now. You expect to earn a return
of 7.5% on an effective annual basis.
   a) If you make equal annual deposits, how much would you have to deposit
      at the end of each year to reach your target?
   b) If you made equal deposits at the start of each month instead, how much
      would your deposits have to be to reach your goal?
   c) Which savings plan is better? Why?

   FV   annuity   = $1,000,000
   FVIFA(40, 0.075) = 227.2565
   Payment = $1 million/FVIFA = $4,400.31
   Must contribute $4,400 per year.

   FV   annuity due   = $1,000,000
   rm = (1 + ra)(1/12) - 1 = 0.0060449
   FVIFA due (480, 0.0060449) = 2819.6x(1 + r) = 28.36.64
   Payment = $1 million/FVIFA due = $352.53
   Must contribute $352.53 at start of each month

   The payment streams have the same value so they are effectively the
   same. Plan b pays fewer dollars, but pays earlier for the same value. The
   thing that would make one plan better is how it fits with the investor's
   circumstance, if you are paid monthly, plan b may be easier to arrange, if
   you receive a $5,000 Christmas bonus each year, plan a may be better.
   In either case you have $1,000,000 at the end.

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Commerce 2FA3                       Mid term exam                  July 17, 2002

Problem 3
A $1,000 face value bond, originally issued with a 30-year maturity, has 8 years
remaining until it matures. The bond pays a 14% coupon (semi-annual
payments) and it is currently trading at a YTM of 8.0%
   a) What is the price of that bond?
   b) If the bond were callable 3 years from today at a 14% premium, how much
      would the bond be worth?
   c) If the firm offered to remove the call provision in exchange for not paying
      the next coupon payment, should the bondholders agree to that deal?

      Part a) 6 month rate = 4%, coupon = $70, n = 16
      PVbond = PVcoupons + PVface
      PVbond = $1,350.57  is the price if the bond is not callable.

      Part b) 6 month rate = 4%, coupon = $70, n = 6, face + call = $1,140
      PVbond = PVcoupons + PVface
      PVbond = $1,267.91  is the price if the bond is callable.

      Part c) The cost to accept the deal is the present value of the missed
      coupon payment. PV = $70/1.04 = $67.31
      The bondholders have the opportunity to move the price from
      $1,267.91 to $1,349.57 - PVcoupon 1. The new value would be $1,282.26.
      The bond holders should accept the deal since the bond should
      increase in value by $14.35.
      The only other consideration would be why the company is making this
      offer. It is likely a cash flow problem, they are willing to pay extra to
      avoid having to raise money to pay that coupon payment. The required
      return (YTM) is low enough to indicate that the company is probably
      considered a low risk in the long run.

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Commerce 2FA3                   Mid term exam                      July 17, 2002

Problem 4
KTH Inc. shares are trading at a P/E ratio of 18. The latest EPS figure was $2.50.
The dividend last year was $2. Dividends have been growing at a rate of 4% and
are expected to continue to grow at that rate?
   a) What is the current price of KTH Inc.'s shares?
   b) What is the required rate of return on KTH?
   c) What is the net present value of growth opportunities per share (NPVGO)?
   d) If KTH's management decided to switch strategies and pay out all earnings
      as dividends, reducing the growth rate to zero, what would happen to
      KTH's stock price?

Use the P/E ratio and earnings per share to find current price.
      P/E = 18 and E = $2.50
      P0 = 18 x $2.50 = $45.00

Use the Gordon Growth Model to find the required return.
      r=[D0 x (1 + g)/ P0] + g = $2 x 1.04 /$45 + 0.04 = 8.62222%

The NPVGO can be found using P/E, E and r
      P/E = 1/r + NPVGO/E
      18 = 1/0.062222 + NPVGO/$2.5
      NPVGO = $16.01

If management changes strategy, they would be eliminating the NPVGO,
which is worth $16.01. The share price would fall by $16.01 to $28.99.
You can get the same new price using the dividend growth model.
      D1 = $2.5, g = 0 and r = 8.62222%
      P0 = $2.5/0.0862222 = $28.99

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Commerce 2FA3                   Mid term exam                      July 17, 2002

Problem 5
Big Horn Mines is examining a capital budgeting proposal to open a new mine.
The startup costs are estimated to be $8 million. The mine should produce net
cash flows of $2 million per year for 25 years. Shutdown costs are estimated to
be $42 million to be spent in year 26.
   a) Describe the NPV profile for this project giving the NPV at both zero and
      infinite discount rates.
   b) One IRR of this project is 24%.     What is the other IRR to the nearest
   c) If Big Horn Mines has a cost of capital of 12%, what are the net present
      value and profitability index of the project and should it be accepted?
   d) Find the payback period for this project. Is this useful? Why or why not?

a) The NPV profile starts at 0 at a discount rate of 0% (just add up cash
   flows), rises into positive ground before falling and crossing the axis at
   24% (see b). The rate of decline slows, approaching -$8 million (all
   future cash flows discounted to zero) as the discount rate approaches
b) The other IRR is 0%.
c) Initial cost = $8,000,000
   PV annuity = $2 m x PVIFA(12%, 25) = $15,686,278
   PV shutdown = -$42 m x PVIF(12%, 26) = -$2,205,874
   NPV = -$8,000,000 + $15,686,278-$2,205,874 = $5,480,404
   PI = $8,000,000/($15,686,278-$2,205,874) = 1.685
   Since both NPV>0 and PI>1 Big Horn Mines should proceed.

d) Payback period = $8 m/$2 m = 4 years.
   This is not very useful since the biggest expenditure happens after the
   end of the payback period and is therefore ignored. Also we do not know
   what arbitrary value Big Horn Mines has chosen to use as a cut off value
   for payback period and cannot accept or reject the project.

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