Midterm; Finance 5360; Fall 2009
Name ________________________________
Note: For all problems requiring calculations, you will only earn points for setting up solutions. You will not earn
any points for calculating or solving anything. “Setting up solutions” means writing down the appropriate equation
or equations and plugging in as many numbers as possible. For later steps in multi-step problems, you can plug in
unsolved variables...variables you have set up to solve but have not actually solved.
Short Answer (15 points each)
1. Assume you have the opportunity to buy an office building for $1.5 million that you can sell for $1.8 million.
What else do you need to know before you can make a decision on whether to buy the building?
2. In order for there to be no arbitrage opportunities, what relationship must always exist between bid prices and ask
prices for Dell stock in the markets on which Dell stock trades?
3. What is the law of one price?
4. Assume you invest in a 1-year Treasury offering a return of 0.4%. If inflation ends up being 18% over the next
year, calculate the real return on your investment.
5. Your firm is considering investing $500,000 in a project that will generate annual cash flows that will begin four
months from today and which will continue forever. After an initial cash inflow of $25,000, the net inflows will
shrink each year. List the sequence of steps that would allow you to solve for a cost of capital that would make
the net present value of the project equal to zero. For each step, list the variable you are solving for.
6. Assume that three years ago you built a factory for $1,500,000 and that you have been depreciating the factory to
a zero salvage value on a straight-line basis over the factory’s 20 year life. Assume that the factory’s first sales
occurred two years ago and that the net cash flow from the most recent year was $230,000. Calculate the
factory’s EVA for the most recent year if the factory’s cost of capital is 8%.
7. List two reasons why the internal rate of return rule might not indicate which project has the highest net present
value.
8. Given the following information on Bank of America, calculate the realized return between March 4 and
September 2nd.
Date
Days
12/31/08
0
3/4/09
63
6/3/09 154
9/2/09 245
9/30/09 273
Dividend
$0.00
$0.01
$0.02
$0.03
$0.00
Price
$14.02
$3.58
$11.20
$16.27
$16.92
Use the following information to answer questions 9 and 10. You should answer both questions on the same graph
and should be sure to label which parts of your graph answer each question.
Stock
Merck
Ford
Wal-Mart
HP
Expected Return Volatility
7%
11%
11%
35%
15%
20%
22%
43%
9. If you can buy or short-sell any of the four stocks, sketch a reasonable efficient frontier you could achieve by
combining the four stocks. Identify (show where it is) the portfolio offering the highest expected return if you
want a volatility of 20%. Note: you will need to show the four stocks on your graph.
10. Identify the portfolio offering the highest expected return if you want a volatility of 20% and the return on a riskfree investment is 2%.
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Midterm; Finance 5360; Fall 2009
Problems (75 points each)
1. Assume that you can buy or sell the following securities at the market prices listed below.
Security
S
L
ETF
Market Price
100
110
510
Payoff one year from
today if the economy is:
Strong Weak
90
125
0
0
180
250
Payoff two years from
today if the economy is:
Strong
Weak
0
0
100
150
300
450
Note: In order to answer this question, you will need to do some actual calculations. If you cannot do them in
your head, feel free to use a calculator.
a. Assume that the ETF has invested in some number of shares of S and L. Calculate the no arbitrage price for
the ETF.
b. Given the market prices, list the transactions that would allow you to earn an arbitrage profit.
c. Show that the conditions of arbitrage are met today, a year from today, and two years from today.
2. You have just made the first of a series of equal monthly deposits into a savings account that pays an APR of 3%
per year with monthly compounding and you plan to make your final deposit one year and two months from
today. Two years from today, you plan to make the first of a series of semiannual withdrawals from the account.
You plan for your first withdrawal from the account to equal $5000 and you would like each subsequent
withdrawal to be 1% larger than the previous one. You plan to continue making these semiannual withdrawals
through five years from today. Calculate how large each of your deposits must be to achieve your goal.
3. Assume you have sold $200,000 of GE short, that you have purchased $700,000 of security General Mills (GIS).
Returns on securities GE and GIS over the past 5 years:
Year
1
2
3
4
Return on:
GE
GIS
7%
21%
21%
5%
-35%
22%
-31%
-3%
The average annual return on GE over the past 4 years = R
The standard deviation of returns (volatility) of GE over the past 4 years = S
Note: For parts a and b, you do not need to show any calculations for the average annual return or volatility of
GE. You may simply use R and S.
a. Calculate the correlation between the returns on securities GE and GIS.
b. Calculate the volatility of the portfolio you have created with GE and GIS.
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Midterm; Finance 5360; Fall 2009
4. Use the following information to calculate the project’s expected unlevered net income and free cash flow three
years from today.
Your firm is considering investing $10,000,000 in a project that will be depreciated using the MACRS
depreciation method for 3-year property. The investment would occur today and the project will produce its first
sales of $3,000,000 a year from today. After these initial sales, sales are expected to grow by 15% per year
through five years from today and then by 4% per year for the rest of the project’s life. Cost of goods sold for
the project is expected to equal 70% of sales. If your firm invests in the project, then beginning one year from
today, $550,000 per year will be paid in salaries to the new personnel hired for the project, and $150,000 per
year of the salaries of current employees already working at the firm’s home office (the CEO, etc.) will be
allocated to the project. The project will be built on land that cost $2,000,000 to acquire a year ago that could be
sold today for $1,100,000. The firm’s marginal tax rate is 35%. If the firm undertakes the project, then the
increase in the firm’s current assets and current liabilities (compared to if the project is not undertaken) at the
end of years 0 (today), 1, 3, 4, and 5 equal:
Cash
Inventory
Accounts Receivable
Accounts Payable
Year 0
15,000
700,000
0
300,000
Year 1
35,000
750,000
800,000
450,000
Year 2
45,000
850,000
900,000
600,000
Year 3
50,000
1,000,000
1,200,000
650,000
Year 4
57,000
1,100,000
1,250,000
550,000
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