Name: ________________________________
Student Number: _______________________
Commerce 2FA3: Introduction to Finance
Mid term test, summer session 2006
Time allowed for this test: 3 hours.
Instructor: K. Brewer
July 13, 7:00-10:00
Instructions:
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Each multiple choice question has only one right answer. Fill in the
appropriate bubble on the scan sheet. Be sure to enter your name and
student number on the scan sheet. Right answers will be worth 2 marks and
wrong or missing answers will be worth zero. There is no correction factor.
This exam has 10 pages (including this one) and a formula sheet. Please check
that you are not missing any pages and bring any problems to the attention
of the invigilator.
Long answer questions are to be answered on the question paper. If you are
running short of space and decide to use the back of a page, please indicate
where the rest of the answer is located. The marker cannot give you marks for
an answer that they cannot find.
There is a formula sheet attached to the back of this exam, no other
references are allowed.
Only the standard McMaster calculator is allowed in this exam.
Multiple choice
/40
Problem 1
/10
Problem 2
/10
Problem 3
/15
Problem 4
/10
Problem 5
/15
Total
/100
Commerce 2FA3
Mid term test
July 13, 2006
Page 2 of 10
Commerce 2FA3
Mid term test
July 13, 2006
Multiple choice questions; 2 marks each.
1)
From the point of view of the owners, the primary objective of the financial
manager should be to;
a) maximize revenue
b) maximize net income
c) maximize shareholder wealth
d) maximize dividend payments
e) maximize managerial compensation
2)
Which of the following is a depository intermediary?
a) a pension fund
b) a chartered bank
c) a securities dealer
d) a finance company
e) a life insurance company
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 limited 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 most amount of paperwork to
set up
If you are indifferent between receiving $100 today and receiving $144 in
two years, approximately what is your discount rate?
a) 9.5%
b) 10%
c) 20%
d) 6.5%
e) 10.25%
4)
5)
6)
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
You've been offered a simple interest investment that pays 8% per year for
Page 3 of 10
r = (1+5*.08)0.2 -1
Commerce 2FA3
Mid term test
July 13, 2006
5 years. What would this be if converted to an effective annual rate?
a) Below 4%
b) Between 4.00% and 5.0%
c) Between 5.00% and 6.0%
d) Between 6.00% and 7.0%
e) Between 7.00% and 8.0%
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Commerce 2FA3
Mid term test
July 13, 2006
7)
What is the value of a bond that pays $90 per year forever?
a) $800 if your required return is12%
b) $1,050 if your required return is 9%
c) $1,250 if your required return is 8.5%
d) $1,500 if your required return is 6%
e) $2,000 if your required return is 4%
8)
If a $1,000 face value, 15% coupon bond with 5 years to maturity is trading
at $1,250, what is it's YTM?
a) Less than 8%
b) Between 8% and 10%
c) Between 10% and 12%
d) Between 12% and 15%
e) Over 15%
9)
You have two $1,000 face value bonds from the same company. One will
mature in 7 years, the other in 9 years. Which bond will decrease more in
price if market interest rates rise?
a) the price decrease will be the same
b) the 7 year bond will decease more in price
c) the 9 year bond will decease more in price
d) it would depend on how risky the company is
e) the bonds will actually rise in price
10)
Which of the following features will decrease the value of a bond
a) the bond is extendable
b) the bond has a sinking fund provision
c) the bond is callable at a 10% premium
d) the bond is convertible into 40 shares with a current market value of
$12 per share
e) none of the above, they will all increase the value of the bond
11)
Currently available interest rates are 7% for a one year term deposit and
8% for a 2 year term deposit. What would you be expecting the one year
rate to be next year if you were indifferent between investing in the 2 year
term deposit and investing in the one year term deposit and reinvesting
the proceeds for one year at the prevailing interest rates at that time?
a) 7%
b) 8%
c) 9%
d) 10%
e) 11%
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Commerce 2FA3
12)
13)
14)
15)
16)
Mid term test
July 13, 2006
To settle a debt of $4,000, a friend of yours has offered to pay you $300
per month for 15-months. What is the implied EAR in these terms?
a) 9.0%
b) 12.5%
c) 18.1%
d) 19.7%
e) none of the above
If the terms of a loan agreement call for you to make equal periodic
payments over the life of the loan, and a balloon payment at the end of the
term equal to 40% 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
A bond that pays a variable coupon, set in relation to a measure of
prevailing inflation rates (e.g. CPI) is called a(n) _______
a) LYON
b) income bond
c) real return bond
d) floating rate bond
e) deep discount bond
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) retractable
b) cumulative
c) convertible
d) subordinated
e) participating
The duration of a 3-year 15% coupon bond is
a) slightly more than 3 years
b) greater than a 3-year 5% bond
c) equal to a 4 year pure discount bond
d) dependent on the discount rate
e) dependent on the bond rating
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Commerce 2FA3
17)
18)
19)
20)
Mid term test
July 13, 2006
Paradise Properties is trading at $30 per share. According to their annual
report their earnings last year were $17,000,000. There are 8.5 million
shares of Paradise Properties outstanding. If investors require a return of
12% to invest in Paradise Properties, what percentage of that $30 per share
represents the growth potential of the company?
a) 8.33
b) 15.0
c) 44.4
d) 55.6
e) cannot be determined from the information given
Investors require a yield of 12.5% to buy shares in BSB. The shares have a
dividend yield of 8.5%. If the current price of BSB's shares is $18.00, what
price should you expect BSB's shares to be trading at in one year?
a) $18.00
b) $18.72
c) $19.53
d) $20.25
e) none of the above
AMW Inc. is considering two conventional investment projects that are not
mutually exclusive. Project A has an IRR of 13.5% and project B has an IRR
of 16%. 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
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 pays back on a discounted basis
e) the payback period is shorter than the firm's required cutoff point
Page 7 of 10
Commerce 2FA3
Mid term test
July 13, 2006
Problem 1; 10 marks
You are buying a new car. The price, including taxes is $32,587. The dealer has
offered you lease financing at a rate of 6% apr with monthly compounding. The
lease requires a $5,000 down payment and payments of $399 per month for the
next 36 months. At the end of that time you have the choice of returning the car
or paying the balance. How much would you have to pay at the end of the lease
if you decided to keep the car?
Rm = 6%/12 = 0.005
PVPAY = 399 x (1 – (1 + 0.005)-36)/0.005 = $13,115.54
Balance = (32,587-5,000-13,115.54)(1+0.005)36 = $17,317.72
Can also be done as FV(price - down payment) – FV(payments)
If the dealer offered a bargain lease rate of 3% apr on the lease with the same
down payment and monthly payments, what would be the equivalent cash
discount?
Rm = 3%/12 = 0.0025
PVPAY = 399 x (1 – (1 + 0.0025)-36)/0.0025 = $13,720.20
Balance = (32,587-5,000-13,720.20)(1+0.005)36 = $16,594.13
Difference = 17,317.72 – 16,594.13 = 723.59
PV = 723.59/(1.005)36 = $604.66
The bargain lease rate is equivalent to the price being reduced by $604.66
Page 8 of 10
Commerce 2FA3
Mid term test
July 13, 2006
Problem 2; 10 marks
A $1,000 face value bond, originally issued with a 30-year maturity, has 8 years
remaining until it matures. The bond has coupon rate of 12% and it is currently
trading at a YTM of 8.5%, what is the price of that bond?
P = PVface – PVcoupons = 60 x (1 – (1 + 0.0425)-16)/0.0425 + 1000/1.042516
P = $1,200.21
If the bond is callable in 3 years at a premium of 10%, at what price would the
bond trade?
P = PVface – PVcoupons = 60 x (1 – (1 + 0.0425)-6)/0.0425 + 1,100/1.04256
P = $1,168.90
If the firm offered to trade it's right to call the bond, in exchange for not having
to pay the next coupon payment, should the bondholders agree to that deal?
Why?
Price drop due to call = $1,200.21 - $1,168.90 = $31.31
PV of next coupon = $60/1.045 = $57.42
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Commerce 2FA3
Mid term test
July 13, 2006
Bondholders should reject the offer since it is significantly lower. If the
firm is in financial distress and likely to file for bankruptcy if the offer is
rejected, the offer might be considered. This is unlikely given the low YTM.
Page 10 of 10
Commerce 2FA3
Mid term test
July 13, 2006
Problem 3; 15 marks
Six months ago Larry paid $952 for a $1,000 face value, 6% coupon bond. The
bond has just paid its semi-annual coupon and is trading at a YTM of 7% with five
years to maturity.
What was Larry's holding period return expressed as an effective annual rate.
P = PVface – PVcoupons = 30 x (1 – (1 + 0.035)-10)/0.035 + 1000/1.03510
P = $958.42
r = ((958.42 + 30)/952) 2 –1 = 7.798%
What would return be as a stated rate with continuous compounding?
(1 + r) = ert
ln(1.07798) = rc = 7.509%
What is the real rate of return, as an effective annual rate, if the CPI has risen from
129.5 to 131.1 over those 6 months?
r = (1 + Rannual)/(131.1/129.5)2 –1 = 5.182%
Given that the bond’s duration is 4.377 years, what would be the approximate
price change for a 20 basis point increase in the stated YTM?
P = 0.002x-D/(1+YTM) = 0.002x-4.377/1.035 = -0.846%
In dollars P= 958.42x(1 - 0.00846) = 950.31
P = $8.11 decrease
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Commerce 2FA3
Mid term test
July 13, 2006
Problem 4; 10 marks
KTH Inc. is currently a no growth company paying a $5 per share annual dividend.
The required rate of return on KTH stock is 8%. How much is KTH stock worth
today?
P0 = D/r =5/0.08 = $62.5
Management is considering two proposals to alter KTH’s status. The first
proposal would suspend dividend payments for 2 years (allowing some
investment) and then resume a no growth pattern at $6 per share. This would
not change the required rate of return on KTH stock. What effect would this have
on the price of KTH shares?
P2 = D3/r =6/0.08 = 75
P0 = P2/(1+r)2 = $64.30
The second proposal would change KTH into a growth stock. Next year’s
dividend would be reduced to $2.55 to fund a growth rate of 7% (growth starts at
end of year 1). The increased risk would increase the required rate of return to
11%. What effect would this have on the price of KTH shares?
P0 = D1/(r-g) = 2.55/(0.11 - 0.07) = $63.75
As a shareholder, what decision would you want the managers to make? Why?
Accept proposal #1, it increases the value of the company the most.
A highly risk averse investor may then sell their shares, but they would still
gain by the decision.
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Commerce 2FA3
Mid term test
July 13, 2006
Problem 5; 15 marks
TSH Inc. is considering a proposal to launch a new product. This project would
require the purchase of production machinery (class 8, 20%) for $90,000 and
$10,000 in net working capital. The project is expected to generate $40,000 in
net pre-tax cash flows for the next 5 years. At the end of the fifth year the
product will be discontinued and the machinery scrapped for an expected salvage
value of $9,000 (the pool will not be left empty or with a negative balance). TSH
has a cost of capital of 12% and a marginal tax rate of 30%.
What are the net present value and profitability index for this proposal?
Item
Cash Flow
Present value
Purchase machine
-90,000
Tax shield (1/2 year)
Varies over time
Working capital required
-10,000
-10,000.00
5 years of op. cash flow
40,000(1 – T)*PVIFA(12%, 5)
100,933.73
Salvage value
9,000
Lost tax shield
[SdT/(r + d)]/(1 + r)5
Recover working capital
10,000
-90,000.00
15,970.98
5,106.84
-957.93
5,674.27
NPV = sum of all PV of cash flows =
26,727.89
PI = sum of PV of CF after T0/CF at T0 =126,728/100,000 =
1.27
If this proposal were complementary to a project with a negative NPV, how would
that affect your decision?
A complementary project can only proceed if the other project is also
accepted. The choice is; do the negative NPV project, do both projects, or
do neither project.
Add the NPV of both projects, if the total is greater than zero, accept both
projects, if the combined NPV<0, reject both. Although this project looks
good, we can’t accept it in isolation.
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