Sample Midterm

Question 1

Which of the following appears to be the most appropriate goal for corporate management?

a. Maximizing market value of the company’s stock.

b. Maximizing the company’s market share.

c. Maximizing the current profits of the company.

d. Minimizing the company’s liabilities.

Answer 1

a. Maximizing market value of the company’s stock.

Question 2

Deciding what long term assets a company should invest in is referred to as:

a. Capital structure decisions

b. Capital budgeting decisions

c. Working capital management decisions

d. Financing decisions

Answer 2

b. Capital budgeting decisions

Question 3

If Esther deposits $100 into a bank account which earns 10% interest compounded quarterly for 3 years, how much money does she have at the end of 3 years?

Answer 3

FV = PV (1+(r/m))n*m
= 100 (1 + (.1/4)) 12
= 134.49

Question 4

Which account would be preferred by a depositor (i.e. you are earning money) and why?

A 6% APR with monthly compounding or 6.5% APR with semi-annual compounding?

Answer 4

EAR = (1+r/m)m – 1
Option 1. (1+ .06/12) 12 –1 = 6.1678%
Option 2. (1 + .065/2) 2 –1 = 6.6056%*

*Choice 2 is preferred because you are earning money, and with that choice you earn more.

Question 5

What is the present value of the following payment stream discounted at 8% annually: $1,000 at the end of year 1, $3,000 at the end of year 2, and $5,000 at the end of year 3?

Answer 5

PV = 1000 + 3000 + 5000
(1.08)1 (1.08)2 (1.08)3

= 925.93 + 2572.01 + 3969.16
= 7467.11

Question 6

A local bank will pay you a level cash payment each year beginning today for your lifetime if you deposit $2,500 in the bank today. You require a 10% rate of return. You plan to live forever.

a. Is this an annuity, a perpetuity, or neither?
b. What level cash payment is the bank paying you?

Answer 6

PV=c/r +c

250 = 1.10C
C = 227.27

Question 7

You want to buy a car and it costs $15,000. Interest rates are 7.5% annually. You decide that you want a 5-year loan where payments are made at the end of each month. What are your monthly payments?

Answer 7

15,000/
C= 1- (1/1+(.075/12))60
(.075/12)

= 15,000/
49.905

= 300.57

Question 8

Suppose you want to fund a scholarship at the University of Oregon with the extra $1,000,000 you have. You expect the fund to earn 9% interest and begin making payments one year from now. If you instruct the University not to touch the principle, how much will the annual scholarship be?

Answer 8

PV=C/R
1,000,000 = C/.09
C = 90,000

Question 9

For the next 30 years you plan to put $1,000 per year into your IRA account for retirement. You expect your money to grow at 10% per year. How much will you have in 30 years?

Answer 9

FV = 1000 (((1.1)30 – 1)/.1)

= 164,494

Question 10

If investors receive a 10% interest rate on their bank deposits, how much will their purchasing power increase if the inflation rate over the year is 6%?

Answer 10

1+ real = 1+nominal/1+inflation

1+real = 1.10/1.06

1+real = 1.0337736

real = .037736

= 3.7736%

Question 11

A company paid a $2 per share dividend yesterday (Div0). You expect the dividend to grow steadily at a rate of 3% per year forever.

a. What is the expected dividend in each of the next three years?
b. If the discount rate for the stock is 9%, what is the stock’s current price?
c. What is the expected price of the stock in year 3?

Answer 11

a.
GIVEN: Div0 = 2
Div1 = Div0 (1+g)1 = 2(1.03)1 = 2.06
Div2 = Div0 (1+g)2 = 2(1.03)2 = 2.1218
Div3 = Div0 (1+g)3 = 2(1.03)3 = 2.1854

b.
P0 = Div0 (1+g) /
r-g

= 2(1.03)/
.09 - .03

= 34.33

Alternatively:
P0 = Div1/(r-g)
P0 = 2.06/(.09-.03)
= 34.33

c.
Alternatively:
P3= Div0(1+g)^4/ r-g
= 2(1.03)4/
.09 - .03

= 37.52

Alternatively (there are additional ways besides this one):
p3 = div1(1+g)^3/(r-g)
p3 = 2.06(1+.03)^3/(.09-.03)

P3 = 37.52

Question 12

You are considering the purchase of a 3-year bond with an annual coupon rate of 8% and a par value of $1,000. The bond pays coupons annually. The discount rate (interest rate) for similar bonds is 9%.

a. Without doing any calculations, will the bond be priced at par, a premium, or a discount? Why?
b. What are the annual coupon payments from this bond?
c. What price are you willing to pay for the bond today (also referred to as beginning price)?
d. Will the price of the bond increase, decrease, or remain constant if the interest rate decreases?

Answer 12

a.
coupon rate < required rate, sells at a discount.

b.
Par value*coupon rate = coupon payment

1,000*.08= 80

c.
N = 3
C = 80
M = 1
R = .09

Step 1: find the present value of the coupons as an $80, 3-year annuity

Step 2: find the present value of par ($1,000) as a single cash flow

Step 3: add the results of steps 1&2: = 974.68

d.
Value will increase, there is an inverse relation between bond prices and interest rates.

Question 13

You buy an 8% coupon bond. It matures in 5 years and pays annual coupons. When you buy the bond, the market interest rate is 8%. You decide to sell the bond 1-year later, when the market interest rate is 7%.

a. What is the beginning price of the bond (the buy price)?
b. What is the price of the bond when you decide to sell it (ending price)?
c. What are the annual coupon payments?
d. What is your rate of return (or holding period return) over the year?

Answer 13

a.
In this example, coupon rate =required rate, so bond sells at par $1000. Keep in mind this is NOT always the case-sometimes you do have to go through the three step valuation process to find the buy price.

b.
N=4
R=.07
C=80 (see part c)
M=1

Go through three step bond valuation process, as outlined in previous practice questions and instructor notes
$1033.88

c.
Par* coupon rate = coupon payment
$1000 * .08 = $80

d.
((1033.88 – 1000) + 80) / 1000 =

11.39%

Question 14

What is the value today of a stock that pays a dividend of $5.00 every year and has an expected rate of return of 10%?

Answer 14

P0 = 5.00/
.10

= $50

Question 15

If a bond offers investors an 11% nominal rate of return during a year in which the rate of inflation was 4%, then the investor’s real rate of return is what?

Answer 15

1+real = 1.11/
1.04

real = 6.73%

Question 16

A share of preferred stock pays an annual dividend of $1.25 per share. If the value of this preferred stock today is $30.00, what rate of return do investors require on this investment?

Answer 16

P0 = Div/r

30=1.25/r

r=4.16%

Question 17

Which ONE of the following is FALSE? (Choose one)

A. Bond investors get to vote for the Board of Directors

B. Bonds are required to pay coupon payments or else they are in default.

C. Bonds represent debt for the companies selling them to investors.

D. The US government, through the Treasury Department, sells bonds to investors.

Answer 17

A. Bond investors get to vote for the Board of Directors

Question 18

You buy a 6% coupon bond with a maturity of ten years that pays annual coupons. When you buy the bond, the market interest rate is 9%. You decide to sell the bond 3 years later, after you’ve received three coupon payments, and the market interest rate is 6%. You sell the bond for $1,000.

a. What is the price of the bond when you buy it (beginning price)?
b. What is your holding period return (HPR or rate of return)?

Answer 18

a.

N = 10
C = 60
M = 1
R = .09

Step 1: find the present value of the coupons as a $60, 10-year annuity

Step 2: find the present value of par ($1,000) as a single cash flow

Step 3: add the results of steps 1&2: = 807.47

b.

((1000 – 807.47) +180) / 807.47 =

= 46.14%

Question 19

What is the value today of a stock that will pay a dividend of $1.00 next year, $1.40 in two years, if its expected price in two years is $40 and it has a required rate of return of 6%?

Answer 19

P0 = Div1/ (1+r)^1 + Div2+Pn/ (1+r)^2

P0= 1.00/(1+.06)^1 + 1.40+40/(1+.06)^2

= 37.79

Question 20

The required rate of return on the common stock of Gondry Corporation is 10%. The stock’s current dividend is $2.50 and is expected to grow at a constant rate of 3% forever. What is the value of the stock today?

a. What are you willing to pay for the stock above in year 15?

Answer 20

P0 = Div0(1+g)^1/(r-g)
P0= 2.50(1+.03)^1/ (.10-.03)

=36.79

a.
p15= Div0(1+g)^16/(r-g)
p15 = 2.50(1+.03)^16/(.10-.03)

=57.31

Question 21

Which of the following is true:

a. When interest rates rise, bond prices rise.
b. When interest rates rise, long term bonds will decline in value more than short term bonds.
c. When interest rates rise bond values do not change as they are fixed.
d. When interest rates rise coupon payments decrease.

Answer 21

b. When interest rates rise, long term bonds will decline in value more than short term bonds.

Question 22

Which of the following is true:

a. Stocks selling between investors occur on the primary market.
b. If you expect interest rates to fall, you want to buy short term bonds.
c. The default risk premium compensates investors for interest rate risk.
d. Common stock has the least priority in bankruptcy.

Answer 22

d. Common stock has the least priority in bankruptcy.

Question 23

Agency problems:

a. Result from the separation of the board of directors and management.
b. May interfere with the goal of maximizing shareholder wealth.
c. Cause shareholders to want managers to maximize profits.
d. Can be reduced by giving managers salaries that are fixed.

Answer 23

b. May interfere with the goal of maximizing shareholder wealth.

Question 24

What is the present value of a 10 year annuity with payments of $1,000 per year if interest rates are 6% annually?

Answer 24

= 7,360.09

Question 25

How long will it take to save $10,000 if you deposit $200 monthly and earn an annual rate of 15% on your money? (remember that monthly payments imply monthly compounding)

Answer 25

= 3.27 years

Question 26

An annuity will pay you $300 per year for 25 years but the first payment does not come until 10 years from now. If interest rates are 10% what is the present value of this delayed annuity?

Answer 26

= 2,723.11 is the value of the annuity at year 9. This is now a single cash flow that needs to be discounted back to present value, year 0.

=1154.87
Is the present value of the delayed annuity

Question 27

Techy company expects to have extraordinary growth of 15% for the next 3 years. Then, they expect their growth will level off at 2%. The discount rate on the stock is 12%. Last year’s dividend (DIV 0) was 2.50. What should the current stock price be?

Answer 27

P_0=(Div_1)/((1+r)^1 )+(Div_2)/((1+r)^2 )+(Div_3+P_3)/((1+r)^3 )

This is the basic formula that you would need to plug into, but it’s not easy as you do not have the dividends, or year 3 price, you need to find them.

P_0=(2.50(1.15))/((1.12)^1 )+(2.50(1.15)^2)/((1.12)^2 )+(2.50(1.15)^3+(3.80(1.02)^1)/(.12-.02))/((1.12)^3 )=35.50

In case you do not understand all of what is happening above, I will explain some of it in more detail.

Here is how I got 3.80 above which is Div3:

Div_3=Div_0 (1+g)^3=2.50(1.15)^3=3.80

I then grew that dividend another year at 2% to make it div 4, which I use to find P3:

P_3=(Div_4)/(r-g)=(Div_3 (1+g)^1)/(r-g)=(3.80(1+.02)^1)/(.12-.02)=38.76

(Note that to find dividend 4, I HAD TO START with dividend 3 and then use the new growth rate of 2%. In this instance, you cannot use dividend 0 or 1 or 2 as your starting point with the 2% growth rate because the dividends do not grow at 2% for years 1, 2 and 3, they grow at 15%.)

Here is another, equivalent, way to see the P0 formula from above:

P_0=(2.50(1.15))/((1.12)^1 )+(2.50(1.15)^2)/((1.12)^2 )+(3.80+38.76)/((1.12)^3 )=35.50