Final Exam Solutions 2011 6 Fall

FNAN 301, fall 2011, final exam, solutions
Conceptual: effect of rate and time on future value

1. For each of the 4 investments described in the table, the investor would pay $500 today to purchase the
investment. Each investment would have the annual return noted in the table and each investment would
make a single, lump sum payment to the investor in the number of years from today noted in the table. If
RA > RB and TQ > TZ, then which assertion is true? All annual returns and numbers of years from today
when the single, lump sum payment is made are greater than zero.
Number of years from today when the single,
Investment
Annual return
lump sum payment is made
A
RA
T
B
RB
T
Q
R
TQ
Z
R
TZ
A. Investment A will make a larger single, lump sum payment in T years than investment B, and
investment Q will make a larger single, lump sum payment in TQ years than investment Z will make in
TZ years
B. Investment A will make a larger single, lump sum payment in T years than investment B, and
investment Z will make a larger single, lump sum payment in TZ years than investment Q will make in
TQ years
C. Investment B will make a larger single, lump sum payment in T years than investment A, and
TZ years
D. Investment B will make a larger single, lump sum payment in T years than investment A, and
TQ years
E. None of the above assertions is true
RA > RB and TZ > TQ, then which assertion is true? All annual returns and numbers of years from today
Investment
Annual return
A
RA
T
B
RB
T
Q
R
TQ
Z
R
TZ
TZ years
TQ years
TZ years
TQ years

RB > RA and TQ > TZ, then which assertion is true? All annual returns and numbers of years from today
Investment
Annual return
A
RA
T
B
RB
T
Q
R
TQ
Z
R
TZ
TZ years
TQ years
TZ years
TQ years
RB > RA and TZ > TQ, then which assertion is true? All annual returns and numbers of years from today
Investment
Annual return
A
RA
T
B
RB
T
Q
R
TQ
Z
R
TZ
TZ years
TQ years
TZ years
TQ years

Find missing CF associated with future value of multiple cash flows
2. In 3 years from today, Maya expects to invest $17,000 in an account. She also expects to
make an investment of X in the same account in 1 year from today. What is X if Maya expects
to have $36,000 in her account in 5 years from today and the expected return for the account is
9.9 percent per year?
A. An amount equal to or greater than $10,700 but less than $11,700
B. An amount equal to or greater than $11,700 but less than $12,700
C. An amount equal to or greater than $12,700 but less than $13,700
D. An amount equal to or greater than $13,700 but less than $14,700
E. An amount less than $10,700 or an amount equal to or greater than $14,700

Find future value with simple interest and PMT for FV annuity
3. Two years ago from today, Portia invested $7,300 in a security that has earned and is expected to
continue to earn 14.9 percent per year in simple interest and that pays investors in 5 years from today.
Christina wants to have as much money in 5 years from today as Portia expects to have in 5 years from
today. How much would Christina need to contribute to her investment account each year for 5 years if
she has $1,200 currently saved in her investment account, makes equal annual contributions to her
investment account, makes her first contribution in 1 year, and can earn 12.5 percent per year in
compound interest? Recall that interest rates are assumed to be compound rates unless told otherwise
(such as with Portias security), so the vast majority of the analysis of the time value of money in
FNAN 301 involves compound rates. Therefore, the analysis of Christinas account should be
conducted in a way that is consistent with similar problems analyzed in the course.
Christina wants to have as much money in 5 years from today as Portia expects to have in 5 years
from today. How much would Christina need to contribute to her investment account each year for 5
years if she has $1,200 currently saved in her investment account, makes equal annual contributions
to her investment account, makes her first contribution in 1 year, and can earn 12.5 percent per year in


Growth rate on perpetuity after saving with FV annuity due
4. Hal wants to create a scholarship trust fund that will make its first scholarship payment in 6
years from today. He plans to save $80,000 per year in a trust fund for 5 years. His first savings
donation to the trust fund is expected later today. How much can the annual payments from the
trust fund be expected to grow each year if the fund is expected to earn 12.1 percent per year,
make its first scholarship payment in 6 years from today, have that first payment be $17,000, and
have all subsequent payments grow annually at a constant rate forever?
A. A rate equal to or greater than 5.00% but less than 6.00%
B. A rate equal to or greater than 6.00% but less than 7.00%
C. A rate equal to or greater than 7.00% but less than 8.00%
D. A rate equal to or greater than 8.00% but less than 9.00%
E. A rate less than 5.00% or a rate greater than or equal to 9.00%
6

Find payment with PV annuity and an extra, interim cash flow
5. Hal just took out a loan from the bank for $8,300. He plans to repay this loan by making a
special payment to the bank of $2,800 in 5 years and by also making equal, regular annual
payments for 7 years. If the interest rate on the loan is 11.1 percent per year and he makes his
first regular annual payment in 1 year, then what would Hals regular annual payment be?
Assume that Hal makes two payments in 5 years: the extra payment of $2,800 and the regular
annual payment.
annual payment.
annual payment.
annual payment.

Quantitative: discount a single cash flow with a periodic rate that must be computed
6. What is the value of an investment that is scheduled to pay you $12,300 in 2 years and that has
an annual rate of return of 17.2 percent, compounded quarterly?

Quantitative: find return for a bond
7. A bond issued by Patriot Theaters pays fixed annual coupons, just paid an annual coupon, has an
annual coupon rate of 16.4%, has a face value of $1,000, and matures in 5 years from today. One
year ago, the yield-to-maturity (YTM) of the bond was 17.1%. Today, the YTM of the bond is
17.7%. What was the rate of return over the past year (in other words, the return from 1 year ago
until today) for the Patriot Theaters bond?

Identifying riskier stock after computing 2 expected returns
8. For the next year, stock A, which pays annual dividends with the next one expected in 1 year,
has an expected dividend yield of 2.3 percent and an expected capital appreciation yield of 3.4
percent. Stock B is currently priced at $54.50 per share and is expected to pay its next annual
dividend in 1 year. If stock Bs next dividend is expected to be $4.30 per share and the stock is
expected to be priced at $53.40 in 1 year, then which of the following assertions is most strongly
supported by the information if the expected annual return for each stock is expected to remain
unchanged forever?
A. Stock A is more risky than stock B
B. Stock B is more risky than stock A
C. Stock A and stock B are equally as risky as each other
D. All of the above assertions are supported equally as strongly by the information
unchanged forever?
unchanged forever?
unchanged forever?
10

Price bond and then get fixed dividend
9. Maya has one share of stock and one bond issued by Patriot Theaters. The total value of the
two securities is $1,100. The bond has a yield-to-maturity (YTM) of 16.8 percent, an annual
coupon rate of 14.6 percent, and a face value of $1,000; pays semi-annual coupons with the next
one expected in 6 months; and matures in 4 years. The stock pays annual dividends that are
expected to remain unchanged forever. The next dividend is expected to be paid in one year.
The stock has an expected return of 18.7 percent per year. What is the next dividend expected
to be?
to be?
to be?
to be?
11

Rank securities by risk, which is reflected through expected return or YTM
10. Patriot Theaters has issued bonds, common stock, and preferred stock. The YTM on the
bonds is 13% and the expected annual return on the preferred stock is 17%. Which of the
following assertions about the expected annual return on the common stock issued by Patriot
Theaters is most likely to be true?
A. The expected annual return on the common stock is less than 13%
B. The expected annual return on the common stock is equal to 13%
C. The expected annual return on the common stock is greater than 13% but less than 17%
D. The expected annual return on the common stock is equal to 17%
E. The expected annual return on the common stock is greater than 17%
bonds is 13% and the expected annual return on the common stock is 17%. Which of the
following assertions about the expected annual return on the preferred stock issued by Patriot
A. The expected annual return on the preferred stock is less than 13%
B. The expected annual return on the preferred stock is equal to 13%
C. The expected annual return on the preferred stock is greater than 13% but less than 17%
D. The expected annual return on the preferred stock is equal to 17%
E. The expected annual return on the preferred stock is greater than 17%
A. The expected annual return on the common stock is greater than 22%
E. The expected annual return on the common stock is less than 17%
A. The expected annual return on the preferred stock is greater than 22%
E. The expected annual return on the preferred stock is less than 17%
12

Compute maximum value that can be created and compute NPV
11. The managers of Patriot Theaters are evaluating 5 potential projects (A, B, C, D, and E).
Based on the information presented in the 2 tables, what is the maximum amount of value that
the managers can create for the firm if they can choose to undertake none, one, some, or all of
the 5 potential projects?
Discounted
Internal
Average
Initial
Net present
Payback
payback
rate of
accounting
investment
value
period
period
return
return
Project (in $ millions)
(in $ millions) (in years)
(in years)
(in %)
(in %)
A
2.3
3.3
3.4
4.1
6.1
-2.7
B
1.7
-2.8
2.3
19.8
20.1
C
4.2
8.9
0.9
4.9
4.4
12.7
Expected cash flows (number of years from today) in millions of dollars
Project Cost of capital
0
1
2
3
4
D
8.0%
-5.0
12.0
9.0
-8.0
-3.0
E
10.0%
-10.0
1.0
2.0
3.0
4.0
A. An amount equal to or greater than $9 million and less than $11 million
B. An amount equal to or greater than $11 million and less than $14 million
C. An amount equal to or greater than $14 million and less than $16 million
D. An amount less than $9 million or an amount equal to or greater than $16 million
E. The question can not be answered for one or more of the following reasons: at least one of the
projects has non-conventional cash flows; the cost of capital is not known for all projects; and the
payback, discounted payback, and average accounting return thresholds are not known.
Discounted
Internal
Average
Initial
Net present
Payback
payback
rate of
accounting
investment
value
period
period
return
return
(in years)
(in %)
(in %)
A
2.3
4.2
3.4
4.1
6.1
-2.7
B
4.2
7.3
0.9
4.9
4.4
12.7
C
1.7
-5.9
2.3
19.8
20.1
0
1
2
3
4
D
8.0%
-5.0
12.0
9.0
-8.0
-6.0
E
10.0%
-10.0
1.0
2.0
3.0
4.0
13

Discounted
Internal
Average
Initial
Net present
Payback
payback
rate of
accounting
investment
value
period
period
return
return
(in years)
(in %)
(in %)
A
4.4
-3.9
0.9
21.4
12.9
B
1.6
6.1
2.5
2.9
19.8
20.3
C
2.7
3.5
3.2
4.1
6.1
-2.8
0
1
2
3
4
D
8.0%
-10.0
12.0
9.0
-8.0
-6.0
E
10.0%
-5.0
1.0
2.0
3.0
4.0
Discounted
Internal
Average
Initial
Net present
Payback
payback
rate of
accounting
investment
value
period
period
return
return
(in years)
(in %)
(in %)
A
1.9
4.9
2.6
4.9
19.9
21.4
B
4.1
-3.2
0.9
21.6
13.7
C
2.2
1.9
3.9
4.5
6.8
-3.8
0
1
2
3
4
D
10.0%
-10.0
12.0
9.0
-8.0
-6.0
E
8.0%
-5.0
1.0
2.0
3.0
4.0
14

Find NPV from revs/costs/investment/asset sale
12. Patriot Theaters is considering a project that would last for 2 years. The project would involve an
initial investment of $600,000 for new equipment that would be sold for an expected price of $420,000 at
the end of the project in 2 years. The equipment would be depreciated to zero over 5 years using straightline depreciation. In years 1 and 2, relevant, incremental annual revenue from the project is expected to
be $440,000 per year and relevant, incremental annual costs for the project are expected to be $260,000
per year. The tax rate is 40 percent and the cost of capital for the project is 9 percent. What is the net
present value (NPV) of the project?
A. An amount equal to or greater than $0 but less than $30,000
E. An amount less than $0 or an amount equal to or greater than $120,000
15

Find NPV from OCF, CF from capital spending, and NWC levels
13. Patriot Theaters is considering a project that would last for 3 years and have a cost of capital
of 4.0 percent. The relevant level of net working capital for the project is expected to be $2,000
immediately (at year 0), $6,000 in 1 year, $3,000 in 2 years, and $0 in 3 years. Relevant
expected operating cash flows and cash flows from capital spending in years 0, 1, 2, and 3 are
presented in the following table. What is the net present value of this project? Assume that the
cash flow from selling the project, terminal value, and opportunity costs are $0 in each year.
Year 0
Year 1
Year 2
Year 3
Operating cash flows
$0
$3,000
$3,000
$3,000
Cash flows from capital spending
-$14,000
$0
$0
$11,000
Year 0
Year 1
Year 2
Year 3
$0
$3,000
$3,000
$3,000
-$14,000
$0
$0
$11,000
Year 0
Year 1
Year 2
Year 3
$0
$3,000
$3,000
$3,000
-$14,000
$0
$0
$11,000
Year 0
Year 1
Year 2
Year 3
$0
$3,000
$3,000
$3,000
-$14,000
$0
$0
$11,000
16

Find the tax rate from an incomplete project income statement with partial sunk costs
14. Patriot Theaters is evaluating the claw machine project. During year 1, the claw machine
project is expected to have relevant revenue of $95,000, relevant variable costs of $35,000, and
relevant depreciation of $0. In addition, Patriot Theaters would have one source of fixed costs
associated with the claw machine project. Yesterday, Patriot Theaters signed a deal with Ruby
Marketing to develop a marketing campaign for use in the project. The terms of the deal require
Patriot Theaters to pay Ruby Marketing either $15,000 in 1 year if the project is pursued or
$20,000 in 1 year if the project is not pursued. Relevant net income for the claw machine project
in year 1 is expected to be 31,000. What is the tax rate expected to be in year 1?
A. A rate less than 40.00% or a rate greater than or equal to 60.00%
E. A rate equal to or greater than 55.00% but less than 60.00%
17

18

Conceptual:usingbasecaseNPVtomakefinaldecisions
15.PatriotTheatersoperatesmovietheatersintheMidAtlanticregionoftheUnitedStates.The
objectiveofthefirmsmanagersistomaximizeshareholdervalue.Thefirmisevaluatinganew
projectthatwouldinvolveexpandingintoBoston,wherethereareoftenblizzards.Basedonthe
informationgiveninthequestionandthefollowingtableontheBostonproject,whichassertion
istrue?
BasecaseNPV(basedonfinalestimatesandexpectations)
$27,000
Valuecreatediftheblizzardscenariooccurs(basedonscenarioanalysis)
$230,000
Valuecreatedifworstcasesalesoccur(basedonsensitivityanalysis)
$420,000
Valuecreatedifbestcasesalesoccur(basedonsensitivityanalysis)
$210,000
ProbabilitythatprojectwillhaveNPV>0(basedonsimulationanalysis)
18%
A.ItisnotclearwhetherPatriotTheatersshouldacceptorrejecttheBostonproject,becausethe
informationthatisprovidediscontradictorywithrespecttoansweringthequestion
B.ItisnotclearwhetherPatriotTheatersshouldacceptorrejecttheBostonproject,becausethe
costofcapitalisnotgiven
C.PatriotTheatersshouldbeindifferentbetweenacceptingandrejectingtheBostonproject
D.PatriotTheatersshouldaccepttheBostonproject
E.PatriotTheatersshouldrejecttheBostonproject
istrue?
$27,000
$230,000
$210,000
$420,000
81%
19

projectthatwouldinvolveexpandingintoMiami,wherethereareoftenhurricanes.Basedonthe
informationgiveninthequestionandthefollowingtableontheMiamiproject,whichassertion
istrue?
$27,000
Valuecreatedifthehurricanescenariooccurs(basedonscenarioanalysis)
$230,000
$420,000
$210,000
18%
A.ItisnotclearwhetherPatriotTheatersshouldacceptorrejecttheMiamiproject,becausethe
B.ItisnotclearwhetherPatriotTheatersshouldacceptorrejecttheMiamiproject,becausethe
C.PatriotTheatersshouldbeindifferentbetweenacceptingandrejectingtheMiamiproject
D.PatriotTheatersshouldrejecttheMiamiproject
E.PatriotTheatersshouldaccepttheMiamiproject
istrue?
$27,000
$230,000
$210,000
$420,000
81%
20

Get geometric from arithmetic and all but one return
16. A stock had returns of 21.0%, -20.0%, and 32.0% in each of the past three years. Over the
past four years, the arithmetic average annual return for the stock was 5.0%. What was the
geometric return for the stock over the past four years?
21

Get expected SD from 2 states and P0, D1, and P1
17. Shares of Patriot Theaters are currently priced at $80 per share. The following table indicates
what could happen with the Patriot Theaters stock price and dividend per share over the next
year. What is the standard deviation of Patriot Theaters stocks returns?
Probability of Price of Patriot Theaters
Dividend paid by Patriot
Outcome
outcome
stock in 1 year
Theaters in 1 year
Good
.7
$85
$11
Bad
.3
$59
$5
Outcome
outcome
stock in 1 year
Theaters in 1 year
Good
.7
$85
$15
Bad
.3
$59
$1
22

Outcome
outcome
stock in 1 year
Theaters in 1 year
Good
.7
$63
$6
Bad
.3
$50
$1
Outcome
outcome
stock in 1 year
Theaters in 1 year
Good
.7
$62
$4
Bad
.3
$52
$2
23

Risk premium of a portfolio
18. You own a portfolio that has a total value of $19,000. The portfolio has 2,000 shares of stock
A, which is priced at $6.00 per share and has an expected return of 11.2%. The portfolio also has
5,000 shares of stock B, which has an expected return of 4.5%. The risk-free return is 2.3% and
inflation is expected to be 3.2%. What is the risk premium for your portfolio?
A. 6.43% (plus or minus 0.05 percentage points)
B. 5.53% (plus or minus 0.05 percentage points)
C. 5.36% (plus or minus 0.05 percentage points)
D. 4.11% (plus or minus 0.05 percentage points)
E. The question can not be answered without knowing the share price of stock B or the question
can be answered without knowing the share price of stock B, but none of the above is within 0.05
percentage points of the correct answer
24

Ethics of insider trading
19. According to the class overheads and basic ethics, which one of the following assertions
about insider trading, which is against the law, is true?
A. Insider trading is illegal and should not be considered as a potential approach to investing
B. Insider trading is illegal and should be considered as a potential approach to investing
C. Insider trading is legal and should not be considered as a potential approach to investing
D. Insider trading is legal and should be considered as a potential approach to investing
A. Insider trading is illegal and should be considered as a potential approach to investing
B. Insider trading is illegal and should not be considered as a potential approach to investing
C. Insider trading is legal and should be considered as a potential approach to investing
D. Insider trading is legal and should not be considered as a potential approach to investing
A. Insider trading is legal and should not be considered as a potential approach to investing
B. Insider trading is legal and should be considered as a potential approach to investing
C. Insider trading is illegal and should not be considered as a potential approach to investing
D. Insider trading is illegal and should be considered as a potential approach to investing
A. Insider trading is legal and should be considered as a potential approach to investing
B. Insider trading is legal and should not be considered as a potential approach to investing
C. Insider trading is illegal and should be considered as a potential approach to investing
D. Insider trading is illegal and should not be considered as a potential approach to investing
25

Conceptual: unexpected return on a given day and bank beta
20. Which one of the assertions about statement 1 and statement 2 is true?
Statement 1: On a given day, a single stocks unexpected return would likely be zero.
Statement 2: If Global National Bank is a bank, then the beta of Global National Bank common
stock is likely to be greater than 1.
A. Statement 1 is true and statement 2 is true
B. Statement 1 is true and statement 2 is false
C. Statement 1 is false and statement 2 is true
D. Statement 1 is false and statement 2 is false
stock is likely to be less than 1.
26

Compute holdings of asset from portfolio and asset betas
21. Hal owns a portfolio worth $1,200 that consists of 2 stocks: Patriot Theaters, which has a
beta of 1.80, and East West Cola, which has a beta of 0.50. How much is his East West Cola
stock worth if his portfolio has a beta of 1.30?
A. An amount less than $300 or an amount equal to or greater than $700
B. An amount equal to or greater than $300 but less than $400
C. An amount equal to or greater than $400 but less than $500
D. An amount equal to or greater than $500 but less than $600
E. An amount equal to or greater than $600 but less than $700
27

Find beta from ERM, RF, and ER of stock
22. If the expected return on the market is 12.8 percent, the risk-free rate is 4.7 percent, and
Patriot Theaters common stock has an expected return of 17.8 percent, then what is the beta for
Patriot Theaters according to the Capital Asset Pricing Model (CAPM)?
A. An amount less than 1.10 or an amount greater than or equal to 1.90
B. An amount equal to or greater than 1.10 but less than 1.30
C. An amount equal to or greater than 1.30 but less than 1.50
D. An amount equal to or greater than 1.50 but less than 1.70
E. An amount equal to or greater than 1.70 but less than 1.90
28

Find inflation from CAPM ER and expected real rate
23. The risk-free return is 3.0%, the expected return on the market is 16.0%, the expected real
return for Patriot Theaters stock is 4.5%, and the beta for Patriot Theaters stock is 0.8. What is
the inflation rate expected to be?
Compute WACC with 2 items
24. Patriot Theaters has 900,000 shares of common equity outstanding that have an expected
return of 18.90% and a current price of $50 each. The expected return on the market is 22.50%
and the risk-free rate is 1.70%. Patriot Theaters has issued 80,000 bonds with a face value of
$1,000 and a market value of $1,050 each. The yield to maturity on these bonds is 6.24%, the
annual coupon rate is 7.42%, and the current yield is 7.07%. If the corporate tax rate is 40%,
what is the weighted-average cost of capital for Patriot Theaters?
$1,000 and a market value of $950 each. The yield to maturity on these bonds is 7.42%, the
29

Compute NPV from WACC and adjustment for below/above average risk for firm
25. Patriot Theaters is evaluating the Harvard project, which is a 2-year project with expected
cash flows of -$100,000 today; $60,000 in 1 year; and $60,000 in 2 years. The Harvard project
is considered more risky than an average-risk project at Patriot Theaters, such that the
appropriate discount rate for it is 2.6 percentage points different than the discount rate used for
an average-risk project at Patriot Theaters. What is the NPV of the Harvard project if the
weighted-average cost of capital for Patriot Theaters is 7.2 percent?
is considered less risky than an average-risk project at Patriot Theaters, such that the appropriate
discount rate for it is 2.6 percentage points different than the discount rate used for an averagerisk project at Patriot Theaters. What is the NPV of the Harvard project if the weighted-average
cost of capital for Patriot Theaters is 7.2 percent?
30

Conceptual: effect of rate and time on future value
1. For each of the 4 investments described in the table, the investor would pay $500 today to
purchase the investment. Each investment would have the annual return noted in the table and
each investment would make a single, lump sum payment to the investor in the number of years
from today noted in the table. If RA > RB and TQ > TZ, then which assertion is true? All
annual returns and numbers of years from today when the single, lump sum payment is made are
greater than zero.
Number of years from today when the
Investment
Annual return
single, lump sum payment is made
A
RA
T
B
RB
T
Q
R
TQ
Z
R
TZ
A. Investment A will make a larger single, lump sum payment in T years than investment
B, and investment Q will make a larger single, lump sum payment in TQ years than
investment Z will make in TZ years
investment Z will make a larger single, lump sum payment in TZ years than investment Q will
make in TQ years
investment Q will make a larger single, lump sum payment in TQ years than investment Z will
make in TZ years
make in TQ years
Investment A will make a larger single, lump sum payment in T years than investment B
With any investment in T years, you would have 500 (1 + r)T
With investment A, you would have 500 (1 + RA)T in T years
With investment B, you would have 500 (1 + RB)T in T years
We can conclude that 500 (1 + RA)T > 500 (1 + RB)T
Since both A and B are positive, 1+RA and 1+RB are both greater than 1, which means that both
investments get more valuable each year, and since RA > RB, investment A will get more
valuable each year than investment B
Investment Q will make a larger single, lump sum payment in TQ years than investment Z will
make in TZ years
With any investment that pays R per year, you would get 500 (1 + R) t in t years
With investment Q, you would get 500 (1 + R)TQ in TQ years
With investment Z, you would get 500 (1 + R)TZ in TZ years
We can conclude that 500 (1 + R)TQ > 500 (1 + R)TZ
Since R is positive, 1+R is greater than 1, which means that both investments get more valuable
each year, and since TQ > TZ, investment Q will increase its value for more years, so it will pay
a larger single, lump sum than investment Z, which will pay off earlier
Putting it together, the answer is:
A. Investment A will make a larger single, lump sum payment in T years than investment B and
make in TZ years
31

from today noted in the table. If RA > RB and TZ > TQ, then which assertion is true? All
greater than zero.
Investment
Annual return
A
RA
T
B
RB
T
Q
R
TQ
Z
R
TZ
make in TZ years
B. Investment A will make a larger single, lump sum payment in T years than investment B,
and investment Z will make a larger single, lump sum payment in TZ years than
investment Q will make in TQ years
make in TZ years
make in TQ years
Investment A will make a larger single, lump sum payment in T years than investment B
We can conclude that 500 (1 + RA)T > 500 (1 + RB)T
investments get more valuable each year, and since RA > RB, investment A will get more
valuable each year than investment B
Investment Z will make a larger single, lump sum payment in TZ years than investment Q will
make in TQ years
We can conclude that 500 (1 + R)TZ > 500 (1 + R)TQ
each year, and since TZ > TQ, investment Z will increase its value for more years, so it will pay
a larger single, lump sum than investment Q, which will pay off earlier
B. Investment A will make a larger single, lump sum payment in T years than investment B and
make in TQ years
32

from today noted in the table. If RB > RA and TQ > TZ, then which assertion is true? All
greater than zero.
Investment
Annual return
A
RA
T
B
RB
T
Q
R
TQ
Z
R
TZ
make in TZ years
make in TQ years
C. Investment B will make a larger single, lump sum payment in T years than investment
A, and investment Q will make a larger single, lump sum payment in TQ years than
investment Z will make in TZ years
make in TQ years
Investment B will make a larger single, lump sum payment in T years than investment A
We can conclude that 500 (1 + RB)T > 500 (1 + RA)T
investments get more valuable each year, and since RB > RA, investment B will get more
valuable each year than investment A
Investment Q will make a larger single, lump sum payment in TQ years than investment Z will
make in TZ years
We can conclude that 500 (1 + R)TQ > 500 (1 + R)TZ
each year, and since TQ > TZ, investment Q will increase its value for more years, so it will pay
a larger single, lump sum than investment Z, which will pay off earlier
C. Investment B will make a larger single, lump sum payment in T years than investment A and
make in TZ years
33

from today noted in the table. If RB > RA and TZ > TQ, then which assertion is true? All
greater than zero.
Investment
Annual return
A
RA
T
B
RB
T
Q
R
TQ
Z
R
TZ
make in TZ years
make in TQ years
make in TZ years
D. Investment B will make a larger single, lump sum payment in T years than investment
A, and investment Z will make a larger single, lump sum payment in TZ years than
investment Q will make in TQ years
Investment B will make a larger single, lump sum payment in T years than investment A
We can conclude that 500 (1 + RB)T > 500 (1 + RA)T
investments get more valuable each year, and since RB > RA, investment B will get more
valuable each year than investment A
Investment Z will make a larger single, lump sum payment in TZ years than investment Q will
make in TQ years
We can conclude that 500 (1 + R)TZ > 500 (1 + R)TQ
each year, and since TZ > TQ, investment Z will increase its value for more years, so it will pay
a larger single, lump sum than investment Q, which will pay off earlier
D. Investment B will make a larger single, lump sum payment in T years than investment A and
TQ years
34

Find missing CF associated with future value of multiple cash flows
The future value of multiple cash flows at different points in time is the sum of the future values of
each individual cash flow, so find the future value of todays investment, then find the future value
of the investment made in 1 year from today, and then find the actual amount of the investment
made in 1 year from today.
Time
0
1
2
3
4
5
Invest
?
17,000
Future value
36,000
Future value of the investment made in 3 years
If Maya expects to make an investment in 3 years, then in 5 years, which is the point in time of
interest, it will have been invested for 2 years
2 years after investing $17,000 at an expected rate of return of 9.9 percent per year, Maya would
have FV5 = $17,000 (1.099)2 = $20,533
Mode is not relevant, since PMT = 0
Enter
2
9.9
N
I%
Solve for
-17,000
PV
0
PMT
FV
20,533
Future value of investment made in 1 year from today

If Maya expects to have $36,000 in her account in 5 years
And if the investment made in 3 years from today is expected to be worth $20,533 in 5 years, then
The investment made in 1 year from today will be worth $36,000 $20,533 = $15,467 in 5 years
Investment made in 1 year from today
In general, FVt = Ck (1+r)t-k
In this case for the investment made in 1 year from today, FV5 = C1 (1+r)5-1 = C1 (1+r)4
We know FV5 = 15,467; r = .099; t = 5; k = 1; and t - k = 4
So 15,467 = C1 (1.099)4
So C1 = 15,467 / (1.099)4 = 10,603
Enter
4
9.9
N
I%
PV
Solve for
-10,603
Answers may differ slightly due to rounding
0
PMT
15,467
FV
Answer: E
$10,603 is an amount less than $10,700 or an amount equal to or greater than $14,700
35

Time
0
1
2
3
4
5
Invest
?
16,000
Future value
37,000
have FV5 = $16,000 (1.099)2 = $19,325
Enter
2
9.9
N
I%
Solve for
-16,000
PV
0
PMT
FV
19,325

So 17,675 = C1 (1.099)4
So C1 = 17,675 / (1.099)4 = 12,116
Enter
4
9.9
N
I%
PV
Solve for
-12,116
0
PMT
Answer: B
$12,116 is an amount equal to or greater than $11,700 but less than $12,700
36
17,675
FV

Time
0
1
2
3
4
5
Invest
?
17,000
Future value
36,000
have FV5 = $17,000 (1.089)2 = $20,161
Enter
2
8.9
N
I%
Solve for
-17,000
PV
0
PMT
FV
20,161

So 15,839 = C1 (1.089)4
So C1 = 15,839 / (1.089)4 = 11,262
Enter
4
8.9
N
I%
PV
Solve for
-11,262
0
PMT
Answer: A
37
15,839
FV

Time
0
1
2
3
4
5
Invest
?
16,000
Future value
37,000
have FV5 = $16,000 (1.089)2 = $18,975
Enter
2
8.9
N
I%
Solve for
-16,000
PV
0
PMT
FV
18,975

So 18,025 = C1 (1.089)4
So C1 = 18,025 / (1.089)4 = 12,816
Enter
4
8.9
N
I%
PV
Solve for
-12,816
0
PMT
Answer: C
38
18,025
FV

Find future value with simple interest and PMT for FV annuity
3. Two years ago from today, Portia invested $7,300 in a security that has earned and is expected to continue to
earn 14.9 percent per year in simple interest and that pays investors in 5 years from today. Christina wants to
have as much money in 5 years from today as Portia expects to have in 5 years from today. How much would
Christina need to contribute to her investment account each year for 5 years if she has $1,200 currently saved in
her investment account, makes equal annual contributions to her investment account, makes her first contribution
in 1 year, and can earn 12.5 percent per year in compound interest? Recall that interest rates are assumed to be
compound rates unless told otherwise (such as with Portias security), so the vast majority of the analysis of the
time value of money in FNAN 301 involves compound rates. Therefore, the analysis of Christinas account
should be conducted in a way that is consistent with similar problems analyzed in the course.
Solve in two parts:
1) Figure out how much Portia will have in 5 years
2) Figure out how much Christina would need to invest each to have the amount computed in step 1 in 5 years
Step 1: Portias money in 5 years from today
Time
2 yrs ago 1 yr ago
Today
Time
-2
-1
0
Re-time
0
1
2
invest
7,300
Fut val
In 1 yr
1
3
In 2 yrs
2
4
In 3 yrs
3
5
In 4 yrs
4
6
In 5 yrs
5
7
?
Since Portia made her initial investment 2 years ago and the investment pays in 5 years, it will have been
invested for 2 + 5 = 7 years
7 years after investing $7,300 at a simple interest rate of 14.9 percent per year, Portia would have C0 + (C0
simple interest rate per period t), where
C0 = 7,300
Simple interest rate per year = 14.9% = .149
t = 7 years
So, she would have 7,300 + (7,300 .149 7) = 7,300 + 7,613.90 = 14,913.90
Step 2: Christinas annual contribution
Time
2 yrs ago 1 yr ago
Today
Time
-2
-1
0
Re-time
0
1
2
invest
init val
1,200
Fut val
In 1 yr
1
3
?
In 2 yrs
2
4
?
In 3 yrs
3
5
?
In 4 yrs
4
6
?
In 5 yrs
5
7
?
14,913.90
Christina will make 5 equal annual contributions with the first in 1 year and we are interested in the value of her
account in 5 years. We can find this is as the future value of an annuity where
I% = interest rate per year (compound) = 12.5%
N = 5 payments and future value in 5 years
FV = future value in 5 years = 14,913.90 (from step 1)
PV = -1,200 (she currently has $1,200)
END Mode
Enter
5
N
12.5
I%
-1,200
PV
Solve for
PMT
-1,987.37
14,913.90
FV
Answer: B, as $1,987.37 is an amount equal to or greater than $1,900 but less than $2,100
39

Christina need to contribute to her investment account each year for 5 years if she has $1,200 currently saved
in her investment account, makes equal annual contributions to her investment account, makes her first
contribution in 1 year, and can earn 12.5 percent per year in compound interest? Recall that interest rates are
assumed to be compound rates unless told otherwise (such as with Portias security), so the vast majority of the
analysis of the time value of money in FNAN 301 involves compound rates. Therefore, the analysis of
Christinas account should be conducted in a way that is consistent with similar problems analyzed in the
course.
Solve in two parts:
Time
2 yrs ago 1 yr ago
Today
Time
-2
-1
0
Re-time
0
1
2
invest
7,300
Fut val
In 1 yr
1
3
In 2 yrs
2
4
In 3 yrs
3
5
In 4 yrs
4
6
In 5 yrs
5
7
?
C0 = 7,300
t = 7 years
So, she would have 7,300 + (7,300 .194 7) = 7,300 + 9,913.40 = 17,213.40
Time
Time
Re-time
invest
init val
Fut val
2 yrs ago
-2
0
1 yr ago
-1
1
Today
0
2
In 1 yr
1
3
?
In 2 yrs
2
4
?
In 3 yrs
3
5
?
In 4 yrs
4
6
?
In 5 yrs
5
7
?
1,200
17,213.40
END Mode
Enter
5
N
12.5
I%
-1,200
PV
Solve for
PMT
-2,345.75
17,213.40
FV
Answer: D, as $2,345.75 is an amount equal to or greater than $2,300 but less than $2,500
40

course.
Solve in two parts:
Time
2 yrs ago 1 yr ago
Today
Time
-2
-1
0
Re-time
0
1
2
invest
7,300
Fut val
In 1 yr
1
3
In 2 yrs
2
4
In 3 yrs
3
5
In 4 yrs
4
6
In 5 yrs
5
7
?
C0 = 7,300
t = 7 years
So, she would have 7,300 + (7,300 .149 7) = 7,300 + 7,613.90 = 14,913.90
Time
Time
Re-time
invest
init val
Fut val
2 yrs ago
-2
0
1 yr ago
-1
1
Today
0
2
In 1 yr
1
3
?
In 2 yrs
2
4
?
In 3 yrs
3
5
?
In 4 yrs
4
6
?
In 5 yrs
5
7
?
1,200
14,913.90
END Mode
Enter
5
N
15.2
I%
-1,200
PV
Solve for
PMT
-1,843.55
14,913.90
FV
Answer: A, as $1,843.55 is an amount equal to or greater than $1,700 but less than $1,900
41

course.
Solve in two parts:
Time
2 yrs ago 1 yr ago
Today
Time
-2
-1
0
Re-time
0
1
2
invest
7,300
Fut val
In 1 yr
1
3
In 2 yrs
2
4
In 3 yrs
3
5
In 4 yrs
4
6
In 5 yrs
5
7
?
C0 = 7,300
t = 7 years
So, she would have 7,300 + (7,300 .194 7) = 7,300 + 9,913.40 = 17,213.40
Time
Time
Re-time
invest
init val
Fut val
2 yrs ago
-2
0
1 yr ago
-1
1
Today
0
2
In 1 yr
1
3
?
In 2 yrs
2
4
?
In 3 yrs
3
5
?
In 4 yrs
4
6
?
In 5 yrs
5
7
?
1,200
17,213.40
END Mode
Enter
5
N
15.2
I%
-1,200
PV
Solve for
PMT
-2,183.25
17,213.40
FV
Answer: C, as $2,183.25 is an amount equal to or greater than $2,100 but less than $2,300
42

Growth rate on perpetuity after saving with FV annuity due
Step 1: find how much money will be in the trust fund in 5 years (which is one year before the
scholarship payments start)
Step 2: find the annual growth rate of scholarship payments
Time period
Savings #
Savings amount
Future value
Present value
Donation #
Donation amt
0
1
80k
1
2
80k
2
3
80k
3
4
80k
4
5
80k
1
17,000
2
17,000(1+g)
3
17,000(1+g)2
?A
?A
Step 1: find how much money will be in the trust fund in 5 years (denoted by ?A)
If the first savings donation is made later today and savings donation are made for 5 years, then the
amount of money accumulated in 5 years can be found by finding the future value of a 5-year
annuity due, since the first payment will be made today, there will be 5 expected payments, and all
expected payments will be equal.
BEGIN mode
Enter
5
N
12.1
I%
0
PV
-80,000
PMT
Solve for
In 5 years, the scholarship fund is expected to have $570,856
FV
570,856
Step 2: find the growth rate of scholarship payments

The first scholarship payment is expected 1 year after the reference point, when the fund is
expected to have $570,856. That payment is expected to be $17,000. To find the growth rate in
scholarship payments, we need to find the growth rate associated with a growing perpetuity with a
present value of $570,856, a discount rate of 12.1%, and a payment in 1 year of $17,000.
PV5 = C6 / (r g) or resetting the timeline gets PV0 = C1 / (r g)
So r = (C1 / PV0) + g and g = r (C1 / PV0)
So g = r (C1 / PV0)
= .121 17,000 / 570,856
= .121 .0298
= .0912
Answer: E
9.12% is a rate less than 5.00% or a rate greater than or equal to 9.00%
43

Time period
Savings #
Savings amount
Future value
Present value
Donation #
Donation amt
0
1
80k
1
2
80k
2
3
80k
3
4
80k
4
5
80k
1
19,000
2
19,000(1+g)
3
19,000(1+g)2
?A
?A
BEGIN mode
Enter
5
N
11.6
I%
0
PV
Solve for
-80,000
PMT
FV
562,691

So g = r (C1 / PV0)
= .116 19,000 / 562,691
= .116 .0338
= .0822
Answer: D
8.22% is a rate equal to or greater than 8.00% but less than 9.00%
44

Time period
Savings #
Savings amount
Future value
Present value
Donation #
Donation amt
0
1
80k
1
2
80k
2
3
80k
3
4
80k
4
5
80k
1
17,000
2
17,000(1+g)
3
17,000(1+g)2
?A
?A
BEGIN mode
Enter
5
N
10.3
I%
0
PV
Solve for
-80,000
PMT
FV
541,941

So g = r (C1 / PV0)
= .103 17,000 / 541,941
= .103 .0314
= .0716
Answer: C
45

Time period
Savings #
Savings amount
Future value
Present value
Donation #
Donation amt
0
1
80k
1
2
80k
2
3
80k
3
4
80k
4
5
80k
1
19,000
2
19,000(1+g)
3
19,000(1+g)2
?A
?A
BEGIN mode
Enter
5
N
9.7
I%
0
PV
Solve for
-80,000
PMT
FV
532,593

So g = r (C1 / PV0)
= .097 19,000 / 532,593
= .097 .0357
= .0613
Answer: B
46

Find payment with PV annuity and an extra, interim cash flow
annual payment.
A. $1,414.90 (plus or minus $1)
B. $1,170.96 (plus or minus $1)
C. $1,481.76 (plus or minus $1)
D. $1,767.08 (plus or minus $1)
E. None of the above is within $1 of the correct answer
Time
Payment #
Regular Pmt amt
Extra Pmt
Present value
0
0
0
0
-$8,300
1
1
?
0
2
2
?
0
3
3
?
0
4
4
?
0
5
5
?
-2,800
6
6
?
0
7
7
?
0
The annual payment can not be found in one step on the financial calculator.
Approach
1) Find the present value of the extra payment made in 5 years
2) Find the present value of the stream of regular payments
3) Find the amount of each regular payment
The present value of a -$2,800 cash flow in 5 years at an annual rate of 11.1% is equal to:
-2,800/1.1115 = -1,654.20
The present value of all cash flows associated with all loan payments is -8,300
If the -2,800 cash flow in 5 years has a present value of -1,654.20, then the present value of
the 7 annual fixed cash flows that start in 1 year and end in 7 years is equal to:
-8,300 (-1,654.20) = -6,645.80
Find the payment associated with an annuity with a present value of -6,645.80, a total of 7
payments, and a periodic discount rate of 11.1%
END mode
Enter
Solve for
7
N
11.1
I%
PMT
-1,414.90
47
6,645.80
PV
0
FV

annual payment.
A. $1,238.81 (plus or minus $1)
B. $872.90 (plus or minus $1)
C. $1,339.10 (plus or minus $1)
D. $1,767.08 (plus or minus $1)
Time
Payment #
Regular Pmt amt
Extra Pmt
Present value
0
0
0
0
-$8,300
1
1
?
0
2
2
?
0
3
3
?
0
4
4
?
0
5
5
?
-4,200
6
6
?
0
7
7
?
0
Approach
-4,200/1.1115 = -2,481.30
-8,300 (-2,481.30) = -5,818.70
END mode
Enter
Solve for
7
N
11.1
I%
PMT
-1,238.81
48
5,818.70
PV
0
FV

annual payment.
A. $1,353.82 (plus or minus $1)
B. $1,133.45 (plus or minus $1)
C. $1,416.25 (plus or minus $1)
D. $1,710.48 (plus or minus $1)
Time
Payment #
Regular Pmt amt
Extra Pmt
Present value
0
0
0
0
-$8,300
1
1
?
0
2
2
?
0
3
3
?
0
4
4
?
0
5
5
?
-2,800
6
6
?
0
7
7
?
0
Approach
-2,800/1.1015 = -1,730.70
-8,300 (-1,730.70) = -6,596.30
END mode
Enter
Solve for
7
N
10.1
I%
PMT
-1,353.82
49
6,596.30
PV
0
FV

annual payment.
A. $1,175.48 (plus or minus $1)
B. $844.94 (plus or minus $1)
C. $1,269.14 (plus or minus $1)
D. $1,710.48 (plus or minus $1)
Time
Payment #
Regular Pmt amt
Extra Pmt
Present value
0
0
0
0
-$8,300
1
1
?
0
2
2
?
0
3
3
?
0
4
4
?
0
5
5
?
-4,200
6
6
?
0
7
7
?
0
Approach
-4,200/1.1015 = -2,596.05
-8,300 (-2,596.05) = -5,703.95
END mode
Enter
Solve for
7
N
10.1
I%
PMT
-1,175.48
50
5,703.95
PV
0
FV

Quantitative: discount a single cash flow with a periodic rate that must be computed
Timeline tip: compounding occurs quarterly, so the relevant period is a quarter
2 years = 2 years 4 quarters per year = 8 quarters
Quarterly rate = annual rate / number of quarters per year
= 17.2 percent / 4 = 4.3 percent
PV = $12,300 / (1.043)8 = $8,782.75
Enter
8
4.3
N
I%
PV
Solve for
-8,782.75
0
PMT
12,300
FV
Answer: E
$8,782.75 is an amount less than $8,900 or an amount equal to or greater than $9,800
51

PV = $13,200 / (1.043)8 = $9,425.39
Enter
8
4.3
N
I%
PV
Solve for
-9,425.39
0
PMT
13,200
FV
Answer: C
$9,425.39 is an amount equal to or greater than $9,300 but less than $9,500
52

PV = $12,300 / (1.039)8 = $9,056.92
Enter
8
3.9
N
I%
PV
Solve for
-9,056.92
0
PMT
12,300
FV
Answer: A
53

PV = $13,200 / (1.039)8 = $9,719.63
Enter
8
3.9
N
I%
PV
Solve for
-9,719.63
0
PMT
13,200
FV
Answer: D
54

Quantitative: find return for a bond
E. None of the above is within 0.02 percentage points of the correct answer
Rate of return = (cash flows from investment + capital gain) price at start of period
= (cash flows from investment + price at period-end price at period-start) price at period-start
1. Cash flows from investment = coupon that was just paid in this case
= coupon rate face coupons per year = .164 1,000 1 = $164
2. Price at start of period = price of the bond 1 year ago = price of a bond with the following:
If the bond matures in 5 years from today, then it matures in 6 years from 1 year ago, so
N = 6 years 1 coupon per year = 6
I% = YTM # coupons per year = 17.1 1 = 17.1
PMT = par coupon rate # coupons per year = 1000 16.4% 1 = 164
FV = 1,000 = par
END mode
Enter
6
N
17.1
I%
Solve for
164
PMT
PV
-974.94
1,000
FV
3. Price at end of period = price of bond today = price of a bond with the following:
FV = 1,000 = par
END mode
Enter
5
N
17.7
I%
Solve for
164
PMT
PV
-959.07
Rate of return
Cash flows from investment = $164.00
Price at start of period = $974.94
Price at end of period = $959.07
Rate of return = (164.00 + 959.07 974.94) / 974.94
= (164.00 + (-15.87)) / 974.94
= 148.13 / 974.94 = .1519 = 15.19%
55
1,000
FV

FV = 1,000 = par
END mode
Enter
6
N
17.3
I%
Solve for
166
PMT
PV
-975.07
1,000
FV
FV = 1,000 = par
END mode
Enter
5
N
17.9
I%
Solve for
166
PMT
PV
-959.25
Rate of return
Rate of return = (166.00 + 959.25 975.07) / 975.07
= (166.00 + (-15.82)) / 975.07
= 150.18 / 975.07 = .1540 = 15.40%
56
1,000
FV

FV = 1,000 = par
END mode
Enter
6
N
16.8
I%
Solve for
164
PMT
PV
-985.57
1,000
FV
FV = 1,000 = par
END mode
Enter
5
N
17.4
I%
Solve for
164
PMT
PV
-968.30
Rate of return
Rate of return = (164.00 + 968.30 985.57) / 985.57
= (164.00 + (-17.27)) / 985.57
= 146.73 / 985.57 = .1489 = 14.89%
57
1,000
FV

FV = 1,000 = par
END mode
Enter
6
N
17.2
I%
Solve for
166
PMT
PV
-978.58
1,000
FV
FV = 1,000 = par
END mode
Enter
5
N
17.8
I%
Solve for
166
PMT
PV
-962.30
Rate of return
Rate of return = (166.00 + 962.30 978.58) / 978.58
= (166.00 + (-16.28)) / 978.58
= 149.72 / 978.58 = .1530 = 15.30%
58
1,000
FV

Identifying riskier stock after computing 2 expected returns
unchanged forever?
Stock A
Expected return = expected dividend yield + expected capital appreciation yield
Expected dividend yield = 2.3 percent = .023
Expected capital appreciation yield = 3.4 percent = .034
Expected return = .023 + .034 = .057 = 5.7 percent
Stock B
P0 = (D1 + P1) / (1 + expected return) = (D1 + P1) / (1 + R)
P0 = 54.50
D1 = 4.30
P1 = 53.40
54.50 = (4.30 + 53.40) / (1 + R)
54.50 = 57.70 / (1 + R)
1 + R = [57.70 / 54.50] = 1.0587
R = 1.0587 1 = 0.0587 = 5.87 percent
Expected return of stock B = 5.87% > 5.7% = expected return of stock A
Stock B is more risky than stock A
59

unchanged forever?
Stock A
Stock B
P0 = 54.50
D1 = 5.40
P1 = 53.40
54.50 = (5.40 + 53.40) / (1 + R)
54.50 = 58.80 / (1 + R)
1 + R = [58.80 / 54.50] = 1.0789
R = 1.0789 1 = 0.0789 = 7.89 percent
Expected return of stock B = 7.89% > 7.5% = expected return of stock A
Stock B is more risky than stock A
60

unchanged forever?
Stock A
Stock B
P0 = 45.40
D1 = 4.30
P1 = 43.50
45.40 = (4.30 + 43.50) / (1 + R)
45.40 = 47.80 / (1 + R)
1 + R = [47.80 / 45.40] = 1.0529
R = 1.0529 1 = 0.0529 = 5.29 percent
Expected return of stock A = 5.7% > 5.29% = expected return of stock B
Stock A is more risky than stock B
61

unchanged forever?
Stock A
Stock B
P0 = 45.40
D1 = 5.20
P1 = 43.50
45.40 = (5.20 + 43.50) / (1 + R)
45.40 = 48.70 / (1 + R)
1 + R = [48.70 / 45.40] = 1.0727
R = 1.0727 1 = 0.0727 = 7.27 percent
Expected return of stock A = 7.5% > 7.27% = expected return of stock B
Stock A is more risky than stock B
62

Price bond and then get fixed dividend
The stock has an expected return of 18.7 percent per year. What is the next dividend expected to
be?
A. $30.34 (plus or minus $0.05)
B. $25.21 (plus or minus $0.05)
C. $27.26 (plus or minus $0.05)
D. $23.69 (plus or minus $0.05)
E. None of the above is within $0.05 of the correct answer
Since the stocks annual dividends are expected to remain constant forever and the next
annual dividend is due in 1 year, P0 = D1 / R
We know that R = .187
We dont know what P0 and D1 are, but we know that bond value + stock value (P0) = $1,100
If we find the bond value, we can find the stock value, and we can find D1
Finding the bond value
N = 4 years 2 coupons per year = 8
FV = 1,000 = par
END mode
Enter
8
N
8.4
I%
Solve for
73
PMT
PV
-937.74
1000
FV
Finding the stock value

Since bond value + stock value = $1,100, stock value = $1,100 $937.74 = $162.26
Finding the expected dividend
Since P0 = D1/ R
Then $162.26 = D1 / .187
So D1 = $162.26 .187 = $30.34
63

be?
A. $29.05 (plus or minus $0.05)
B. $24.11 (plus or minus $0.05)
C. $25.75 (plus or minus $0.05)
D. $22.61 (plus or minus $0.05)
FV = 1,000 = par
END mode
Enter
8
N
8.2
I%
Solve for
72
PMT
PV
-942.97
1000
FV

Since P0 = D1/ R
Then $157.03 = D1 / .185
So D1 = $157.03 .185 = $29.05
64

be?
A. $29.28 (plus or minus $0.05)
B. $25.90 (plus or minus $0.05)
C. $26.31 (plus or minus $0.05)
D. $23.18 (plus or minus $0.05)
FV = 1,000 = par
END mode
Enter
8
N
8.4
I%
Solve for
74
PMT
PV
-943.40
1000
FV

Since P0 = D1/ R
Then $156.60 = D1 / .187
So D1 = $156.60 .187 = $29.28
65

be?
A. $30.76 (plus or minus $0.05)
B. $27.22 (plus or minus $0.05)
C. $26.69 (plus or minus $0.05)
D. $23.11 (plus or minus $0.05)
FV = 1,000 = par
END mode
Enter
8
N
8.2
I%
Solve for
71
PMT
PV
-937.26
1000
FV

Since P0 = D1/ R
Then $162.74 = D1 / .189
So D1 = $162.74 .189 = $30.76
66

Rank securities by risk, which is reflected through expected return or YTM
A. The expected annual return on the common stock is less than 13%
E. The expected annual return on the common stock is greater than 17%
Patriot Theaters common stock is most likely to be the most risky, Patriot Theaters bonds
are most likely to be the least risky, and Patriot Theaters preferred stock is most likely to
be in the middle.
Therefore, Patriot Theaters common stock should have the highest expected return, Patriot
Theaters bonds should have the lowest expected return as measured by YTM, and Patriot
Theaters preferred stock should have an expected return that is in between the expected
return of common stock and the YTM of bonds.
Thus, the answer is E as the expected annual return on the common stock is greater than
17% is the assertion that is most likely to be true.
67

A. The expected annual return on the preferred stock is less than 13%
E. The expected annual return on the preferred stock is greater than 17%
be in the middle.
Thus, the answer is C as the expected annual return on the preferred stock is greater than
13% but less than 17% is the assertion that is most likely to be true.
68

A. The expected annual return on the common stock is greater than 22%
E. The expected annual return on the common stock is less than 17%
be in the middle.
Thus, the answer is A as the expected annual return on the common stock is greater than
22% is the assertion that is most likely to be true.
69

A. The expected annual return on the preferred stock is greater than 22%
E. The expected annual return on the preferred stock is less than 17%
be in the middle.
Thus, the answer is C as the expected annual return on the preferred stock is greater than
17% but less than 22% is the assertion that is most likely to be true.
70

Compute maximum value that can be created and compute NPV
Discounted
Internal
Average
Initial
Net present
Payback
payback
rate of
accounting
investment
value
period
period
return
return
(in years)
(in %)
(in %)
A
2.3
3.3
3.4
4.1
6.1
-2.7
B
1.7
-2.8
2.3
19.8
20.1
C
4.2
8.9
0.9
4.9
4.4
12.7
0
1
2
3
4
D
8.0%
-5.0
12.0
9.0
-8.0
-3.0
E
10.0%
-10.0
1.0
2.0
3.0
4.0
The value created by pursuing a project is its NPV, so the most value that can be created
would be the aggregate NPV of all projects with positive NPV.
Among projects A, B, and C, projects A and C have positive NPV, so pursuing each of them would
increase the amount of value created. Therefore, each should be undertaken.
The NPVs of projects D and E must be computed.
NPV (D) = [-5.0] + [12.0/1.08] + [9.0/1.082] + [-8.0/1.083] + [-3.0/1.084] = 5.3
Project D: npv(8.0,-5.0,{12.0,9.0,-8.0,-3.0}) 5.3
Project D has a positive NPV, so pursuing it would increase the amount of value created, so it should
be undertaken.
NPV (E) = [-10.0] + [1.0/1.10] + [2.0/1.102] + [3.0/1.103] + [4.0/1.104] = -2.5
Project E: npv(10.0,-10.0,{1.0,2.0,3.0,4.0}) -2.5
Project E has a negative NPV, so pursuing it would decrease the amount of value created, so it should
not be undertaken.
Among all 5 projects, Patriot Theaters should pursue projects A, C, and D
Value created by pursuing projects with positive NPV (in $ millions) is the sum of their NPVs
= 3.3 + 8.9 + 5.3 = 17.5
Answer: D, $17.5 million is an amount less than $9 million or an amount equal to or greater
than $16 million

71

Discounted
Internal
Average
Initial
Net present
Payback
payback
rate of
accounting
investment
value
period
period
return
return
(in years)
(in %)
(in %)
A
2.3
4.2
3.4
4.1
6.1
-2.7
B
4.2
7.3
0.9
4.9
4.4
12.7
C
1.7
-5.9
2.3
19.8
20.1
0
1
2
3
4
D
8.0%
-5.0
12.0
9.0
-8.0
-6.0
E
10.0%
-10.0
1.0
2.0
3.0
4.0
Among projects A, B, and C, projects A and B have positive NPV, so pursuing each of them would
NPV (D) = [-5.0] + [12.0/1.08] + [9.0/1.082] + [-8.0/1.083] + [-6.0/1.084] = 3.1
Project D: npv(8.0,-5.0,{12.0,9.0,-8.0,-6.0}) 3.1
Project D has a positive NPV, so pursuing it would increase the amount of value created, so it should
be undertaken.
NPV (E) = [-10.0] + [1.0/1.10] + [2.0/1.102] + [3.0/1.103] + [4.0/1.104] = -2.5
Project E: npv(10.0,-10.0,{1.0,2.0,3.0,4.0}) -2.5
Project E has a negative NPV, so pursuing it would decrease the amount of value created, so it should
not be undertaken.
Among all 5 projects, Patriot Theaters should pursue projects A, B, and D
= 4.2 + 7.3 + 3.1 = 14.6
Answer: C
$14.6 million is an amount equal to or greater than $14 million and less than $16 million
72

Discounted
Internal
Average
Initial
Net present
Payback
payback
rate of
accounting
investment
value
period
period
return
return
(in years)
(in %)
(in %)
A
4.4
-3.9
0.9
21.4
12.9
B
1.6
6.1
2.5
2.9
19.8
20.3
C
2.7
3.5
3.2
4.1
6.1
-2.8
0
1
2
3
4
D
8.0%
-10.0
12.0
9.0
-8.0
-6.0
E
10.0%
-5.0
1.0
2.0
3.0
4.0
Among projects A, B, and C, projects B and C have positive NPV, so pursuing each of them would
NPV (D) = [-10.0] + [12.0/1.08] + [9.0/1.082] + [-8.0/1.083] + [-6.0/1.084] = -1.9
Project D: npv(8.0,-10.0,{12.0,9.0,-8.0,-3.0}) -1.9
Project D has a negative NPV, so pursuing it would decrease the amount of value created, so it should
not be undertaken.
NPV (E) = [-5.0] + [1.0/1.10] + [2.0/1.102] + [3.0/1.103] + [4.0/1.104] = 2.5
Project E: npv(10.0,-5.0,{1.0,2.0,3.0,4.0}) 2.5
Project E has a positive NPV, so pursuing it would increase the amount of value created, so it should
be undertaken.
Among all 5 projects, Patriot Theaters should pursue projects B, C, and E
= 6.1 + 3.5 + 2.5 = 12.1
Answer: B
73

Discounted
Internal
Average
Initial
Net present
Payback
payback
rate of
accounting
investment
value
period
period
return
return
(in years)
(in %)
(in %)
A
1.9
4.9
2.6
4.9
19.9
21.4
B
4.1
-3.2
0.9
21.6
13.7
C
2.2
1.9
3.9
4.5
6.8
-3.8
0
1
2
3
4
D
10.0%
-10.0
12.0
9.0
-8.0
-6.0
E
8.0%
-5.0
1.0
2.0
3.0
4.0
Among projects A, B, and C, projects A and C have positive NPV, so pursuing each of them would
NPV (D) = [-10.0] + [12.0/1.10] + [9.0/1.102] + [-8.0/1.103] + [-6.0/1.104] = -1.8
Project D: npv(10.0,-10.0,{12.0,9.0,-8.0,-3.0}) -1.8
Project D has a negative NPV, so pursuing it would decrease the amount of value created, so it should
not be undertaken.
NPV (E) = [-5.0] + [1.0/1.08] + [2.0/1.082] + [3.0/1.083] + [4.0/1.084] = 3.0
Project E: npv(8.0,-5.0,{1.0,2.0,3.0,4.0}) 3.0
Project E has a positive NPV, so pursuing it would increase the amount of value created, so it should
be undertaken.
Among all 5 projects, Patriot Theaters should pursue projects A, C, and E
= 4.9 + 1.9 + 3.0 = 9.8
Answer: A
74

Find NPV from revs/costs/investment/asset sale
In a given year, the relevant cash flow for a project
= operating cash flow + cash flow effects from changes in net working capital + cash flow from capital
spending + cash flow from selling project + terminal value opportunity costs
In this case, cash flow effects from changes in net working capital, cash flow from selling project,
terminal value, and opportunity costs are zero in each year. Therefore, to get relevant cash flow is each
year, we need to find operating cash flow and cash flow from capital spending.
Annual SL depreciation = (investment amount asset is depreciated to) / depreciable life
= (600,000 0) / 5 = 120,000 per year
OCF
Year
0
1
2
Revenues
0
440,000
440,000
Costs
0
260,000
260,000
Annual depreciation
0
120,000
120,000
EBIT (revs costs depreciation)
0
60,000
60,000
Tax rate
0.40
0.40
0.40
Taxes
0
24,000
24,000
Net income = EBIT taxes
0
36,000
36,000
OCF = Net income + depreciation
0
156,000
156,000
CF from asset sale
Accumulated depreciation = 0 + 120,000 + 120,000 = 240,000
Book value = 600,000 240,000 = 360,000
Taxable gain on asset sale = 420,000 360,000 = 60,000
Taxes on sale of asset = 60,000 .40 = 24,000
CF from asset sale = 420,000 24,000 = 396,000
Relevant CF
Year
1
156,000
0
0
0
0
0
156,000
0
2
OCF
0
156,000
Cash flow effects from NWC
0
0
CF from capital spending
-600,000
396,000
CF from project sale
0
0
Terminal value
0
0
Opportunity costs
0
0
Relevant CF
-600,000
552,000
npv(9,-600000,{156000,552000}) 7,727
Answer: A, $7,727 is an amount equal to or greater than $0 but less than $30,000
75

= (600,000 0) / 5 = 120,000 per year
OCF
Year
0
1
2
Revenues
0
460,000
460,000
Costs
0
220,000
220,000
Annual depreciation
0
120,000
120,000
0
120,000
120,000
Tax rate
0.40
0.40
0.40
Taxes
0
48,000
48,000
0
72,000
72,000
0
192,000
192,000
CF from asset sale
Book value = 600,000 240,000 = 360,000
Relevant CF
0
0
0
-600,000
0
0
0
-600,000
Year
1
192,000
0
0
0
0
0
192,000
2
OCF
192,000
0
396,000
0
Terminal value
0
Opportunity costs
0
Relevant CF
588,000
npv(8,-600000,{192000,588000}) 81,893
Answer: C, $81,893 is an amount equal to or greater than $60,000 but less than $90,000
76

= (600,000 0) / 5 = 120,000 per year
OCF
Year
0
1
2
Revenues
0
440,000
440,000
Costs
0
260,000
260,000
Annual depreciation
0
120,000
120,000
0
60,000
60,000
Tax rate
0.40
0.40
0.40
Taxes
0
24,000
24,000
0
36,000
36,000
0
156,000
156,000
CF from asset sale
Book value = 600,000 240,000 = 360,000
Relevant CF
0
0
0
-600,000
0
0
0
-600,000
Year
1
156,000
0
0
0
0
0
156,000
2
OCF
156,000
0
432,000
0
Terminal value
0
Opportunity costs
0
Relevant CF
588,000
npv(9,-600000,{156000,588000}) 38,027
Answer: B, $38,027 is an amount equal to or greater than $30,000 but less than $60,000
77

= (600,000 0) / 5 = 120,000 per year
OCF
Year
0
1
2
Revenues
0
460,000
460,000
Costs
0
220,000
220,000
Annual depreciation
0
120,000
120,000
0
120,000
120,000
Tax rate
0.40
0.40
0.40
Taxes
0
48,000
48,000
0
72,000
72,000
0
192,000
192,000
CF from asset sale
Book value = 600,000 240,000 = 360,000
Relevant CF
0
0
0
-600,000
0
0
0
-600,000
Year
1
192,000
0
0
0
0
0
192,000
2
OCF
192,000
0
432,000
0
Terminal value
0
Opportunity costs
0
Relevant CF
624,000
npv(8,-600000,{192000,624000}) 112,757
Answer: D, $112,757 is an amount equal to or greater than $90,000 but less than $120,000
78

Find NPV from OCF, CF from capital spending, and NWC levels
Year 0
Year 1
Year 2
Year 3
$0
$3,000
$3,000
$3,000
-$14,000
$0
$0
$11,000
A $3,699 (plus or minus $10)
B. $4,510 (plus or minus $10)
C. -$6,439 (plus or minus $10)
D. $11,391 (plus or minus $10)
Relevant cash flows in a given year = OCF + CF effects from NWC + CF from capital
spending + CF from project sale + terminal value opportunity costs. In this problem,
opportunity costs = 0, CF from project sale = 0, and terminal value = 0. Therefore, relevant
cash flows in a given year = OCF + CF effects from NWC + CF from capital spending
We are given OCF and CF from capital spending. We are given NWC for each point in
time (years 0, 1, 2, and 3) and must compute NWC as NWC at the end of a period minus
NWC at the start of the period and the cash flow effects from NWC as NWC.
Year
OCF
0
0
1
3,000
2
3,000
3
3,000
NWC
2,000
NWC
2,000
-2,000
6,000
6,000
2,000 =
4,000
-4,000
3,000
3,000
6,000 =
-3,000
3,000
0
0
3,000 =
-3,000
3,000
-14,000
11,000
Rel CF (OCF+CF NWC+CF cap spend)
-16,000
-1,000
6,000
17,000
npv(4,-16000,{-1000,6000,17000}) 3,699
79

Year 0
Year 1
Year 2
Year 3
$0
$3,000
$3,000
$3,000
-$14,000
$0
$0
$11,000
A. $4,673 (plus or minus $10)
C. -$12,535 (plus or minus $10)
Year
OCF
0
0
1
3,000
2
3,000
3
3,000
NWC
4,000
NWC
4,000
-4,000
5,000
5,000
4,000 =
1,000
-1,000
9,000
9,000
5,000 =
4,000
-4,000
0
0
9,000 =
-9,000
9,000
-14,000
11,000
-18,000
2,000
-1,000
23,000
npv(2,-18000,{2000,-1000,23000}) 4,673
80

Year 0
Year 1
Year 2
Year 3
$0
$3,000
$3,000
$3,000
-$14,000
$0
$0
$11,000
C. -$8,862 (plus or minus $10)
Year
OCF
0
0
1
3,000
2
3,000
3
3,000
NWC
4,000
NWC
4,000
-4,000
2,000
2,000
4,000 =
-2,000
2,000
7,000
7,000
2,000 =
5,000
-5,000
0
0
7,000 =
-7,000
7,000
-14,000
11,000
-18,000
5,000
-2,000
21,000
npv(6,-18000,{5000,-2000,21000}) 2,569
81

Year 0
Year 1
Year 2
Year 3
$0
$3,000
$3,000
$3,000
-$14,000
$0
$0
$11,000
C. -$13,872 (plus or minus $10)
Year
OCF
0
0
1
3,000
2
3,000
3
3,000
NWC
7,000
NWC
7,000
-7,000
4,000
4,000
7,000 =
-3,000
3,000
8,000
8,000
4,000 =
4,000
-4,000
0
0
8,000 =
-8,000
8,000
-14,000
11,000
-21,000
6,000
-1,000
22,000
npv(3,-21000,{6000,-1000,22000}) 4,016
82

Find the tax rate from an incomplete project income statement with partial sunk costs
The cost is partially sunk in 1 year. Patriot Theaters must pay $15,000 in 1 year if it does the
project and $20,000 in 1 year if it does not do the project, so the incremental cost would be $15,000
$20,000 = -$5,000. Therefore, -$5,000 of the fixed cost should be included in the cost of the project
in 1 year. Note that the incremental effect of pursuing the project is to lower fixed costs.
Since total costs = fixed costs + variable costs, total costs = (-$5,000) + $35,000 = $30,000
To solve:
1) Find expected taxable income
2) Find expected taxes paid
3) Find the expected tax rate
Revenue
Total costs
Annual depreciation
EBIT = taxable income
Year 1
95,000
30,000
0
65,000
Taxable income = EBIT = revenues costs depreciation

95,000 30,000 0 = 65,000
Net income = taxable income taxes
31,000 = 65,000 taxes
So taxes = 65,000 31,000 = 34,000
The tax rate = taxes paid / taxable income
= 34,000 / 65,000
0.523 = 52.3%
Answer: D
83

To solve:
Revenue
Total costs
Annual depreciation
Year 1
95,000
30,000
0
65,000

95,000 30,000 0 = 65,000
37,000 = 65,000 taxes
So taxes = 65,000 37,000 = 28,000
= 28,000 / 65,000
0.431 = 43.1%
Answer: B
84

To solve:
Revenue
Total costs
Annual depreciation
Year 1
95,000
25,000
0
70,000

95,000 25,000 0 = 70,000
36,000 = 70,000 taxes
So taxes = 70,000 36,000 = 34,000
= 34,000 / 70,000
0.486 = 48.6%
Answer: C
85

To solve:
Revenue
Total costs
Annual depreciation
Year 1
95,000
25,000
0
70,000

95,000 25,000 0 = 70,000
29,000 = 70,000 taxes
So taxes = 70,000 29,000 = 41,000
= 41,000 / 70,000
0.586 = 58.6%
Answer: E
86

Conceptual:usingbasecaseNPVtomakefinaldecisions
istrue?
$27,000
$230,000
$420,000
$210,000
18%
RecallthatyoushouldcomputeabasecaseNPVbasedonfinalestimates,pursuethe
projectwhenthatbasecaseNPVispositive,andrejecttheprojectwhenthatbasecase
NPVisnegative.In this case, the base-case NPV based on final estimates and expectations
is positive, so Patriot Theaters should accept the project.
IfawhatifanalysisproducesanegativeNPV,butthebasecaseNPVbasedon
expectationsispositive,thenpursuetheproject.Ifawhatifanalysisproducesapositive
NPV,butthebasecaseNPVbasedonexpectationsisnegative,thendonotpursuethe
project.
87

istrue?
$27,000
$230,000
$210,000
$420,000
81%
is negative, so Patriot Theaters should reject the project.
project.
88

istrue?
$27,000
$230,000
$420,000
$210,000
18%
is positive, so Patriot Theaters should accept the project.
project.
89

istrue?
$27,000
$230,000
$210,000
$420,000
81%
NPV is negative. In this case, the base-case NPV based on final estimates and expectations
is negative, so Patriot Theaters should reject the project.
If a what-if analysis produces a negative NPV, but the base-case NPV based on expectations
is positive, then pursue the project. If a what-if analysis produces a positive NPV, but the
base-case NPV based on expectations is negative, then do not pursue the project.
90

Get geometric from arithmetic and all but one return
To solve:
1) Find the return from 4 years ago
2) Use the returns from the past four years to get the geometric return
Arithmetic annual return = [(r1) + (r2) + + (rn)] / n
Over the past 4 years, arithmetic annual return = [(r1) + (r2) + (r3) + (r4)] / 4
So .050 = [(.210) + (-.200) + (.320) + (r4)] / 4
So .050 4 = [(.210) + (-.200) + (.320) + (r4)]
So .200 = [(.210) + (-.200) + (.320) + (r4)]
= (.330) + (r4)
So .200 (.330) = r4
r4 = -.130
Geometric annual return = [(1 + r1)(1 + r2) (1 + rn)]1/n 1
Over the past four years, geometric annual return = [(1 + r1)(1 + r2)( 1 + r3)(1 + r4)]1/4 1
= [(1 + .210)(1 + (-.200))(1 + .320)(1 + (-.130)]1/4 1
= [(1.210)(0.800)(1.320)(0.870)]1/4 1
= [1.1116512]1/4 1
= 1.0268 1
= .0268 = 2.68%
Answer: A
91

To solve:
So .080 = [(.210) + (-.200) + (.320) + (r4)] / 4
So .080 4 = [(.210) + (-.200) + (.320) + (r4)]
So .320 = [(.210) + (-.200) + (.320) + (r4)]
= (.330) + (r4)
So .320 (.330) = r4
r4 = -.010
= [(1 + .210)(1 + (-.200))(1 + .320)(1 + (-.010)]1/4 1
= [(1.210)(0.800)(1.320)(0.990)]1/4 1
= [1.2649824]1/4 1
= 1.0605 1
= .0605 = 6.05%
Answer: D
92

To solve:
So .060 = [(.120) + (-.200) + (.390) + (r4)] / 4
So .060 4 = [(.120) + (-.200) + (.390) + (r4)]
So .240 = [(.120) + (-.200) + (.390) + (r4)]
= (.300) + (r4)
So .240 (.310) = r4
r4 = -.007
= [(1 + .120)(1 + (-.200))(1 + .390)(1 + (-.070)]1/4 1
= [(1.120)(0.800)(1.390)(0.930)]1/4 1
= [1.1582592]1/4 1
= 1.0374 1
= .0374 = 3.74%
Answer: B
93

To solve:
So .070 = [(.120) + (-.200) + (.390) + (r4)] / 4
So .070 4 = [(.120) + (-.200) + (.390) + (r4)]
So .280 = [(.120) + (-.200) + (.390) + (r4)]
= (.300) + (r4)
So .280 (.310) = r4
r4 = -.003
= [(1 + .120)(1 + (-.200))(1 + .390)(1 + (-.030)]1/4 1
= [(1.120)(0.800)(1.390)(0.970)]1/4 1
= [1.2080768]1/4 1
= 1.0484 1
= .0484 = 4.84%
Answer: C
94

Get expected SD from 2 states and P0, D1, and P1
Outcome
outcome
stock in 1 year
Theaters in 1 year
Good
.7
$85
$11
Bad
.3
$59
$5
Find the return for Patriot Theaters for each possible outcome
Return = (dividends + ending price initial price) / initial price
Return in good = ($11 + $85 $80) / $80 = $16 / $80 = 0.200
Return in bad = ($5 + $59 $80) / $80 = -$16 / $80 = -0.200
Outcome
R(s)
Good
Bad
Total
0.200
-0.200
Weight
for mean
p(s)
0.70
0.30
E(R) =
p(s)
R(s)
R(s)
E(R)
[R(s)
E(R)]2
0.140
-0.060
0.080
0.120
-0.280
0.0144
0.0784
Weight
for var
p(s)
0.70
0.30
Var(R) =
SD(R) =
Answer: D
95
p(s)
[R(s) E(R)]2
0.01008
0.02352
0.03360
0.183 = 18.3%

Outcome
outcome
stock in 1 year
Theaters in 1 year
Good
.7
$85
$15
Bad
.3
$59
$1
Return in good = ($15 + $85 $80) / $80 = $20 / $80 = 0.250
Return in bad = ($1 + $59 $80) / $80 = -$20 / $80 = -0.250
Outcome
R(s)
Good
Bad
Total
0.250
-0.250
Weight
for mean
p(s)
0.70
0.30
E(R) =
p(s)
R(s)
R(s)
E(R)
[R(s)
E(R)]2
0.175
-0.075
0.100
0.150
-0.350
0.0225
0.1225
Weight
for var
p(s)
0.70
0.30
Var(R) =
SD(R) =
Answer: E
96
p(s)
[R(s) E(R)]2
0.01575
0.03675
0.0525
0.229 = 22.9%

Outcome
outcome
stock in 1 year
Theaters in 1 year
Good
.7
$63
$6
Bad
.3
$50
$1
Return in good = ($6 + $63 $60) / $60 = $9 / $60 = 0.150
Return in bad = ($1 + $50 $60) / $60 = -$9 / $60 = -0.150
Outcome
R(s)
Good
Bad
Total
0.150
-0.150
Weight
for mean
p(s)
0.70
0.30
E(R) =
p(s)
R(s)
R(s)
E(R)
[R(s)
E(R)]2
0.105
-0.045
0.060
0.090
-0.210
0.0081
0.0441
Weight
for var
p(s)
0.70
0.30
Var(R) =
SD(R) =
Answer: C
97
p(s)
[R(s) E(R)]2
0.00567
0.01323
0.01890
0.137 = 13.7%

Outcome
outcome
stock in 1 year
Theaters in 1 year
Good
.7
$62
$4
Bad
.3
$52
$2
Return in good = ($4 + $62 $60) / $60 = $6 / $60 = 0.100
Return in bad = ($2 + $52 $60) / $60 = -$6 / $60 = -0.100
Outcome
R(s)
Good
Bad
Total
0.100
-0.100
Weight
for mean
p(s)
0.70
0.30
E(R) =
p(s)
R(s)
R(s)
E(R)
[R(s)
E(R)]2
0.070
-0.030
0.040
0.060
-0.140
0.0036
0.0196
Answer: A
98
Weight
for var
p(s)
0.70
0.30
Var(R) =
SD(R) =
p(s)
[R(s) E(R)]2
0.00252
0.00588
0.00840
0.092 = 9.2%

Risk premium of a portfolio
Risk premium = E(Rp) risk-free return
E(Rp) = [xA E(RA)] + [xB E(RB)]
Approach
1) Find the portfolio weights
2) Find the expected return of the portfolio
3) Find the risk premium for the portfolio
Total value of the portfolio = value of stock A + value of stock B
So value of stock B = Total value of the portfolio value of stock A
Total value of the portfolio = $19,000
Value of stock A = 2,000 shares $6 per share = $12,000
Value of stock B = $19,000 $12,000 = $7,000
xA = $12,000 / $19,000
xB = $7,000 / $19,000
xA = 12,000 / 19,000
xB = 7,000 / 19,000
E(Rp) = [(12,000/19,000) 0.112] + [(7,000/19,000) 0.045]
= 0.0707 + 0.0166 = 0.0873 = 8.73%
Risk premium for the portfolio
= expected return of the portfolio risk-free return
= .0873 .023 = .0643 = 6.43%
Note that the inflation rate and the number of shares of stock B are irrelevant and/or
unnecessary for finding the answer.
99

Approach
Value of stock B = $19,000 $12,000 = $7,000
xA = $12,000 / $19,000
xB = $7,000 / $19,000
xA = 12,000 / 19,000
xB = 7,000 / 19,000
E(Rp) = [(12,000/19,000) 0.112] + [(7,000/19,000) 0.045]
= 0.0707 + 0.0166 = 0.0873 = 8.73%
= .0873 .032 = .0553 = 5.53%
100

Approach
Value of stock B = $19,000 $12,000 = $7,000
xA = $12,000 / $19,000
xB = $7,000 / $19,000
xA = 12,000 / 19,000
xB = 7,000 / 19,000
E(Rp) = [(12,000/19,000) 0.045] + [(7,000/19,000) 0.112]
= 0.0284 + 0.0413 = 0.0697 = 6.97%
= .0697 .023 = .0467 = 4.67%
101

Approach
Value of stock B = $19,000 $12,000 = $7,000
xA = $12,000 / $19,000
xB = $7,000 / $19,000
xA = 12,000 / 19,000
xB = 7,000 / 19,000
E(Rp) = [(12,000/19,000) 0.045] + [(7,000/19,000) 0.112]
= 0.0284 + 0.0413 = 0.0697 = 6.97%
= .0697 .032 = .0377 = 3.77%
102

Ethics of insider trading
A. Insider trading is illegal and should not be considered as a potential approach to
investing
B. Insider trading is illegal and should be considered as a potential approach to investing
C. Insider trading is legal and should not be considered as a potential approach to investing
D. Insider trading is legal and should be considered as a potential approach to investing
Answer: A. Insider trading is illegal and should not be considered as a potential approach
to investing
103

A. Insider trading is illegal and should be considered as a potential approach to investing
B. Insider trading is illegal and should not be considered as a potential approach to
investing
C. Insider trading is legal and should be considered as a potential approach to investing
D. Insider trading is legal and should not be considered as a potential approach to investing
Answer: B. Insider trading is illegal and should not be considered as a potential approach
to investing
104

A. Insider trading is legal and should not be considered as a potential approach to investing
B. Insider trading is legal and should be considered as a potential approach to investing
C. Insider trading is illegal and should not be considered as a potential approach to
investing
D. Insider trading is illegal and should be considered as a potential approach to investing
Answer: C. Insider trading is illegal and should not be considered as a potential approach
to investing
105

A. Insider trading is legal and should be considered as a potential approach to investing
B. Insider trading is legal and should not be considered as a potential approach to investing
C. Insider trading is illegal and should be considered as a potential approach to investing
D. Insider trading is illegal and should not be considered as a potential approach to
investing
Answer: D. Insider trading is illegal and should not be considered as a potential approach
to investing
106

Conceptual: unexpected return on a given day and bank beta
stock is likely to be greater than 1.
Statement 1 is false
The unexpected return for an asset for a given period consists of two portions: the
systematic portion and the unsystematic portion. Both would likely not be zero on a given
day, so the unexpected return for a single stock would likely not be zero on a given day.
Statement 2 is true
The beta of Global National Bank common stock is likely to be greater than 1
Beta > 1 indicates above-average systematic risk and that an assets price tends to change
in response to news that affects the returns of all or virtually all assets with changes that
are in the same direction as the average asset and above-average in magnitude. Examples
would include stocks of firms with performance that tends to vary a lot with economic
conditions such as banks or luxury-goods sellers like Tiffany or Coach.
Answer: C. Statement 1 is false and statement 2 is true
107

stock is likely to be less than 1.
The unexpected return for an asset for a given period consists of two portions: the
systematic portion and the unsystematic portion. Both would likely not be zero on a given
day, so the unexpected return for a single stock would likely not be zero on a given day.
The beta of Global National Bank common stock is likely to be greater than 1
Beta > 1 indicates above-average systematic risk and that an assets price tends to change
in response to news that affects the returns of all or virtually all assets with changes that
are in the same direction as the average asset and above-average in magnitude. Examples
would include stocks of firms with performance that tends to vary a lot with economic
conditions such as banks or luxury-goods sellers like Tiffany or Coach.
Answer: D. Statement 1 is false and statement 2 is false
108

Compute holdings of asset from portfolio and asset betas
p = x11 + x22 = xPTPT + xEWCEWC
We dont know either of the weights, but we know that 1 = xPT + xEWC, so xPT = 1 xEWC
PT = 1.80
EWC = 0.50
p = xPTPT + xEWCEWC
= (1 xEWC)PT + xEWCEWC
= PT xEWCPT + xEWCEWC
So, 1.30 = 1.80 (xEWC)(1.80) + (xEWC)(0.50)
1.30 1.80 = -(xEWC)(1.80) + (xEWC)(0.50)
-0.50 = (xEWC)(-1.80 + 0.50)
xEWC = -0.50 / (-1.80 + 0.50)
xEWC = -0.50 / -1.30 = 0.3846 = 38.46%
38.46% of the value of the portfolio is in East West Cola
Hals East West Cola stock is worth .3846 $1,200 = $461.52
Answers may differ slightly from rounding
Answer: C
$461.52 is an amount equal to or greater than $400 but less than $500
109

PT = 1.80
EWC = 0.50
p = xPTPT + xEWCEWC
So, 1.20 = 1.80 (xEWC)(1.80) + (xEWC)(0.50)
1.20 1.80 = -(xEWC)(1.80) + (xEWC)(0.50)
-0.60 = (xEWC)(-1.80 + 0.50)
xEWC = -0.60 / (-1.80 + 0.50)
xEWC = -0.60 / -1.30 = 0.4615 = 46.15%
Answer: D
110

PT = 1.50
EWC = 0.80
p = xPTPT + xEWCEWC
So, 1.10 = 1.50 (xEWC)(1.50) + (xEWC)(0.80)
1.10 1.50 = -(xEWC)(1.50) + (xEWC)(0.80)
-0.40 = (xEWC)(-1.50 + 0.80)
xEWC = -0.40 / (-1.50 + 0.80)
xEWC = -0.40 / -0.70 = 0.5714 = 57.14%
Answer: E
111

PT = 1.50
EWC = 0.80
p = xPTPT + xEWCEWC
So, 1.30 = 1.50 (xEWC)(1.50) + (xEWC)(0.80)
1.30 1.50 = -(xEWC)(1.50) + (xEWC)(0.80)
-0.20 = (xEWC)(-1.50 + 0.80)
xEWC = -0.20 / (-1.50 + 0.80)
xEWC = -0.20 / -0.70 = 0.2857 = 28.57%
Answer: B
112

Find beta from ERM, RF, and ER of stock
E(Ri) = Rf + (i [E(RM) Rf])
.178 = .047 + (PT [.128 .047])
.178 = .047 + (PT .081)
.178 .047 = (PT .081)
.131 = (PT .081)
PT = .131 / .081 = 1.62
Answer: D
1.62 is an amount equal to or greater than 1.50 but less than 1.70
113

.187 = .047 + (PT [.128 .047])
.187 = .047 + (PT .081)
.187 .047 = (PT .081)
.140 = (PT .081)
PT = .140 / .081 = 1.73
Answer: E
114

.178 = .028 + (PT [.147 .028])
.178 = .028 + (PT .119)
.178 .028 = (PT .119)
.150 = (PT .119)
PT = .150 / .119 = 1.26
Answer: B
115

.187 = .028 + (PT [.147 .028])
.187 = .028 + (PT .119)
.187 .028 = (PT .119)
.159 = (PT .119)
PT = .159 / .119 = 1.34
Answer: C
116

Find inflation from CAPM ER and expected real rate
E. None of the above is within 0.02 percentage point of the correct answer
Approach:
1) Find the expected return for Patriot Theaters stock
2) Find the inflation rate
Although the expected return for Patriot Theaters stock is not given, it can be computed with
the CAPM
E(RPT) = Rf + (H [E(RM) Rf])
= .030 + (0.8 [.160 .030])
= .030 + (0.8 .130)
= .030 + .104
= .134 = 13.4%
(1+inflation rate) = (1+nominal rate) (1+real rate)
(1+inflation rate) = (1+ expected return for PT stock) (1+ expected real return for PT stock)
So inflation rate = [(1+ expected return for PT stock) (1+ expected real return for PT stock)] 1
Inflation rate = [(1.134) (1.045)] 1

= .0852 = 8.52%
117

Approach:
the CAPM
= .030 + (0.8 [.160 .030])
= .030 + (0.8 .130)
= .030 + .104
= .134 = 13.4%
Inflation rate = [(1.134) (1.054)] 1

= .0759 = 7.59%
118

Approach:
the CAPM
= .060 + (0.8 [.130 .060])
= .060 + (0.8 .070)
= .060 + .056
= .116 = 11.6%
Inflation rate = [(1.116) (1.045)] 1

= .0679 = 6.79%
119

Approach:
the CAPM
= .060 + (0.8 [.130 .060])
= .060 + (0.8 .070)
= .060 + .056
= .116 = 11.6%
Inflation rate = [(1.116) (1.054)] 1

= .0588 = 5.88%
120

Compute WACC with 2 items
WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
V=E+D
Expected returns
RE = .1890 = 18.90%
RD = YTM = .0624 = 6.24% = pre-tax cost of debt
Values
E = number of shares market price (value) per share = 900,000 $50 = $45,000,000
D = number of bonds market price (value) per bond = 80,000 $1,050 = $84,000,000
V = E + D = $45,000,000 + $84,000,000 = $129,000,000
Taxes
Tc = 0.40
WACC
WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
= [(45m/129m) .1890] + [(84m/129m) .0624 (1 .40)]
= .0659 + .0244
= .0903 = 9.03%
121

WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
V=E+D
Expected returns
RE = .1890 = 18.90%
Values
D = number of bonds market price (value) per bond = 80,000 $1,050 = $84,000,000
V = E + D = $27,000,000 + $84,000,000 = $111,000,000
Taxes
Tc = 0.40
WACC
WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
= [(27m/111m) .1890] + [(84m/111m) .0624 (1 .40)]
= .0460 + .0283
= .0743 = 7.43%
122

WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
V=E+D
Expected returns
RE = .1890 = 18.90%
Values
D = number of bonds market price (value) per bond = 80,000 $950 = $76,000,000
V = E + D = $45,000,000 + $76,000,000 = $121,000,000
Taxes
Tc = 0.40
WACC
WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
= [(45m/121m) .1890] + [(76m/121m) .0742 (1 .40)]
= .0703 + .0280
= .0983 = 9.83%
123

WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
V=E+D
Expected returns
RE = .1890 = 18.90%
Values
D = number of bonds market price (value) per bond = 80,000 $950 = $76,000,000
V = E + D = $27,000,000 + $76,000,000 = $103,000,000
Taxes
Tc = 0.40
WACC
WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
= [(27m/103m) .1890] + [(76m/103m) .0742 (1 .40)]
= .0495 + .0328
= .0823 = 8.23%
124

Compute NPV from WACC and adjustment for below/above average risk for firm
A. $4,412.39 (plus or minus $10)
B. $12,200.17 (plus or minus $10)
C. $8,181.11 (plus or minus $10)
D. $15,477.13 (plus or minus $10)
NPV = C0 + [C1 / (1+r)1] + [C2 / (1+r)2]
C0 = -$100,000
C1 = $60,000
C2 = $60,000
Because the project is considered to be more risky than the average-risk project at Patriot
Theaters, the projects cost of capital is greater than Patriot Theaters WACC. Since the
difference between the cost of capital for this project and the cost of capital for an averagerisk project at Patriot Theaters is 2.6 percentage points, r = WACC for Patriot Theaters + .
026 = .072 + .026 = .098
NPV = -100,000 + [60,000 / 1.098] + [60,000 / 1.0982] = $4,412.39
125

A. $4,412.39 (plus or minus $10)
B. $12,200.17 (plus or minus $10)
C. $8,181.11 (plus or minus $10)
D. $15,477.13 (plus or minus $10)
NPV = C0 + [C1 / (1+r)1] + [C2 / (1+r)2]
C0 = -$100,000
C1 = $60,000
C2 = $60,000
Because the project is considered to be less risky than the average-risk project at Patriot
Theaters, the projects cost of capital is less than Patriot Theaters WACC. Since the
difference between the cost of capital for this project and the cost of capital for an averagerisk project at Patriot Theaters is 2.6 percentage points, r = WACC for Patriot Theaters .
026 = .072 .026 = .046
NPV = -100,000 + [60,000 / 1.046] + [60,000 / 1.0462] = $12,200.17
126

A. $3,024.93 (plus or minus $10)
B. $7,585.58 (plus or minus $10)
C. $5,261.04 (plus or minus $10)
D. $17,180.23 (plus or minus $10)
NPV = C0 + [C1 / (1+r)1] + [C2 / (1+r)2]
C0 = -$100,000
C1 = $60,000
C2 = $60,000
Because the project is considered to be more risky than the average-risk project at Patriot
Theaters, the projects cost of capital is greater than Patriot Theaters WACC. Since the
difference between the cost of capital for this project and the cost of capital for an averagerisk project at Patriot Theaters is 1.6 percentage points, r = WACC for Patriot Theaters + .
026 = .092 + .016 = .108
NPV = -100,000 + [60,000 / 1.108] + [60,000 / 1.1082] = $3,024.93
127

A. $3,024.93 (plus or minus $10)
B. $7,585.58 (plus or minus $10)
C. $5,261.04 (plus or minus $10)
D. $17,180.23 (plus or minus $10)
NPV = C0 + [C1 / (1+r)1] + [C2 / (1+r)2]
C0 = -$100,000
C1 = $60,000
C2 = $60,000
Because the project is considered to be less risky than the average-risk project at Patriot
Theaters, the projects cost of capital is less than Patriot Theaters WACC. Since the
difference between the cost of capital for this project and the cost of capital for an averagerisk project at Patriot Theaters is 1.6 percentage points, r = WACC for Patriot Theaters .
026 = .092 .016 = .076
NPV = -100,000 + [60,000 / 1.076] + [60,000 / 1.0762] = $7,585.58
128

Final Exam Solutions 2011 6 Fall

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