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GOODMAN SCHOOL OF BUSINESS

BROCK UNIVERSITY
FNCE 2P91, Corporate Finance I
Fall 2013 Midterm Examination
October 26, 2013 (9:00a to 12:00p)
13 Pages

Name:

Student Number:

Please check the box next to your section:

 1 - O. Ozocak (T/R 14:00-15:30)

 2 - O. Ozocak (T/R 9:30-11:00)

 3 - G. Hoover (W 8:00-9:30 / F 11:00-12:30)

 4 – L. Stevenson (T/F 12:30-14:00)

 5 - G. Hoover (T 11:00-12:30 / F 9:30-11:00)

 6 - G. Hoover (M 19:00-22:00)

Answer all questions on the examination paper and hand it in at the completion of the examination. No
examination aids other than those specified are permitted. Use or possession of unauthorized materials
will automatically result in the award of a zero grade for this examination.

Question Marks Awarded

1 10
2 14
3 9
4 12
5 17
6 9
7 8
8 17
9 4
Total 100
 Page 2 of 13

Question 1 (10 Marks)

Circle the correct answer for each of the following questions.

A. Interest earned on both the initial principal and the interest reinvested from prior periods is called:

(a) free interest.

(b) annual interest.
(c) simple interest.
(d) discount interest.
(e) compound interest.

B. The possibility of conflict of interest between the stockholders and management of the firm is
called:

(a) the shareholders' conundrum.

(b) corporate breakdown.
(c) the agency problem.
(d) corporate activism.
(e) legal liability.

C. The required return on a stock is defined as:

(a) the capital gains yield plus the dividend yield.

(b) next year's dividend divided by the current price.
(c) the increase in the value of a share of stock over a period of time.
(d) the rate at which a stock increases in value.
(e) the payment by a corporation to shareholders in the form of cash or stock.

D. The process of planning and managing a firm's long-term investments is called:

(a) working capital management.

(b) financial depreciation.
(c) agency cost analysis.
(d) capital budgeting.
(e) capital structure.

E. In order to compare different investment opportunities of the same risk but with interest rates
quoted in different manners you should:

(a) convert each interest rate to an annual nominal rate.

(b) convert each interest rate to a monthly nominal rate.
(c) convert each interest rate to an effective annual rate.
(d) compare them by using the published annual rates.
(e) convert each interest rate to an APR.

F. Interest rates or rates of return on investment that have been adjusted for the effects of inflation are
called:

(a) real rates.

(b) nominal rates.
(c) effective rates.
(d) stripped rates.
(e) coupon rates.
 Page 3 of 13

G. A firm's capital structure is defined:

(a) as the combination of debt and equity used to finance the firm's operations.
(b) by the types of fixed assets the firm owns.
(c) as the mix of short-term and Long-term assets owned by the firm.
(d) as the amount of fixed assets needed to support every $1 in sales.
(e) by the nature of the product or service provided.

H. The internal rate of return should:

(a) not be used for ranking mutually exclusive projects.

(b) only be applied to small projects.
(c) be relied upon more heavily than the net present value.
(d) always result in the same decision as discounted payback.
(e) lead to correct decisions when comparing mutually exclusive projects.

I. The interest rate which lenders must report to borrowers as required by law is the:

(a) monthly interest rate.

(b) simple rate.
(c) annual percentage rate.
(d) effective annual rate.
(e) periodic rate.

J. The primary goal of financial management is defined as the:

(a) maximization of the current value per share of the outstanding stock.
(b) maximization of the current profits per share of the firm.
(c) minimization of the risks associated with company ownership.
(d) maintenance of a steady stream of dividends to the existing shareholders.
(e) minimization of the outstanding debt owed by the firm to third parties.
 Page 4 of 13

Answer all the following questions in the space provided. Show all your work. No credit will be
given for answers obtained using a financial calculator without the supporting formula and steps
leading to the final answer.

Question 2 (14 Marks)

Today, a friend is celebrating her 25th birthday. She has decided to start planning for her retirement by
saving $1,300 per month until she retires, with her first contribution occurring 1 month from today. Her
goal is to retire 30 years from today with enough savings to fund her retirement plans, which involve living
in Europe for her first 3 years of retirement and then returning home. During her 3 years in Europe, she
wants to be able to withdraw $9,000 per month from her savings, with her first withdrawal occurring 30
years and 1 month from now. After returning home from Europe, she wants to be able to make annual
withdrawals for 33 years, with the first of these withdrawals occurring on her 58th birthday in the amount of
$100,000. The amount of each subsequent annual withdrawal will increase by 3% per year. Finally, she
wants to be able to make a 1-time cash donation to the Goodman School of Business on her 75th
birthday. Assume no other withdrawals or deposits will be made and that her savings will earn a 7.5%
APR compounded quarterly. How much is she expecting to donate to the Goodman School of Business
on her 75th birthday?

𝐴𝑙𝑡𝑒𝑟𝑛𝑎𝑡𝑖𝑣𝑒 #1 𝐴𝑙𝑡𝑒𝑟𝑛𝑎𝑡𝑖𝑣𝑒 #2

. 075 4 . 075 4
𝐸𝐴𝑅 = (1 + ) − 1 = 7.71% 𝐸𝐴𝑅 = (1 + ) − 1 = 7.71%
4 4
4⁄ 1⁄
. 075 12 𝐸𝑀𝑅 = (1 + .0771) 12 − 1 = .62%
𝐸𝑀𝑅 = (1 + ) − 1 = .62%
4

(1 + .0062)30(12) − 1
𝐹𝑉30 𝑜𝑓 𝑆𝑎𝑣𝑖𝑛𝑔𝑠 = 1,300 [ ] = $1,735,495.32
. 0062

1
1−
(1 + .0062)3(12)
𝑃𝑉30 𝑜𝑓 𝐸𝑢𝑟𝑜𝑝𝑒 𝑊𝑖𝑡ℎ𝑑𝑟𝑎𝑤𝑎𝑙𝑠 = 9,000 [ ] = $289,529.50
. 0062

100,000 1 + .03 33
𝑃𝑉32 𝑜𝑓 𝑃𝑜𝑠𝑡 − 𝐸𝑢𝑟𝑜𝑝𝑒 𝑊𝑖𝑡ℎ𝑑𝑟𝑎𝑤𝑎𝑙𝑠 = [1 − ( ) ] = $1,636,963.07
. 0771 − .03 1 + .0771

1,636,963.07 1,636,963.07
𝑃𝑉30 𝑜𝑓 𝑃𝑜𝑠𝑡 − 𝐸𝑢𝑟𝑜𝑝𝑒 𝑊𝑖𝑡ℎ𝑑𝑟𝑎𝑤𝑎𝑙𝑠 = = $1,410,905.44 =
(1 + .0771) 2 (1 + .0062)2(12)

𝑆𝑢𝑟𝑝𝑙𝑢𝑠30 = 1,735,495.32 − 289,529.50 − 1,410,905.44 = $35,060.39

𝑆𝑢𝑟𝑝𝑙𝑢𝑠50 = 𝐷𝑜𝑛𝑎𝑡𝑖𝑜𝑛 = 35,060.39(1 + .0771)20 = $154,962.44 = (1 + .0062)20(12)

 Page 5 of 13

Question 3 (9 Marks)

A company has decided to raise $15 million by issuing 30-year bonds with a YTM of 8% and face value of
$1,000.

For parts (a) and (b), assume the company decides to issue annual coupon bonds at face value (i.e. bond
is selling at par).

(a) How many bonds would the company need to issue? (2 marks)

15,000,000
𝑁= = 15,000
1,000

(b) At maturity, how much will the company’s repayment be (remember to include the final coupon
payment)? (2 marks)

𝐶 = .08(1,000) = $80

𝑅𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡30 = 15,000(1,000 + 80) = $16,200,000

For parts (c) and (d), assume the company decides to issue a zero coupon bond.

(c) How many bonds would the company need to issue? (3 marks)

1,000
𝑃= = $99.38
(1 + .08)30

15,000,000
𝑁= = 150,939.85
99.38

(d) At maturity, how much will the company’s repayment be? (2 marks)

𝑅𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡30 = 150,939.86(1,000) = $150,939,853.30

 Page 6 of 13

Question 4 (12 Marks)

Investment A is a perpetuity that pays $1,000 per month, with the first payment occurring 1 month from
today. Investment A currently sells for $50,000.

(a) What is the monthly rate of return on Investment A? (2 marks)

1,000
50,000 =
𝐸𝑀𝑅

𝐸𝑀𝑅 = 2%

(b) What rate would you expect to be quoted for Investment A? (2 marks)

𝐴𝑃𝑅 = .02(12) = 24%

(c) What is the EAR for Investment A? (2 marks)

𝐸𝐴𝑅 = (1 + .02)12 − 1 = 26.82%

For parts (d) and (e), assume Investment B and Investment C both offer the same EAR as Investment A.

(d) Investment B pays a perpetual stream of payments that will increase by 2% per year forever, with
the first of these payments occurring 1 year from today in the amount of $15,000. What is the
present value of Investment B? (2 marks)

15,000
𝑃𝑉 = = $60,424.96
. 2682 − .02

(e) Investment C is a 20-year annuity of $40,000 annual payments that will make its first payment 5
years from today. What is the present value of Investment C? (4 marks)

1
1−
(1 + .2682)20
𝑃𝑉4 = 40,000 [ ] = $147,832.45
. 2682

147,832.45
𝑃𝑉0 = = $57,142.80
(1 + .2682)4
 Page 7 of 13

Question 5 (17 Marks)

Consider each of the following stocks independently of each other (i.e. parts (a) to (d) are unrelated).

(a) A company has decided to offer preferred stock that will pay an annual dividend of $2 per share.
Assume the required return is 9%. What price per share should the company expect to receive for
this stock offering? (2 marks)
2
𝑃= = $22.22
. 09

(b) A company just paid a $1.50 dividend per share and future dividends are expected to grow at 10%
per year for the next 3 years before leveling off at 5% into perpetuity. The required return on the
company's stock is 14% and dividends are paid annually. What is the current stock price?
(6 marks)

𝐴𝑙𝑡𝑒𝑟𝑛𝑎𝑡𝑖𝑣𝑒 #1

1.50(1 + .1)3 (1 + .05)

𝑃3 = = $23.29
. 14 − .05

1.50(1.1) 1 + .1 3 23.29
𝑃0 = [1 − ( ) ]+ = $19.91
. 14 − .1 1 + .14 (1 + .14)3

𝐴𝑙𝑡𝑒𝑟𝑛𝑎𝑡𝑖𝑣𝑒 #2

1.50(1 + .1)3 (1 + .05)

𝑃3 = = $23.29
. 14 − .05

1.50(1 + .1) 1.50(1 + .1)2 1.50(1 + .1)3 23.29

𝑃0 = + 2
+ 3
+ = $19.91
(1 + .14) (1 + .14) (1 + .14) (1 + .14)3
 Page 8 of 13

(c) A company just paid a dividend of $2 per share. The company plans to increase its dividend by 8%
next year and will then reduce its dividend growth rate by 2 percentage points per year (i.e. year 2
growth rate will be 6%) until it reaches 4% dividend growth. Dividends are then expected to grow
at 4% per year forever. The required return on the company's stock is 12% and dividends are paid
annually. What is the current stock price? (6 marks)

𝑔2 = .08 − .02 = 6%

𝑔3 𝑡𝑜 ∞ = .06 − .02 = 4%

2(1 + .08)(1 + .06)(1 + .04)

𝑃2 = = $29.76
. 12 − .04
2(1 + .08) 2(1 + .08)(1 + .06) 29.76
𝑃0 = + +( ) = $27.48
(1 + .12) (1 + .12)2 (1 + .12)2

(d) A stock currently sells for $22.50 per share. The most recent dividend per share was $1.50 and
future dividends are expected to grow at a rate of 5% per year indefinitely. Assume dividends are
paid annually. What is the required return on the stock? (3 marks)

1.50(1 + .05)
𝑅= + .05 = 12%
22.50
 Page 9 of 13

Question 6 (9 Marks)

A bank has offered a 30-year, $250,000 mortgage at a quoted rate of 6%. The mortgage calls for weekly
payments, with the first payment due 1 week from today.

(a) How much will the weekly payments be? (4 marks)

𝐴𝑙𝑡𝑒𝑟𝑛𝑎𝑡𝑖𝑣𝑒 #1 𝐴𝑙𝑡𝑒𝑟𝑛𝑎𝑡𝑖𝑣𝑒 #2
2⁄
. 06 52 . 06 2
𝐸𝑊𝑅 = (1 + ) − 1 = .11% 𝐸𝐴𝑅 = (1 + ) − 1 = 6.09%
2 2
1⁄
𝐸𝑊𝑅 = (1 + .0609) 52 − 1 = .11%

1
1−
(1 + .0011)30(52)
250,000 = 𝐶 [ ]
. 0011

𝐶 = $342.52

(b) Using your answer to part (a), prepare an amortization schedule for the first 3 payments of the
mortgage. (5 marks)

Beginning Total Interest Ending

Week Balance Payment Payment Balance
1 $250,000.00 $342.52 $284.38 $249,941.86

2 $249,941.86 $342.52 $284.31 $249,883.66

3 $249,883.66 $342.52 $284.25 $249,825.39

 Page 10 of 13

Question 7 (8 Marks)

Two years ago, you paid face value for an 8% semiannual coupon bond that had 10 years to maturity.
Today, the annual YTM on your bond is now 2% lower and you decide to sell.

(a) What is the current price of your bond? (5 marks)

. 08
𝐶= (1,000) = $40 𝑠𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙𝑙𝑦
2
. 08 − .02
𝑌𝑇𝑀 = = 3% 𝑝𝑒𝑟 𝑠𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑒𝑟𝑖𝑜𝑑
2

𝑡 = 2(10 − 2) = 16 𝑠𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑒𝑟𝑖𝑜𝑑𝑠

1
1− 1,000
(1 + .03)16
𝑃 = 40 [ ]+ = $1,125.61
. 03 (1 + .03)16

(b) Assume you want to use trial and error to calculate the holding period yield (HPY) on your
investment. Show how you would set up the bond valuation equation to begin using this method for
finding the HPY. No attempts at actually using trial and error to solve for the HPY are necessary.
(3 marks)

𝑡 = 2(2) = 4 𝑠𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑒𝑟𝑖𝑜𝑑𝑠

1
1− 1,125.61
(1 + 𝐻𝑃𝑌)4
1,000 = 40 [ ]+
𝐻𝑃𝑌 (1 + 𝐻𝑃𝑌)4
 Page 11 of 13

Question 8 (17 Marks)

A company is considering Project A and Project B, which are mutually exclusive. Project A has the
following cash flows:

Project A Cumulative
Year Cash Flow Cumulative PV PV
0 -$80,347
1 $25,000 -$55,347 $21,739.13 -$58,607.87
2 $40,000 -$15,347 $30,245.75 -$28,362.12
3 $50,000 $34,653 $32,875.81 $4,513.69

The required return for both projects is 15%.

(a) Assume the payback period for Project B is 1.67 years. If the company evaluates projects using
the payback period rule, which project would be accepted? (3 marks)

15,347
𝑃𝑃𝐴 = 2 + = 2.31 𝑦𝑒𝑎𝑟𝑠 → 𝐴𝑐𝑐𝑒𝑝𝑡 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝐵
50,000

(b) Assume the discounted payback period for Project B is 2.58 years. If the company evaluates
projects using the discounted payback period rule, which project would be accepted? (3 marks)

28,362.12
𝐷𝑃𝑃𝐴 = 2 + = 2.86 𝑦𝑒𝑎𝑟𝑠 → 𝐴𝑐𝑐𝑒𝑝𝑡 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝐵
32,875.81

(c) Assume the NPV for Project B is $2,776. If the company evaluates projects using NPV analysis,
which project would be accepted? (3 marks)

𝑁𝑃𝑉𝐴 = −80,347.00 + 21,739.13 + 30,245.75 + 32,875.81 = $4,513.69 → 𝐴𝑐𝑐𝑒𝑝𝑡 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝐴

 Page 12 of 13

(d) Assume the IRR for Project B is 17.35%. If the company evaluates projects using the IRR rule,
which project would be accepted? (4 marks)

𝑆𝑜𝑙𝑣𝑒 𝑓𝑜𝑟 𝐼𝑅𝑅𝐴 = 18% → 𝐴𝑐𝑐𝑒𝑝𝑡 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝐴

(e) Assume the profitability index for Project B is 1.03. If the company evaluates projects using the
profitability index rule, which project would be accepted? (3 marks)

21,739.13 + 30,245.75 + 32,875.81

𝑃𝐼𝐴 = = 1.06 → 𝐴𝑐𝑐𝑒𝑝𝑡 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝐴
80,347.00

(f) Which of the above is the preferred decision criterion? (1 mark)

𝑁𝑃𝑉
 Page 13 of 13

Question 9 (4 Marks)

Beginning today, you plan to make monthly deposits of $1,200 into an account that pays 3.5% interest
compounded monthly. How many months will it be until your account balance reaches $139,505?

𝐴𝑙𝑡𝑒𝑟𝑛𝑎𝑡𝑖𝑣𝑒 #1 𝐴𝑙𝑡𝑒𝑟𝑛𝑎𝑡𝑖𝑣𝑒 #2

. 035
12⁄
12 . 035
𝐸𝑀𝑅 = (1 + ) − 1 = .29% 𝐸𝑀𝑅 = = .29
12 12

(1 + .0029)𝑡 − 1
139,505 = 1,200 [ ] (1 + .0029)
. 0029

ln 1.34
𝑡= = 100 𝑚𝑜𝑛𝑡ℎ𝑠
ln 1.0029