JEM034 — Corporate Finance

Winter Semester 2020/2021

Instructor: Olga Bychkova
Date: 3/11/2020

Midterm Exam

You have 80 minutes to complete this setup. The exam is worth 100 points in total,
exact amount of points is indicated for each exercise. Multiple choice questions may have
multiple correct answers. Any violation of academic integrity will be punished accordingly.

NAME:

Problem 1. (4 points) Which of the following statements about the relationship between
interest rates and bond prices are true?
(a) There is an inverse relationship between bond prices and interest rates.
(b) There is a direct relationship between bond prices and interest rates.
(c) The price of short-term bonds fluctuates more than the price of long-term bonds for
a given change in interest rates (assuming that coupon rate is the same for both).
(d) The price of long-term bonds fluctuates more than the price of short-term bonds for
a given change in interest rates (assuming that the coupon rate is the same for both).
(e) None of the given statements are true.

Problem 2. (2 points) Which of the following statements is true?

(a) The spot interest rate is a weighted average of yields to maturity.
(b) Yield to maturity is the weighted average of spot interest rates and estimated forward
rates.
(c) The yield to maturity is always higher than the spot rates.
(d) None of the given statements are true.

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Problem 3. (3 points) World-Tour Co. has just now paid a dividend of $2.83 per share
(DIV0 ). The dividends are expected to grow at a constant rate of 6% per year forever. If
the required rate of return on the stock is 16%, what is the current value on stock after
paying the dividend?

Problem 4. (2 points) You would like to have enough money saved to receive $80,000
per year in perpetuity after retirement, so that you and your family can lead a good life.
How much would you need to save in your retirement fund to achieve this goal? Assume
that the perpetuity payments start one year from the date of your retirement. The interest
rate is 8%.

Problem 5. (2 points) What is the duration of a bond with a face value of $1,000,
coupon rate of 0%, yield to maturity of 9%, and ten years to maturity? Why?

Problem 6. (2 points) A high proportion of the value of a growth stock comes from:
(a) Past dividend payments.
(b) Past earnings.
(c) PVGO (present value of the growth opportunities).

Problem 7. (4 points) The constant dividend growth formula P0 = DIV1/(r−g) assumes:

(a) The dividends are growing at a constant rate g forever.
(b) r > g.
(c) g is never negative.
(d) All of the above.
(e) None of the above.

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Problem 8. (2 points) The following are the main types of real options:
(a) The option to expand if the immediate investment project succeeds.
(b) The option to wait (and learn) before investing.
(c) The option to shrink or abandon a project.
(d) The option to vary the mix of output or the firm’s production methods.
(e) All of the above.
(f) None of the above.

Problem 9. (4 points) Calculator Company proposes to invest $5 million in a new

calculator making plant. Fixed costs are $2 million a year. A calculator costs $5/unit to
manufacture and can be sold for $20/unit. If the plant lasts for 3 years and the cost of
capital is 12%, what is the approximate break-even level (i.e. N P V = 0) of annual sales?
Assume no taxes.

Problem 10. (4 points) Summer Co. is expected to pay a dividend of $4 per share out
of earnings of $7.5 per share in year 1. If the required rate of return on the stock is 15%
and dividends are expected to grow at 10% per year forever, calculate the present value
of the growth opportunities for the stock (PVGO).

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Problem 11. (4 points) Given the following cash flows for project Z: C0 = −$1, 000,
C1 = $600, C2 = $720, and C3 = $2, 000, calculate the discounted payback period for the
project at a discount rate of 20%.

Problem 12. (3 points) After retirement, you expect to live for 25 years. You would like
to have $75,000 of income each year. How much should you have saved in the retirement
to receive this income, if the interest is 9% per year? Assume that the payments start on
the day of retirement.

Problem 13. (2 points) The growth rate in dividends is a function of two ratios. They
are:
(a) PVGO and ROE.
(b) Dividend yield and growth rate in dividends.
(c) ROE and the retention ratio.
(d) Book value per share and EPS.

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Problem 14. (2 points) If the 4-year spot rate is 7% and the 3-year spot rate is 6%,
what is the one-year forward rate of interest three years from now?

Problem 15. (4 points) If the present value of $1 received n years from today at an
interest rate of r is $0.3855, then what is the future value of $1 invested today at an
interest rate of r for n years?

Problem 16. (2 points) Profitability index is the ratio of:

(a) Future value of cash flows to investment.
(b) Net present value of cash flows to investment.
(c) Net present value of cash flows to IRR.
(d) Present value of cash flows to IRR.

Problem 17. (4 points) A company forecasts growth of 6% for 5 years and 3% thereafter.
Given last year’s cash flow was $100, what is the horizon value if the company cost of
capital is 8%?

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Problem 18. (Arbitrage Opportunities)
You are given the following information about three bonds.

Bond Maturity (years) Coupon Price

A 2 10% $1,050
B 2 20% $1,220
C 3 8% $995

Coupons are paid at the end of the year (including the year of maturity). All three bonds
have a face value of $1,000 at maturity.
(a) (15 points) Find the 1-, 2-, and 3-year spot rates of interest.

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(b) (5 points) Is there a profit opportunity here? If so, how would you take advantage
of it?

Problem 19. (NPV) (10 points)

A project has a cost of $240,000. It has a life of 3 years. The cost is depreciated straight-
line to a salvage value of $30,000. Cash sales are $200,000 per year and cash costs run
$100,000 per year. The appropriate discount rate is 8%, and the corporate tax rate is
20%. What is the project’s NPV?

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Problem 20. (Mutually Exclusive Projects) (20 points)
After extensive medical and marketing research, PillAdvent Inc. believes it can penetrate
the pain reliever market. It can follow one of two strategies. The first is to manufacture
a medication aimed at relieving headache pain. The second strategy is to make a pill
designed to relieve headache and arthritis pain. Both products would be introduced at
a price of $4 per package. The broader remedy would probably sell 10 million packages
a year. This is twice the sales rate for the headache-only medication. Cash costs of pro-
duction in the first year are expected to be $1.5 per package for the headache-only brand.
Production costs are expected to be $1.7 for the more general pill. All prices and costs
are expected to rise at the general inflation rate of 5%.
Either strategy would require further investment in plant. The headache-only pill could
be produced using equipment that would cost $10.2 million, last three years, and have
no resale value. The machinery required to produce the broader remedy would cost $12
million and last four years. At this time the firm would be able to sell it for $1 million.
Which pain reliever should the firm produce? Assume a 13% discount rate and ignore
taxes.