Midterm Study Guide Fin 5170 Fall 2009

The exam will consist on multiple choices, and pro lems and may e an essay !uestion" # will as$ a maximum o% two !uestions ta$en %rom the %ollowin& material co'ered in class( )hapter 1 Describe the concept of agency problems and different ways to ameliorate agency problems in a corporation

)hapter * Example 3.7 (pages 65-66) se the concept of arbitrage to explain the price of !ec"rity # in table 3.$% and !ec"rity & in table 3.'). (omp"te the ris) premi"m of both sec"rities. Example 3.*+ in page 7, Example 3.** in page 7.roblems *-% *7% *$ (pages 7$-$+)

+ou will also ha'e the opportunity to answer se'eral !uestions %rom the next pa&es(

)hapter 1 - The )orporation

1"1 The Four Types o% Firms ,) /hich of the following organi0ation forms for a b"siness does not a1oid do"ble taxation2 #) 3imited .artnership &) 4(4 (orporation () 4!4 (orporation D) 3imited 3iability (ompany #nswer5 &

3) /hich of the following organi0ation forms has the most re1en"e2 #) 4!4 (orporation &) 3imited .artnership () 4(4 (orporation D) 3imited 3iability (ompany #nswer5 ( -) /hich of the following organi0ation forms acco"nts for the greatest n"mber of firms2 #) 4!4 (orporation &) 3imited .artnership () !ole .roprietorship D) 4(4 (orporation #nswer5 ( 5) /hich of the following is 678 an ad1antage of a sole proprietorship2 #) !ingle taxation &) Ease of set"p ()

3imited liability D) 6o separation of ownership and control #nswer5 ( 6) /hich of the following statements regarding limited partnerships is tr"e2 #) 8here is no limit on a limited partner9s liability. &) # limited partner9s liability is limited by the amo"nt of their in1estment. () # limited partner is not liable "ntil all the assets of the general partners ha1e been exha"sted. D) # general partner9s liability is limited by the amo"nt of their in1estment. #nswer5 & 7) /hich of the following is : are an ad1antage of incorporation2 #) #ccess to capital mar)ets &) 3imited liability () nlimited life D) #ll of the abo1e #nswer5 D ') # limited liability company is essentially #)

a limited partnership witho"t limited partners. &) a limited partnership witho"t a general partner. () ;"st another name for a limited partnership. D) ;"st another name for a corporation. #nswer5 & *+) 8he disting"ishing feat"re of a corporation is that #) their is no legal difference between the corporation and its owners. &) it is a legally defined% artificial being% separate from its owners. () it spreads liability for its corporate obligations to all shareholders. D) pro1ides limited liability only to small shareholders. #nswer5 & *,) <o" own *++ shares of a 4(4 (orporation. 8he corporation earns =5.++ per share before taxes. 7nce the corporation has paid any corporate taxes that are d"e% it will distrib"te the rest of its earnings to its shareholders in the form of a di1idend. >f the corporate tax rate is -+? and yo"r personal tax rate on (both di1idend and non-di1idend) income is 3+?% then how m"ch money is left for yo" after all taxes ha1e been paid2 #) =,*+ &) =3++ () =35+ D)

=5++ #nswer5 # Explanation5 #) E.! n"mber of shares (* - (orporate 8ax @ate) (* - >ndi1id"al 8ax @ate) =5.++ per share *++ shares (* - .-+) x (* - .3+) = =,*+ &) () D)

*3) <o" own *++ shares of a !"b (hapter 4!4 (orporation. 8he corporation earns =5.++ per share before taxes. 7nce the corporation has paid any corporate taxes that are d"e% it will distrib"te the rest of its earnings to its shareholders in the form of a di1idend. >f the corporate tax rate is -+? and yo"r personal tax rate on (both di1idend and non-di1idend) income is 3+?% then how m"ch money is left for yo" after all taxes ha1e been paid2 #) =,*+ &) =3++ () =35+ D) =5++ #nswer5 ( Explanation5 #) &) () E.! n"mber of shares (* - >ndi1id"al 8ax @ate) =5.++ per share *++ shares (* - .3+) = =35+ D)

*-) <o" are a shareholder in a 4(4 corporation. 8his corporation earns =- per share before taxes. #fter it has paid taxes% it will distrib"te the remainder of its earnings to yo" as a di1idend. 8he di1idend is income to yo"% so yo" will then pay taxes on these earnings. 8he corporate tax rate is 35? and yo"r tax rate on di1idend income is *5?. 8he effecti1e tax rate on yo"r share of the corporations earnings is closest to5 #) *5? &) 35? () -5? D) 5+? #nswer5 ( Explanation5 #) &) () Aist the corporation pays taxes. >t earned =- per share% b"t m"st pay =- .35 = =*.-+ to the go1ernment in corporate taxes. 8hat lea1es =-.++ - =*.-+ = =,.6+ to distrib"te to the shareholders. Bowe1er% the shareholder m"st pay =,.6+ .*5 = =+.3' in income taxes on this amo"nt% lea1ing only =,.,* to the shareholder after all taxes are paid. 8he total amo"nt paid in taxes is =*.-+ + +.3' = =*.7'. 8he effecti1e tax rate is then =*.7' C =- = .--75 or --.75? which is closest to -5?. D)

1"2 ,wnership -ersus )ontrol o% )orporations *) >n a corporation% the "ltimate decisions regarding b"siness matters are made by #) the &oard of Directors. &) debt holders. () shareholders. D)

in1estors. #nswer5 # 3) 8he .rincipal-#gent .roblem arises #) beca"se managers ha1e little incenti1e to wor) in the interest of shareholders when this means wor)ing against their own self -interest. &) beca"se of the separation of ownership and control in a corporation. () &oth # and & D) 6one of the abo1e #nswer5 ( -) >f shareholders are "nhappy with a (E79s performance% they are most li)ely to #) b"y more shares in an effort to gain control of the firm. &) file a shareholder resol"tion. () replace the (E7 thro"gh a grassroots shareholder "prising. D) sell their shares. #nswer5 D 5) # DDDDDDDD% is when a rich indi1id"al or organi0ation p"rchases a large fraction of the stoc) of a poorly performing firm and in doing so gets eno"gh 1otes to replace the board of directors and the (E7. #)

shareholder proposal &) le1eraged b"yo"t () shareholder action D) hostile ta)eo1er #nswer5 D 6) /hich of the following statements is false2 #) >n ban)r"ptcy% management is gi1en the opport"nity to reorgani0e the firm and renegotiate with debt holders. &) &eca"se a corporation is a separate legal entity% when it fails to repay its debts% the people who lent to the firm% the debt holders are entitled to sei0e the assets of the corporation in compensation for the defa"lt. () #s long as the corporation can satisfy the claims of the debt holders% ownership remains in the hands of the eE"ity holders. D) >f the corporation fails to satisfy debt holders9 claims% debt holders may lose control of the firm. #nswer5 D Explanation5 #) &) () D) >f the corporation fails to satisfy debt holders9 claims% debt holders may ta)e control of the firm. 7) /hat strategies are a1ailable to shareholders to help ens"re that managers are moti1ated to act in the interest of the shareholders rather than their own interest2 #nswer5

*. ,. 3.

8he threat of a hostile ta)eo1er !hareholder initiati1es .erformance based compensation

)hapter 2 - #ntroduction to Financial Statement .nalysis

2"1 The /isclosure o% Financial #n%ormation *) .!. p"blic companies are reE"ired to file their ann"al financial statements with the .!. !ec"rities and Exchange (ommission on which form2 #) *+-# &) *+-F () *+-G D) *+-!E( #nswer5 &

3) 8he third party who chec)s ann"al financial statements to ens"re that they are prepared according to H##. and 1erifies that the information reported is reliable is the #) 6<!E Enforcement &oard. &) #cco"nting !tandards &oard. () !ec"rities and Exchange (ommission (!E(). D) a"ditor. #nswer5 D

2"2 The 0alance Sheet *)

/hich of the following balance sheet eE"ations is incorrect2 #) #ssets - 3iabilities = !hareholders9 EE"ity &) #ssets = 3iabilities + !hareholders9 EE"ity () #ssets - ("rrent 3iabilities = 3ong 8erm 3iabilities D) #ssets - ("rrent 3iabilities = 3ong 8erm 3iabilities + !hareholders9 EE"ity #nswer5 ( 3) #cco"nts payable is a #) 3ong-term liability. &) ("rrent #sset. () 3ong-term asset. D) ("rrent 3iability. #nswer5 D

Use the table for the question(s) below. (onsider the following balance sheet5 1uther )orporation )onsolidated 0alance Sheet /ecem er *1, 2002 and 2005 3in 4 millions5 1ia ilities and Stoc$holders6 7!uity Current Liabilities #cco"nts payable 6otes payable : short-term debt ("rrent mat"rities of longterm debt 7ther c"rrent liabilities 8otal c"rrent liabilities Long-Term Liabilities 3ong-term debt (apital lease obligationss 8otal Debt Deferred taxes 7ther long-term liabilities 8otal long-term liabilities 8otal liabilities !toc)holders9 EE"ity Total lia ilities and Stoc$holders6 7!uity

.ssets Current Assets (ash #cco"nts recei1able >n1entories 7ther c"rrent assets 8otal c"rrent assets Long-Term Assets 3and &"ildings EE"ipment 3ess acc"m"lated depreciation 6et property% plant% and eE"ipment Hoodwill 7ther long-term assets 8otal long-term assets

2002 63.6 55.5 -5.' 6.+ *7*.+

2005 5$.5 3'.6 -,.' 3.+ *--.+

2002 $7.6 *+.5 3'.' 6.+ *--.+

2005 73.5 '.6 36.' *,.+ *3,.+

66.6 *+'.5 **'.* (56.*) ,3'.* 6+.+ 63.+ 36,.*

6,.* '*.5 ''.6 (5,.5) ,++.7 --,.+ ,-,.7

,3'.7 --,3'.7 ,,.$ --,6,.5 -+6.5 *,6.6

*6$.' --*6$.' ,,., --*'*.* 3,3.* 63.6

Total .ssets 6)

5**"1

*82"7

5**"1

*82"7

/hat is 3"ther9s net wor)ing capital in ,++52 #) =*, million &) =,7 million () =3' million D) =63.6 million #nswer5 # Explanation5

#) 6/( = c"rrent assets - c"rrent liabilities = *-- - *3, = =*, million &) () D)

7) >f in ,++6 3"ther has *+., million shares o"tstanding and these shares are trading at =*6 per share% then 3"ther9s Iar)et -to-boo) ratio wo"ld be closest to5 #) +.3' &) +.76 () *.,' D) ,.57 #nswer5 ( Explanation5 #) &) () I8& = mar)et cap : boo) 1al"e of eE"ity = (*+., million *6) : *,6.6 = *63., : *,6.6 = *.,$' D)

$) /hen "sing the boo) 1al"e of eE"ity% the debt to eE"ity ratio for 3"ther in ,++6 is closest to5 #) ,.,* &)

,.,' () ,.'$ D) 3.+3 #nswer5 & Explanation5 #) &) D:E = 8otal Debt : 8otal EE"ity 8otal Debt = (notes payable (*+.5) + c"rrent mat"rities of long-term debt (3'.') + long-term debt (,3'.7) = ,'+.* million 8otal EE"ity = *,6.6% so D:E = ,'+.* : *,6.6 = ,.,' () D)

') >f in ,++6 3"ther has *+., million shares o"tstanding and these shares are trading at =*6 per share% then "sing the mar)et 1al"e of eE"ity% the debt to eE"ity ratio for 3"ther in ,++6 is closest to5 #) *.7* &) *.7$ () ,.3* D) ,.35 #nswer5 & Explanation5 #) &) D:E = 8otal Debt : 8otal EE"ity

8otal Debt = (notes payable (*+.5) + c"rrent mat"rities of long-term debt (3'.') + long-term debt (,3'.7) = ,'+.* million 8otal EE"ity = *+., =*6 = *63.,% so D:E = ,'+.* : *63., = *.7$ () D)

*+) >f in ,++6 3"ther has *+., million shares o"tstanding and these shares are trading at =*6 per share% then what is 3"ther9s Enterprise Jal"e2 #) -=63.3 million &) =353.* million () =3$'.7 million D) =5*6.' million #nswer5 ( Explanation5 #) &) () Enterprise 1al"e = IJE + Debt - (ash = *+., =*6 + ,'+.* - 63.6 = 3$'.7 D)

**)
3"ther9s c"rrent ratio for ,++6 is closest to5 #) +.$&) +.$7 () *.*5 D) *.*' #nswer5 D Explanation5 #) &) () D) c"rrent ratio = c"rrent assets : c"rrent liabilities = *7* : *-- = *.*' 2"* The #ncome Statement *) /hich of the following statements regarding the income statement is incorrect2 #) 8he income statement shows the earnings and expenses at a gi1en point in time. &) 8he income statement shows the flow of earnings and expenses generated by the firm between two dates. () 8he last or 4bottom4 line of the income statement shows the firm9s net income. D) 8he first line of an income statement lists the re1en"es from the sales of prod"cts or ser1ices. #nswer5 #

#) &) () D)

Use the table for the question(s) below. )onsider the %ollowin& income statement and other in%ormation( 1uther )orporation )onsolidated #ncome Statement +ear ended /ecem er *1 3in 4 millions5 2002 2005 8otal sales 6*+.* 57$.3 (ost of sales (5++.,) (-$*.') Hross profit *+'.' '6.!elling% general% and administrati1e expenses (-+.5) (3'.+) @esearch and de1elopment (,-.6) (,,.$) Depreciation and amorti0ation (3.6) (3.3) 7perating income -*., 3*.3 ----7ther income Earnings before interest and taxes (E&>8) -*., 3*.3 >nterest income (expense) (,5.*) (*5.$) .retax income *6.* *5.5 8axes (5.5) (5.3) 6et income *+.6 *+., .rice per share !hares o"tstanding (millions) !toc) options o"tstanding (millions) !toc)holders9 EE"ity 8otal 3iabilities and !toc)holders9 EE"ity -) Aor the year ending December 3*% ,++6 3"ther9s earnings per share are closest to5 #) =*.+* &) =*.+() =*.5$ D) =-.+=*6 *+., +.3 *,6.6 533.* =*5 $.+ +., 63.6 3$6.7

& Explanation5 #) &) E.! = 6et >ncome : !hares 7"tstanding = =*+.6 : *+., = =*.+() D)

6) 3"ther9s 7perating Iargin for the year ending December 3*% ,++5 is closest to5 #) *.$? &) ,.7? () 5.-? D) *6.7? #nswer5 ( Explanation5 #) &) () 7perating Iargin = 7perating >ncome : !ales 7I = 3*.3 : 57$.3 = .+5- or 5.-? D)

7) 3"ther9s 6et .rofit Iargin for the year ending December 3*% ,++5 is closest to5 #)

*.$? &) ,.7? () 5.-? D) *6.7? #nswer5 # Explanation5 #) 6et .rofit Iargin = 6et >ncome : 8otal !ales = *+., : 57$.3 = .+*$ or *.$? &) () D)

$) 3"ther9s earnings before interest% taxes% depreciation% and amorti0ation (E&>8D#) for the year ending December 3*% ,++6 is closest to5 #) *'.7 million &) 37.6 million () -*., million D) --.$ million #nswer5 D Explanation5 #) &) () D) E&>8D# = E&>8 + Depreciation K #morti0ation = -*., + 3.6 = = --.$ million

') 3"ther9s ret"rn on eE"ity (@7E) for the year ending December 3*% ,++6 is closest to5 #) ,.+? &) 6.5? () $.-? D) *,.7? #nswer5

( Explanation5 #) &) () @7E = 6et income : shareholders9 eE"ity = *+.6 : *,6.6 = .+$- or $.-? D) *+) 3"ther9s ret"rn on assets (@7#) for the year ending December 3*% ,++6 is closest to5 #) ,.+? &) 6.5? () $.-? D) *,.7? #nswer5 # Explanation5 #) @7# = 6et income : total assets. 8his is a little tric)y in that total assets aren9t gi1en in the problem. 8he st"dent m"st remember the basic balance sheet eE"ation # = 3 + !E. 8otal 3iabilities and !hareholders9 EE"ity is gi1en and this is the same as total assets. !o @7# = *+.6 : 533.* = .+,+ or ,.+? &) () D)

* **. 3"ther9s price - earnings ration (.:E) for the year ending December 3*% ,++6 is closest to5 #) 7.' &) *+.* () *5.D) *6.+ #nswer5 ( Explanation5 #) &) () .:E = .rice : E.! or Iar)et (ap : Earnings = (*+., =*6) : =*+.6 = *5.D)

2"9 The Statement o% )ash Flows *) /hich of the following is not a section on the cash flow statement2 #) >ncome generating acti1ities &) >n1esting acti1ities () 7perating acti1ities D) Ainancing acti1ities #nswer5 # Explanation5

#) &) () D)

2"2 .ccountin& Manipulation *) >n response to corporate scandals s"ch as Enron and /orld(om% in ,++, congress passed a law that reE"ires% among other things% that (E7s and (A7s certify the acc"racy and appropriateness of their firm9s financial statements and increases he penalties against them if the financial statements later pro1e to be fra"d"lent. 8he name of this act is2 #) 8he Hlass-!teagall #ct &) 8he !arbanes-7xley #ct () 8he #cc"racy in #cco"nting #ct D) 8he Ic(ain-Aeingold #ct #nswer5 & Explanation5 #) &) () D)

)hapter * - .r itra&e and Financial /ecision Ma$in&

7) <o" ha1e an in1estment opport"nity in Hermany that reE"ires an in1estment of =,5+%+++ today and will prod"ce a cash flow of L,+$%65+ in one year with no ris). !"ppose the ris)-free rate of interest in Hermany is 6? and the c"rrent competiti1e exchange rate is L+.7$ to =*.++. /hat is the 6.J of this pro;ect2 /o"ld yo" ta)e the pro;ect2 #) 6.J = +M 6o &) 6.J = ,%35$M 6o () 6.J = ,%35$M <es D) 6.J = *3%65+M <es #nswer5 ( Explanation5 #) &) () NPV = -,5+%+++ + (L,+$%65+ : *.+6) =*.++ : L+.7$ = ,35$% so since 6.J > +% accept D)

Use the table for the question(s) below. :ro;ect 4eenie4 4meenie4 4minie4 4moe4 )ash %low today -*+ *+ -*5 *+ )ash %low in one year *5 -$ ,+ -*5

*+) >f the ris)-free interest rate is *+?% then of the fo"r pro;ects listed% if yo" co"ld only in1est in one pro;ect% which on e wo"ld yo" select2 #)

Eenie &) Ieenie () Iinie D) Ioe #nswer5 # Explanation5 #) Eenie has highest 6.J NPV Eenie = -*+ + *5 : *.* = 3.6NPV Ieenie = *+ - $ : *.* = ,.73 NPV Iinie = -*5 + ,+ : *.* = 3.*$ NPV moe = *+ - *5 : *.* = -3.6&) () D)

**) >f the ris)-free interest rate is *+?% then of the fo"r pro;ects listed% which pro;ect wo"ld yo" ne1er want to in1est in2 #) Eenie &) Ieenie () Iinie D) Ioe #nswer5 D Explanation5 #) &) () D) Ioe has negati1e 6.J NPV Eenie = -*+ + *5 : *.* = 3.6NPV Ieenie = *+ - $:*.* = ,.73 NPV Iinie = -*5 + ,+ : *.* = 3.*$ NPV moe = *+ - *5 : *.* = -3.6*"9 .r itra&e and the 1aw o% ,ne :rice ,) /hich of the following statements regarding the 3aw of 7ne .rice is incorrect2 #) #t any point in time% the price of two eE"i1alent goods trading in different competiti1e mar)ets will be the same. &) 7ne "sef"l conseE"ence of the 3aw of 7ne .rice is that when e1al"ating costs and benefits to comp"te a net present 1al"e% we can "se any competiti1e price to determine a cash 1al"e% witho"t chec)ing the price in all possible mar)ets. () >f eE"i1alent goods or sec"rities trade sim"ltaneo"sly in different competiti1e mar)ets% then they will trade for the same price in both mar)ets.

D) #n important property of the 3aw of 7ne .rice is that it holds e1en in mar)ets where arbitrage is not possible. #nswer5 D Explanation5 #) &) () D)

Use the table for the question(s) below. (onsider the following prices from a IcDonald9s @esta"rant5 &ig Iac !andwich =,.'' 3arge (o)e =*.3' 3arge Ary =*.+' -) # IcDonald9s &ig Iac 1al"e meal consists of a &ig Iac !andwich% 3arge (o)e% and a 3arge Ary. #ss"me that there is a competiti1e mar)et for IcDonald9s food items and that IcDonalds sells the &ig Iac 1al"e meal for =-.7'. Does an arbitrage opport"nity exists and if so how wo"ld yo" exploit it and how m"ch wo"ld yo" ma)e on one extra 1al"e meal2 #) <es% b"y extra 1al"e meal and then sell &ig Iac% (o)e% and Aries to ma)e arbitrage profit of =+.6$ &) 6o% no arbitrage opport"nity exists () <es% b"y &ig Iac% (o)e% and Aries then sell 1al"e meal to ma)e arbitrage profit of =*.+' D) <es% b"y &ig Iac% (o)e% and Aries then sell 1al"e meal to ma)e arbitrage profit of =+.6$

#nswer5 # Explanation5 #) &"y 1al"e meal and sell &ig Iac% (o)e and Aries --.7' + ,.'' + *.3' + *.+' = +.6$ (so arbitrage exists) &) () D) 5) /algreen (ompany (6<!E5 /#H) is c"rrently trading at =-$.75 on the 6<!E. /algreen (ompany is also listed on 6#!D#G and ass"me it is c"rrently trading on 6#!D#G at =-$.5+. Does an arbitrage opport"nity exists and if so how wo"ld yo" exploit it and how m"ch wo"ld yo" ma)e on a bloc) trade of *++ shares2 #) 6o% no arbitrage opport"nity exists &) <es% b"y on 6#!D#G and sell on 6<!E% ma)e =,5 () <es% b"y on 6<!E and sell on 6#!D#G% ma)e =,5 D) <es% b"y on 6#!D#G and sell on 6<!E% ma)e =,5+ #nswer5 & Explanation5 #) &) <es% b"y *++ shares -$.5+ and sell *++ shares -$.75 = =,5.++ () D)

7) #d1anced Iicro De1ices (6<!E5 #ID) is c"rrently trading at =,+.75 on the 6<!E. #d1anced Iicro De1ices is also listed on 6#!D#G and ass"me it is c"rrently trading on 6#!D#G at =,+.5+. Does an arbitrage opport"nity exists and if so how wo"ld yo"

exploit it and how m"ch wo"ld yo" ma)e on a bloc) trade of *+++ shares2 #nswer5 <es% b"y *+++ shares ,+.5+ and sell *+++ shares ,+.75 = =,5+.++ *"5 <o-.r itra&e and Security :rices *) /hich of the following statements regarding arbitrage and sec"rity prices is incorrect2 #) /e call the price of a sec"rity in a normal mar)et the no-arbitrage price for the sec"rity. &) >n financial mar)ets it is possible to sell a sec"rity yo" do not own by doing a short sale. () /hen a bond is "nderpriced% the arbitrage strategy in1ol1es selling the bond and in1esting some of the proceeds. D) 8he general form"la for the no-arbitrage price of a sec"rity is .rice(sec"rity) = PV(#ll cash flows paid by the sec"rity). #nswer5 ( Explanation5 #) &) () D)

Use the information for the question(s) below. #n independent film ma)er is considering prod"cing a new mo1ie. 8he initial cost for ma)ing this mo1ie will be =,+ million today. 7nce the mo1ie is completed% in one year% the mo1ie will be sold to a ma;or st"dio for =,5 million. @ather than paying for the =,+ million in1estment entirely "sing its own cash% the film ma)er is considering raising additional f"nds by iss"ing a sec"rity that will pay in1estors =** million in one year. !"ppose the ris)-free rate of interest is *+?. 6) /itho"t iss"ing the new sec"rity% the np1 for this pro;ect is closest to what amo"nt2 !ho"ld the film ma)er ma)e the in1estment2 #) =*.7 millionM <es &) =*.7 millionM 6o () =,.7 millionM <es D) =,.7 millionM 6o #nswer5 ( Explanation5 #) &) () NPV = -,+ + ,5 : *.*+ = =,.7 million% since 6.J > + ta)e the in1estment D)

$) /hat is the 6.J of this pro;ect if the film ma)er does not iss"e the new sec"rity2 /hat is the 6.J if the film ma)er iss"es the new sec"rity2 #) =*.7 millionM =*.7 million &) =*.7 millionM =,.7 million ()

=,.7 millionM =*.7 million D) =,.7 millionM =,.7 million #nswer5 D Explanation5 #) &) () D) NPV (no sec"rity) = -,+ + ,5 : *.* = =,.7 NPV(w: sec"rity) = -*+ + (,5 - **) : *.*+ = =,.7 million Use the table for the question(s) below. Security # & ( ') >f the ris)-free rate of interest is 7.5?% then the 1al"e of sec"rity 4#4 is closest to5 #) ='*.++ &) =',.5+ () ='3.++ D) =*++.++ #nswer5 ( Explanation5 #) &) )ash %low today + *++ *++ )ash %low in one year *++ + *++

() = *++ : *.+75 = '3.+, which is approximately ='3.++ D)

**) >f the 1al"e of sec"rity 4(4 is =*$+% then what m"st be the 1al"e of sec"rity 4#42 #) =$+ &) ='+ () =*++ D) nable to determine witho"t the ris)-free rate. #nswer5 # Explanation5 #) 8he cash flows from ( are simply a combination of # K &% so price(() = price(#) + price(&) !ince & is already in todays dollars% price(&) m"st = *++% so price # = *$+ - *++ = =$+. &) () D)

Use the information for the question(s) below. #n exchange traded f"nd (E8A) is a sec"rity that represents a portfolio of indi1id"al stoc)s. (onsider an E8A for which each share represents a portfolio of two shares of >nternational &"siness Iachines (>&I)% three shares of Ierc) (I@F)% and three shares of (itigro"p >nc. ((). !"ppose the c"rrent mar)et price of each indi1id"al stoc) are shown below5 Stoc$ >&I I@F ( *3) !"ppose that the E8A is trading for =-,-.5+M yo" sho"ld )urrent :rice =7'.5+ =-+.++ =-$.5+

#) sell the EA8 and b"y , shares of >&I% 3 shares of I@F% and 3 shares of (. &) sell the EA8 and b"y 3 shares of >&I% , shares of I@F% and 3 shares of (. () b"y the EA8 and sell , shares of >&I% 3 shares of I@F% and 3 shares of (. D) do nothing% no arbitrage opport"nity exists. #nswer5 D Explanation5 #) &) () D) Jal"e of E8A = , 7'.5+ + 3 -+.++ + 3 -$.5+ = =-,-.5+% so no arbitrage opport"nity exists *-) !"ppose a sec"rity with a ris)-free cash flow of =*+++ in one year trades for ='+' today. >f there are no arbitrage opport"nities% then the c"rrent ris)-free interest rate is closest to5 #) $? &) *+? () **? D) *,? #nswer5 & Explanation5 #)

&) PV = FV : (* + i) ==>>> (* + i) = FV : PV = =*+++ : ='+' = *.*+ so i = *+? () D)

Use the information for the question(s) below. #n exchange traded f"nd (E8A) is a sec"rity that represents a portfolio of indi1id"al stoc)s. (onsider an E8A for which each share represents a portfolio of two shares of >nternational &"siness Iachines (>&I)% three shares of Ierc) (I@F)% and three shares of (itigro"p >nc. ((). !"ppose the c"rrent mar)et price of each indi1id"al stoc) are shown below5 Stoc$ >&I I@F ( *5) #ss"me that the E8A is trading for =-,6.++% what (if any) arbitrage opport"nity exists2 /hat (if any) trades wo"ld yo" ma)e2 #nswer5 Jal"e of E8A = , 7'.5+ + 3 -+.++ + 3 -$.5+ = =-,-.5+% so an arbitrage opport"nity exists. <o" sho"ld sell the EA8 for =-,6.++ and b"y , shares of >&I% 3 shares of I@F% and 3 shares of (. *"2 The :rice o% =is$ *) /hich one of the following statements is false2 #) /hen we comp"te the ret"rn of a sec"rity based on the a1erage payoff we expect to recei1e% we call it the expected ret"rn. &) 8he notion that in1estors prefer to ha1e a safe income rather than a ris)y one of the same a1erage amo"nt is call ris) a1ersion. () &eca"se in1estors are ris) a1erse% the ris)-free interest rate is not the right rate to "se when con1erting ris)y cash flows across time. D) 8he more ris) a1erse in1estors are% the higher the c"rrent price of a ris)y asset will be compared to a ris) -free bond. #nswer5 D Explanation5 #) &) () D) Use the table for the question(s) below. Security Mar$et :rice Today )ash Flow in ,ne +ear :oor 7conomy Good 7conomy )urrent :rice =7'.5+ =-+.++ =-$.5+

# & ( ,)

,++ 6++ 222

$-+ + $-+

+ $-+ -,++

&ased "pon the information pro1ided abo"t sec"rities #% &% and (% the ris)-free rate of interest is closest to5 #) -? &) 5? () $? D) *+? #nswer5 & Explanation5 #) &) /e can constr"ct the ris)-free asset by forming a portfolio of # and &. 8his portfolio has a certain payoff of =$-+. 8he price for this portfolio is =$++. /e )now that =$++ = =$-+ : (* + i) ==> (* + i) = $-+ : $++ = *.+5 ==> i = .+5 or 5?. () D)

-) !"ppose a ris)y sec"rity pays an a1erage cash flow of =*++ in one year. 8he ris)-free rate is 5?% and the expected ret"rn on the mar)et index is *3?. >f the ret"rns on this sec"rity are high when the economy is strong and low when the economy is wea)% b"t the ret"rns 1ary by only half as m"ch as the mar)et index% what ris) premi"m is appropriate for this sec"rity2 #) -? &) 6.5? () '? D) **? #nswer5 # Explanation5 #) !ince the sec"rity is half as ris)y as the mar)et% then the ris)-premi"m for the sec"rity sho"ld be half of the mar)et ris) premi"m. 8he mar)et ris) premi"m is *3? - 5? = $?% so the ris) premi"m on this sec"rity sho"ld be half of this or -?. &) () D)

Use the table for the question(s) below. Security # & ( Mar$et :rice Today ,++ 6++ 222 )ash Flow in ,ne +ear :oor 7conomy Good 7conomy $-+ + + $-+ $-+ -,++

*"7 .r itra&e with Transaction )osts *) /hich of the following statements is false2 #) 6o arbitrage opport"nities will exist "ntil the "nderlying prices di1erge by more than the amo"nt of the transaction costs. &)

&eca"se yo" will generally pay a slightly lower price when yo" b"y a sec"rity (the as) price) than yo" recei1e when yo" sell (the bid price) yo" will pay the bid-as) spread. () 8he price of a sec"rity sho"ld eE"al the present 1al"e of its cash flows% "p to the transaction costs of trading the sec"rity and the cash flows. D) >n most mar)ets% yo" m"st pay transactions costs to trade sec"rities. #nswer5 & Explanation5 #) &) () D)

,) (onsider a bond that pays =*+++ in one year. !"ppose that the mar)et interest rate for sa1ings is $?% b"t the interest rate for borrowing is *+?. 8he price range that this bond m"st trade in a normal mar)et if no arbitrage opport"nities exist is closest to5 #) ='+' to ='*7 &) ='+' to =',6 () ='*7 to =',6 D) ='+' to =*+++ #nswer5 & Explanation5 #) &) J& N $? = *+++ : *.+$ = =',6 J& N *+? = *+++ : *.*+ = ='+' so range is '+' to ',6 () D) Use the table for the question(s) below. Security >&I I@F ( 6) (onsider an E8A that is made "p of one share each of >&I% I@F% and (. 8he c"rrent E"ote for this E8A c"rrently is =*67.75 (bid) =*67.$5 (as)). /hat sho"ld yo" do2 #nswer5 8here is an arbitrage opport"nity. &"y the E8A at the as) of =*67.$5 and sell the "nderlying sec"rities at the bid prices. !o we ha1e +7'.-5 + 3'.'5 + -$.5+ - *67.$5 = .+5 arbitrage profit per share 7) (onsider an E8A that is made "p of one share each of >&I% I@F% and (. 8he c"rrent E"ote for this E8A c"rrently is =*67.$5 (bid) =*67.'5 (as)). /hat sho"ld yo" do2 #nswer5 0id 7'.-5 3'.'5 -$.5+ .s$ 7'.5+ -+.+5 -$.55

6othing% there is no arbitrage opport"nity here. 8he as) price m"st fall below =*67.'+ or the bid price m"st be abo1e =*6$.*+ for there to be an arbitrage. $) (onsider an E8A that is made "p of one share each of >&I% I@F% and (. 8he c"rrent E"ote for this E8A c"rrently is =*6$.*5 (bid) =*6$.,+ (as)). /hat sho"ld yo" do2 #nswer5 8here is an arbitrage opport"nity. !ell the E8A at the bid of =*6$.*5 and b"y the "nderlying sec"rities at the as) prices. !o we ha1e + *6$.*5 - 7'.5+ - -+.+5 - -$.55 = .+5 arbitrage profit per share

)hapter 9 - The Time -alue o% Money

3) /hich of the following statements is false2 #) 8he process of mo1ing a 1al"e or cash flow bac)ward in time is )nown as disco"nting. &) C (* + r )n ()

FV =

8he process of mo1ing a 1al"e or cash flow forward in time is )nown as compo"nding. D) 8he 1al"e of a cash flow that is mo1ed forward in time is )nown as its f"t"re 1al"e. #nswer5 & Explanation5 #) &) FV = C(* + r)n () D)

$) (onsider the following timeline5

>f the c"rrent mar)et rate of interest is '?% then the present 1al"e of this timeline as of year + is closest to5 #)

=-', &) =637 () =6++ D) =-++ #nswer5 # Explanation5 #) PV = FV(* + r)n *++ : (*.+')* = '*.7,++ : (*.+'), = *6$.33++ : (*.+')3 = ,3*.66 !"m = -'*.7- which is approximately =-', &) () D)

') (onsider the following timeline5

>f the c"rrent mar)et rate of interest is $?% then the 1al"e as of year * is closest to5 #) =+ &) =*++3 () =5-+ D) =77 #nswer5 D Explanation5 #) &) () D) 8wo part problem5 FV = PV(* + r)n = 5++(*.+$)* = =5-+ PV = FV:(* + r)n = -5++ : (*.+$)* = -=-63 !o the answer is =5-+ + -=-63 = =77 9"* The :ower o% )ompoundin&( .n .pplication ,) >t has long been told that the D"tch p"rchased Ianhattan island in *6,6 for the 1al"e of 6+ g"ilders (=,-). #ss"ming that the D"tch in1ested this money into an acco"nt earning 5?% approximately how m"ch wo"ld their in1estment be worth 3$+ years later in ,++62 #)

=,.7 billion &) =3.* billion () =-.5 billion D) =*.' trillion #nswer5 # Explanation5 #) FV = ,-(*.+5)3$+ = ,%7+-%$6+%6+, or ,.7 billion &) () D)

,) /hich of the following statements is false2 #) PV (* + r )n &)

FV =

PV =

Cn (* + r )n ()

n =+

FV =

n =+

Cn (* + r)n D)

Iost in1estment opport"nities ha1e m"ltiple cash flows that occ"r at different points in time. #nswer5 #

-) (onsider the following timeline detailing a stream of cash flows5

>f the c"rrent mar)et rate of interest is *+?% then the present 1al"e of this stream of cash flows is closest to5 #) =67&) =6++ () =-6+ D) =,$7 #nswer5 ( Explanation5 #) &) () PV = *++ : (*.*+)* + *++ : (*.*+), + ,++ : (*.*+)3 + ,++ : (*.*+)- = =-6+ D)

Use the information for the question(s) below. Ooe ;"st inherited the family b"siness% and ha1ing no desire to r"n the family b"siness% he has decided to sell it to an entreprene"r. >n exchange for the family b"siness% Ooe has been offered an immediate payment of =*++%+++. Ooe will also recei1e payments of =5+%+++ in one year% =5+%+++ in two years% and =75%+++ in three years. 8he c"rrent mar)et rate of interest for Ooe is 6?. 6) >n terms of present 1al"e% how m"ch will Ooe recei1e for selling the family b"siness2 #nswer5

PV = =*++%+++ + =5+%+++ : (*.+6)* + =5+%+++ : (*.+6), + =75%+++ : (*.+6)3 = =,5-%6-* 9"5 The <et :resent -alue o% a Stream o% )ash Flows *) <o" ha1e been offered the following in1estment opport"nity% if yo" pay =,5++ today% yo" will recei1e =*+++ at the end of each of the next three years. #ss"ming that yo" co"ld otherwise earn *+? per year on yo"r money% the 6.J for this opport"nity is closest to5 #) =*, &) =*$ () -=*3 D) =5++ #nswer5 ( Explanation5 #) &) () NPV = -,5++ + *+++ : (*.*+)* + *+++ : (*.*+), + *+++ : (*.*+)3 = -*3.*5 which is approximately -=*3 D)

Use the information for the question(s) below. Ooe ;"st inherited the family b"siness% and ha1ing no desire to r"n the family b"siness% he has decided to sell it to an entreprene"r. >n exchange for the family b"siness% Ooe has been offered an immediate payment of =*++%+++. Ooe will also recei1e payments of =5+%+++ in one year% =5+%+++ in two years% and =75%+++ in three years. 8he c"rrent mar)et rate of interest for Ooe is 6?. -) !"ppose a second entreprene"r approaches Ooe and offers him =,5+%+++ today for the b"siness. !ho"ld Ooe accept the new entreprene"r9s offer or stic) with the original offer of =*++%+++ and the series of payments o1er three years2 /hy2 #nswer5 Ooe sho"ld ta)e the original offer of =*++%+++ + payments. PV of the original offer = =*++%+++ + =5+%+++ : (*.+6)* + =5+%+++ : (*.+6), + =75%+++ : (*.+6)3 = =,5-%6-* !o% the 6.J of ta)ing the second offer is =,5+%+++ - =,5-%6-* = -=-%6-* !ince the 6.J is negati1e we wo"ld not ta)e the second offer. Use the table for the question(s) below. +ear + * , 3 5) >f the interest rate is *+?% then which in1estment(s)% if any% wo"ld yo" ta)e and why2 #nswer5 NPV# = -*5+ + -+ : (*.*+)* + $+ : (*.*+), + *++ : (*.*+)3 = =,7.6* NPV& = -,,5 + *75 : (*.*+)* + *,5 : (*.*+), + -5+ : (*.*+)3 = -=+.*7 8herefore% yo" sho"ld ta)e # since NPV# > + and re;ect & since NPV& < +. 9"2 :erpetuities, .nnuities, and ,ther Special )ases *) /hich of the following statements regarding perpet"ities is false2 #) 8o find the 1al"e of a perpet"ity one cash flow at a time wo"ld ta)e fore1er. &) # perpet"ity is a stream of eE"al cash flows that occ"rs at reg"lar inter1als and lasts fore1er. () r C . -=*5+ -+ $+ *++ 0 -=,,5 *75 *,5 -5+

PV of a perpet"ity = D)

7ne example of a perpet"ity is the &ritish go1ernment bond called a consol. #nswer5 ( Explanation5 #) &) () PV of a perpet"ity = C r D)

Use the information for the question(s) below. !"ppose that a yo"ng co"ple has ;"st had their first baby and they wish to ens"re that eno"gh money will be a1ailable to pay for their child9s college ed"cation. ("rrently% college t"ition% boo)s% fees% and other costs% a1erage =*,%5++ per year. 7n a1erage% t"ition and other costs ha1e historically increased at a rate of -? per year.

$) #ss"ming that college costs contin"e to increase an a1erage of -? per year and that all her college sa1ings are in1ested in an acco"nt paying 7? interest% then the amo"nt of money she will need to ha1e a1ailable at age *$ to pay for all fo"r years of her "ndergrad"ate ed"cation is closest to5 #) ='7%**+ &) =*+7%53, () =*+*%,'* D) =5+%+++ #nswer5 # Explanation5 #) 8his is a two step problem. !tep P* determine the cost of the first year of college. FV = PV(* + i)N = =*,%5++(*.+-)*$ = =,5%3,,.7* !tep P, fig"re o"t the 1al"e for fo"r years of college. PV of a growing ann"ity d"e = C x
* *+ g * rg *+ r

(* + r)

* + .+- - * * (* + .+7) = ='7%**+.+* = =,5%3,,.7* .+7 .+- * + .+7 &)

() D)

*3)

!"ppose that a yo"ng co"ple has ;"st had their first baby and they wish to ins"re that eno"gh money will be a1ailable to pay for their child9s college ed"cation. 8hey decide to ma)e deposits into an ed"cational sa1ings acco"nt on each of their da"ghter9s birthdays% starting with her first birthday. #ss"me that the ed"cational sa1ings acco"nt will ret"rn a constant 7?. 8he parents deposit =,+++ on their da"ghter9s first birthday and plan to increase the si0e of their deposits by 5? each year. #ss"ming that the parents ha1e already made the deposit for their da"ghter9s *$th birthday% then the amo"nt a1ailable for the da"ghter9s college expenses on her *$th birthday is closest to5 #) =-,%$,5 &) ='7%33* () =67%''$ D) =*+3%+63 #nswer5 & Explanation5 #) &) AJ of a growing ann"ity * + .+5 *$ * * (*.+7)*$= ='7%33* .+7 .+5 * + .+7 () D)

=,%+++

Use the information for the question(s) below. #ss"me that yo" are 3+ years old today% and that yo" are planning on retirement at age 65. <o"r c"rrent salary is =-5%+++ and yo" expect yo"r salary to increase at a rate of 5? per year as long as yo" wor). 8o sa1e for yo"r retirement% yo" plan on ma)ing ann"al contrib"tions to a retirement acco"nt. <o"r first contrib"tion will be made on yo"r 3*st birthday and will be $? of this year9s salary. 3i)ewise% yo" expect to deposit $? of yo"r salary each year "ntil yo" reach age 65. #ss"me that the rate of interest is 7?. *7) 8he present 1al"e (at age 3+) of yo"r retirement sa1ings is closest to5 #) =$7%+++ &)

=*+$%+++ () =-6%6++ D) =75%,3+ #nswer5 # Explanation5 #) Airst deposit = .+$ =-5%+++ = =3%6++

=3%6++

* + .+5 35 * * = =$7%++3 .+7 .+5 * + .+7 &)

() D)

,6) #ss"me that yo" are 3+ years old today% and that yo" are planning on retiring at age 65. <o"r c"rrent salary is =-5%+++ and yo" expect yo"r salary to increase at a rate of 5? per year as long as yo" wor). 8o sa1e for yo"r retirement% yo" plan on ma)ing ann"al contrib"tions to a retirement acco"nt. <o"r first contrib"tion will be made on yo"r 3*st birthday and will be $? of this year9s salary. 3i)ewise% yo" expect to deposit $? of yo"r salary each year "ntil yo" reach age 65. #t retirement (age 65) yo" will begin withdrawing eE"al ann"al payments to pay for yo"r li1ing expenses d"ring retirement (on yo"r 65th birthday). >f yo" expect to die one day before yo"r *+*st birthday (<o"r last withdraw will be on yo"r *++th birthday) and if the ann"al rate of ret"rn is 7?% then how m"ch money will yo" ha1e to spend in each of yo"r golden years of retirement2 #nswer5 =7*%,6+ Airst deposit = .+$ =-5%+++ = =3%6++

=3%6++

* + .+5 35 * * (*.+7)35= =',$%$'5 .+7 .+5 * + .+7

so% N = 36 I=7 PV = ',$%$'5 FV = + (omp"te P T = 7*,6+

9"8 Sol'in& %or -aria les ,ther Than :resent -alue or Future -alue *) <o" are interested in p"rchasing a new a"tomobile that costs =35%+++. 8he dealership offers yo" a special financing rate of 6? #.@ (+.5?) per month for -$ months. #ss"ming that yo" do not ma)e a down payment on the a"to and yo" ta)e the dealer9s financing deal% then yo"r monthly car payments wo"ld be closest to5 #) =7,' &) =$,, () =$-, D) =6-7 #nswer5 & Explanation5 #) &) PV = 35+++ I = .5 N = -$ FV = + (omp"te .ayment = =$,*.'$ () D)

,) <o" are considering p"rchasing a new home. <o" will need to borrow =,5+%+++ to p"rchase the home. # mortgage company offers yo" a *5 year fixed rate mortgage (*$+ months) at '? #.@ (+.75? month). >f yo" borrow the money from this mortgage company% yo"r monthly mortgage payment will be closest to5 #) =,%5$5 &) =66+ () =,%535

D) =*%3'+ #nswer5 ( Explanation5 #) &) () PV = ,5++++ I = +.75 N = *$+ FV = + (omp"te P T = =,535.67 -) <o" are sa1ing for retirement. 8o li1e comfortably% yo" decide that yo" will need =,.5 million dollars by the time yo" are 65. >f today is yo"r 3+th birthday% and yo" decide% starting today% and on e1ery birthday "p to and incl"ding yo"r 65th birthday% that yo" will deposit the same amo"nt into yo"r sa1ings acco"nt. #ss"ming the interest rate is 5?% the amo"nt that yo" m"st set aside each and e1ery year on yo"r birthday is closest to5 #) =7*%-3+ &) =,7%6$+ () =,6%*++ D) =,6%,6+ #nswer5 ( Explanation5 #) &) () PV (age ,') = ,5+++++ : (*.+5)36 = -3*6-3.5PV = -3*%6-3.5FV = +

I=5 N = 36 (omp"te P T = =,6%+$6

5). <o" are loo)ing for a new tr"c) and see the following ad1ertisement. 47wn a new tr"c)Q 6o money down. O"st fi1e easy ann"al payments of =$+++.4 <o" )now that yo" can get the same tr"c) from the dealer across town for only =3*%*,+. 8he interest rate for the deal ad1ertised is closest to5 # ) '? & )

$?

$.5? D )

*+? # n

# Explanation 5

#) PV = 3**,+ FV = + N=5 P T = -$+++ (omp"te I = $.''65? &)

()