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FINM1415 Introduction to Finance

Practice Mid-Semester Exam

Answer questions 1 to 25 on the multiple choice answer sheet provided. Choose the most correct answer.

1. When investors purchase Harvey Norman shares in a public offering, it is an example of the market.

A. Secondary

B. Bond

C. Primary

D. Derivatives

E. All of them

2. Consider a coupon bond with a coupon rate of 10%. The face value amount is unknown. Suppose the bond is trading at a par. What can we say about yield to maturity of the bond?

A. YTM > 10%.

B. YTM = 10%.

C. YTM < 10%.

D. YTM is negative.

E. There is not enough information to answer the question.

3. The distinguishing feature of a corporation is that:

A. there is no legal difference between the corporation and its owners.

B. it is a legally defined, artificial being, separate from its owners.

C. it spreads liability for its corporate obligations to all shareholders.

D. it provides limited liability only to small shareholders.

E. none of them.

4. You overhear your manager saying that she plans to book an Ocean-view room on her upcoming trip to Miami for a meeting. You know that the interior rooms are much less expensive and that your manager is traveling at the Company's expense. This use of additional funds comes about as a result of:

A. an agency problem.

B. an adverse selection problem.

C. amoral hazard.

D. a publicity problem.

E. None of them.

5. Corporate governance is best defined as:

A. the system of laws and regulations that control corporations.

B. the system that determines who controls and runs a corporation.

C. the system that minimizes agency costs between bondholders and stockholders.

D. the system of controls, regulations, and incentives designed to prevent fraud and minimize conflicts of interest in a corporation.

E. the conflict of interest between managers and investors that derives from the separation of ownership and control in a corporation.

6. A dollar invested today grows to $1.10 in six months. What is the effective annual rate if you deposit your money in a bank for one year?

A. 5%

B. 10%

C. 20%

D. 21%

E. None of them

EAR = (1 + 10%)2 − 1

= 21%

7. Exercise Bicycle Company is expected to pay a dividend in year 1 of $1.20, a dividend in year 2 of $1.50, and a dividend in year 3 of $2.00. After year 3, dividends are expected to grow at the rate of 10% per year. An appropriate required return for the stock is 14%. The value of the stock today is closest to

A. $33.00

B. $39.86

C. $55.00

D. $66.00

E. $40.68

PV = + + = 40.68

8. Walgreen Company (NYSE: WAG) is currently trading at $48.25 on the NYSE. Walgreen Company is also listed on NASDAQ and assume it is currently trading on NASDAQ at $48.50. Does an arbitrage opportunity exist and if so how would you exploit it? How much would you make on a block trade of 100 shares?

A. No, no arbitrage opportunity exists.

B. Yes, buy on NASDAQ and sell on NYSE, make $25.

C. Yes, buy on NYSE and sell on NASDAQ, make $25.

D. Yes, buy on NASDAQ and sell on NYSE, make $250.

E. Yes, buy on NYSE and sell on NASDAQ, make $250.

9. An exchange traded fund (ETF) is a security that represents a portfolio of individual stocks. Consider an ETF for which each share represents a portfolio of two shares of International Business Machines (IBM), three shares of Merck (MRK), and three shares of Citigroup Inc. (C). Suppose the current market price of each individual stock are shown below:

2 ∗ 128.92 + 3 ∗ 71.75 + 3

∗ 64.62

= 666.95

No arbitrage exists.

A. sell the EFT and buy 2 shares of IBM, 3 shares of MRK, and 3 shares of C. B. sell the EFT and buy 3 shares of IBM, 2 shares of MRK, and 3 shares of C. C. buy the EFT and sell 2 shares of IBM, 3 shares of MRK, and 3 shares of C. D. buy the EFT and sell 2 shares of IBM, 2 shares of MRK, and 3 shares of C. E. do nothing, no arbitrage opportunity exists.

10.The effective annual rate (EAR) for a savings account with a stated APR of 4% compounded daily (use 365-day year) is closest to:

A. 3.92%.

B. 4.00%.

C. 4.08%.

D. 14.60%.

E. none of them.

EAR = ( 1 + 365(4%))365 = 4.08%

11.A $1,000 bond with a coupon rate of 5.4% paid semi-annually has five years to maturity and a yield to maturity of 7.5%. If interest rates rise and the yield to maturity increases to 7.8%, what will happen to the price of the bond?

P1 = 1000 ∗ ∗ + = 913.77 P2 = 1000 ∗ ∗ + = 902.18

902.18 − 913.77 = −11.58

A. Fall by $11.59

B. Rise by $12.16

C. Fall by $9.82

D. The price of the bond will not change.

E. None of them.

12.The growth in dividends of Music Doctors, Inc. is expected to be 8% per year for the next two years, followed by a growth rate of 4% per year for three years; after this five-year period, the growth in dividends is expected to be 3% per year, indefinitely. The required rate of return on Music Doctors, Inc. is 11%. Last year's dividends per share were $2.75. The price of the stock today should be closest to

PV = 1(2).1(9)1(7) + 31(.)21(0)12(7)6 1(/)1(1)5(1)% − 3%)

= 39.71329

13.Rearden Metals expects to have earnings this coming year of $2.50 per share. Rearden plans to retain all of its earnings for the next year. For the subsequent three years, the firm will retain 50% of its earnings. It will then retain 25% of its earnings from that point onward. Each year, retained earnings will be invested in new projects with an expected return of 20% per year. Any earnings that are not retained will be paid out as dividends. Assume Rearden's shares outstanding remains constant and all earnings growth comes from the investment of retained earnings. If Rearden's equity cost of capital is 10%, then Rearden's stock price is closest to:

A. $40.80.

B. $44.60.

C. $59.80.

D. $63.50.

E. None of them.

Year 0 1 2 3 4 5 6

Earnings

1 EPS Growth Rate (vs. prioryr) 20.00% 10.00% 10.00% 10.00% 5.00%

2 EPS $2.50 $3.00 $3.30 $3.63 $3.99 $4.19

Dividends

3 Retention Ratio 100% 50% 50% 50% 25% 25%

4 Dividend Payout Rat 0% 50% 50% 50% 75% 75%

5 Div (2 × 4)

Discounted value

Share price

$0.00

$1.50

$1.24

$1.65

$1.24

$1.82

$1.24

$2.99 $3.14

62.8898

$40.91

14.Light Construction Machinery Company has an expected ROE of 11%. The dividend growth rate will be if the firm follows a policy of paying 25% of earnings in the form of

g = (1 − 25%) ∗ 11% = 8.25%

15. Taggart Transcontinental currently has a bank loan outstanding that requires it to make three annual payments at the end of the next three years of $1,500,000 each. The bank has offered to allow Taggart Transcontinental to skip making the next two payments in lieu of making one large payment at the end of the loan's term in three years. If the interest rate on the loan is 6%, then the final payment that the bank will require to make Taggart Transcontinental indifferent between the two forms of payments is closest to:

1106(.5) + 10(1.)6(5)2 + 10(1.)6(5)3 = 1 0(x)63

x = 4.7754 million

16. Manuka took out a 30-year mortgage with an APR of 5.9%, compounding semi-annually. If the effective annual rate does not change, and Manuka borrowed $300,000 to buy his home, then his monthly payment will be closest to

(1 + new montℎly Tate)12 = (1 + 5.9%/2)2

new montℎly Tate = 0.4857%

300000 = Moyment(nt∗ [1) 7(1)66(+)0.4857%)−360]

17.A bank pays interest quarterly with an EAR of 5.13%. What is the periodic interest rate applicable per quarter?

(1 + T)4 − 1 = 5.13%

x = 1.26%

18. You are thinking about investing in a mine that will produce $10,000 worth of ore in the first year. As the ore closest to the surface is removed it will become more difficult to extract the ore. Therefore, the value of the ore that you mine will decline at a rate of 8% per year forever. If the appropriate interest rate is 6%, then the value of this mining operation is closest to:

PV = 10000 = 71429

6% − (−8%)

19. Von Bora Corporation (VBC) is expected to pay a $2.25 dividend at the end of this year. If you expect VBC's dividend to grow by 6.5% per year forever and VBC's equity cost of capital is 12.5%, then the value of a share of VBC is closest to:

2.25

PV = = 37.5

12.5% − 6.5%

20. Which of the following bonds is most sensitive to movements in interest rates? Assume all bonds have the same face value.

A. 10-year zero coupon bond.

B. 10-year coupon paying par bond.

C. 5-year coupon paying bond.

D. 1-year zero coupon bond.

E. 1 month bill of exchange.

21. XYZ Corporation is expected to pay a dividend of $1.40 per share at the end of this year and a $1.50 per share at the end of the second year. You expect Von Bora's stock price to be $25.00 at the end of two years. Von Bora's equity cost of capital is 10%.

The price you would be willing to pay today for a share of Von Bora stock, if you plan to hold the stock for two years is closest to:

P = + + = 23.15

22.Since your first birthday, your grandparents have been depositing $1000 into a savings account on every one of your birthdays. The account pays 4% interest annually. Immediately after your grandparents make the deposit on your 18th birthday, the amount of money in your savings account will be closest to:

FV = 1000 ∗ = 25645

23.Jack Wong purchased a five-year bond today at $991.62. The bond pays 6.5 percent semi- annually and its Face Value is $1000. What will be his yield to maturity?

991.62 = 1000 ∗ [1 − ( 1 + −10] +

By trying with all four solutions, we obtain 991.62 with y = 6.7%

24.You have just sold your house for $1,000,000 in cash. Your mortgage was originally a 30-year mortgage with monthly payments and had an initial balance of $800,000. The mortgage is currently exactly 18.5 years old, and you have just made a payment. If the interest rate on the mortgage is 5.25% p.a. (with monthly compounding), how much cash will you have from the sale once you pay off the mortgage? (Round to the nearest dollar)

800000 = ∗ [1 − (1 + 5.25%/12)−30∗12]