Exam 1 Solutions

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California State University, Fullerton *

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650

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Finance

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Jan 9, 2024

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FIN 600 Seminar in Business Finance Exam 1 Instructor: Aslihan Salih Part I Multiple Choice Please answer the following multiple choice questions 1. Which organizational form has the highest degree of separation between the owners and operators of a business? A. Limited partnerships B. Corporations C. Sole proprietorships Answer: B 2. For a company that is financially sound, thus is repaying interest and principal on debt in full and on time, increasing the company’s rate of growth is most likely to benefit: A. Equity holders, but not debt holders B. Both equity holders, and debt holders C. Debt holders, but not equity holders Answer: A 3. The amount an investor will have in 9 years if $2500 is invested today at an annual interest rate of 6% will be closest to: A. $2110.65 B. $3517.75 C. $4223.70 Answer: C 4. Ferry Corporation preferred stocks are expected to pay a $4 annual dividend forever. If the required rate of return on equivalent investments is 13%, a share of Ferry preferred stock should be worth:

A. $45.45 B. $30.77 C. 38.46 Answer: B 5. An investor has just won the lottery, and will receive $35,000 per year at the end of each of the next 14 years. At an 8% interest rate the present value of the winnings is closet to: A. $288,548.29 B. $322,427.54 C. $342,379.15 Answer: A 6. If $5000 is invested in a fund offering a rate of return of 12% per year, approximately have many years will it take for the investment to reach $15,000? A. 9.69 years B. 13.54 years C. 26.24 years Answer: A 7. If $12,000 is invested today in an account that earns interest at a rate of 9.5%, what is the value of the equal withdrawals that can be taken out of the account at the end of each of the next four years if the investor plans to deplete the account at the end of the time period? A. $2537.66 B. $3052.88 C. $3744.76 Answer: C 8. An investor is looking at a $400,000 home. If 20% must be put down and the balance is financed at a stated annual rate of 7.2% over the next 30 years, what is the monthly mortgage payment? A. $3779.28 B. $4778.67 C. $2172.12 Answer: C

9. What is the effective annual rate (EAR) of the mortgage loan in question 8? A. 7.33% B. 7.44% C. 8.08% Answer: B 10. How much should an investor have in a retirement account on her 65 th birthday if she wishes to withdraw $50,000 on that birthday and each of the following 14 birthdays, assuming her retirement account is expected to earn 12%? A. $331,408.41 B. $340,543.22 C. $381,408.41 Answer: C 11. A T-note has a coupon rate of 4 percent, a face value of $100, and matures in three years. The bond pays semiannual interest payments. Calculate the price of the bond if the yield to maturity is 5 percent. A. $97.25 B. $102.78 C. $100 Answer: A 12. An analyst observes a 20-year, 8% coupon bond with semiannual coupons. The required yield to maturity was 8%, but suddenly it decreased to 7.25%. As a result, the price of this bond: A. decreased. B. increased. C. stayed the same. Answer: B 13. A 2-year bond with a 6 percent coupon rate and $1,000 face value is selling for $972.84. Calculate the yield to maturity on the bond assuming annual interest payments. A. 8.76% B. 6.00% C. 7.51% Answer: C

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14. All else equal, which of the following bonds is likely to have the lowest interest rate risk? A. A 5-year 5% semiannual-pay bond. B. A 5-year 10% semiannual-pay bond. C. A 5-year zero-coupon bond. Answer: B 15. A two-year zero coupon bond with a face value of $1000 is trading at $890. Calculate the two year spot rate. A. 6.0%. B. 5.4%. C. 4.9%. Answer: A 16. If a bond's modified duration is 8.2 and its yield to maturity increases by 0.2%, then the price of the bond will A. Increase by 1.64 percent. B. Decrease by 1.64 percent. C. Decrease by 0.82 percent. Answer: B 17. As CFO of your corporation, you would prefer (all else equal) to see the price of your corporation's bonds: A. decrease, indicating that bond investors view your firm as less risky, thus your cost of capital is decreasing B. increase, indicating that bond investors view your firm as more willing to take risks, with no change on your cost of capital C. increase, indicating that bond investors view your firm as less risky, thus your cost of capital is decreasing Answer: C 18. A firm has a constant growth rate of 5% and just paid a dividend of $4.25. If the required rate of return is 9%, what will the stock sell for one year from now based on the dividend discount model? A. P 1 = $117.14 B. P 1 = $111.56 C. P 1 = $106.25 Answer: A

Scenario: Use the following information about Softech and the multi-period dividend discount model to answer the questions 19 and 20.  Last year’s dividend was $1.5 .  The dividend is expected to grow at 12% for three years.  The growth rate of dividends after three years is expected to stabilize at 5%.  The required return for Softech ’s common stock is 15%. 19. Which of the following statements about Softech’s stock is accurate? A. At the end of three years, Softech ’s stock will sell for $22.13. B. The dividend at the end of year three is expected to be $3.28. C. The dividend at the end of year two is expected to be $1.68. Answer: A 20. Calculate the intrinsic value of the Softech ’s stock now (at t=0) using DDM and the above information in the scenario. A. $21.17 B. $18.82 C. $19.96 Answer: B 21. ATV Incorporated expects to pay a dividend of $1.5 per share at the end of year 1 (Div1) and these dividends are expected to grow at a constant rate of 6 percent per year forever. If the current value of the stock today is $27.12, what is the required rate of return on this stock? A. 14.42% B. 12.75% C. 11.53% Answer: C 22. Corral Company expects to pay a dividend of $4.5 per share — one year from now — out of earnings of $8.00 per share. If the required rate of return on the stock is 12 percent and its dividends are growing at a constant rate of 7 percent per year, calculate the present value of growth opportunities for the stock (PVGO). A. 66.67 B. 90.00 C. 23.33 Answer: C

23. A firm currently pays no dividend but is expected to pay a dividend at the end of Year 4. Year 4 earnings are expected to be $1.64, and the firm will maintain a payout ratio of 50%. Assuming an expected return of equity (ROE) of 15%, and a required rate of return of 10%, estimate the current value of this stock. A. $32.81 B. $24.64 C. $12.32 Answer: B 24. If the cash flows for project Z are C 0 = -1,000; C 1 = 600; C 2 = 720; and C 3 = 2,000, calculate the discounted payback period for the project at a discount rate of 20 percent. A. 1.55 years B. 2 years C. 2.27 years Answer: B 25. A company CFO plotted the below NPV profile for a mining project that have environmental cleanup costs at the end of the project. If the cost of capital is 12% should the company accept the project and which method should be used in this decision? A. Accept the project using NPV rule, the project has a positive NPV at 12% B. Reject the project using IRR rule, IRR of 3.5% is less than the cost of capital. C. CFO cannot give an investment decision in this case as the project has multiple IRRs Answer: A ($6.00) ($4.00) ($2.00) $0.00 $2.00 $4.00 0% 5% 10% 15% 20% 25% 30% 35% NPV

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26. A company is considering the purchase of a copier that costs $5,000. Assume a required rate of return of 10% and the following cash flow schedule: Year 1: $3,000, Year 2: $2,000, Year 3: $2,000. The project’s IRR is closest to: A. 33.75% B. 19.22% C. 20.64% Answer: C 27. Sammy Company is considering investing in a new project. The project will need an initial investment of $1,200,000 and will generate $600,000 (after-tax) cash flows for three years. However, at the end of the fourth year, the project will generate -$500,000 of after-tax cash flow due to dismantling costs. Calculate the NPV for the project if the cost of capital is 15 percent. A. -$115,941.55 B. -$100,818.74 C. -$76,660.28 Answer: A 28. Your company is evaluating the following two projects (X and Y) with the same risk. The risk- adjusted discount rate is 14.2% for both projects. Project Initial Investment Year 1 NPV at 14.2% IRR X ($15,000) $18,000 $761.82 20.0% Y ($5,000) $6,500 $691.77 30.0% Projects X and Y are mutually exclusive, that is, you may undertake one or the other, but not both. Which of the projects should your company choose? A. Project Y B. Project X C. Neither Answer: B

29. A company is considering three independent projects (G, H, and I) that have the following expected cash flows and risk-adjusted discount rates. Project Discount Rate ( r ) Initial Investment Year 1 Year 2 Year 3 Year 4 Year 5 G 9.0% ($800) $200 $200 $200 $200 $250 H 5.0% ($500) $300 $50 $50 $50 $200 I 7.0% ($400) $90 $120 $150 $100 $50 The company has a budget constraint of $1,000. Based on NPV, which project(s) should the company choose? A. Projects H and I B. Project G C. Project H Answer: A 30. An analyst with High-Tech Corporation is evaluating two machines as possible replacements for an existing stamping machine. He estimates that machine 1 has a cost of $5 million and that purchasing it would produce a profitability index of 1.20. He estimates that machine 2 has a cost of $6 million and that purchasing it would produce a profitability index of 1.17. Based on these estimates which one of the following statements is correct if the company follows the NPV rule to choose projects. A. neither project is preferred to the other they both have the same NPV. B. machine 1 should be chosen because it has a higher NPV C. machine 2 should be chosen because it has a higher NPV Answer: C

31. a. Briefly explain the concept of yield curve. Why and when will the yield curve change? Yield Curve is the graph that shows the spot rates obtained from government bonds on the y- axis and the maturities on the x-axis. The yield curve will change continuously with trading the government bonds that are used for capturing the spot rates. b. What is meant by a normal yield curve? Was the yield curve normal during September 2023? Normal yield curve is upward sloping short-term rates are lower than the long term rates. Yield curve was inverted during September 2023, short-term rates were higher than the long-term rates. c. What is the significance of this curve for investors and corporate managers? Why investors and corporate managers follow the changes in yield curve very closely? It is used as a benchmark to price all the financial assets in the market at different maturities. Investors follow yield curve to assess the interest rate risk of their portfolio holdings. Corporate managers follow the yield curve to follow possible changes in their WACC.

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