Final Exam Solutions 2009 3 Fall

FNAN 301, fall 2009, final, solutions
Quantitative: value of a growing perpetuity and return of a fixed perpetuity

1. You own two investments, A and B, that have a combined total value of $14,700. Investment
A is expected to make its next monthly payment in 1 month. As next payment is expected to be
$56 and subsequent payments are expected to grow by 0.2 percent per month forever. The
expected return for investment A is 1.0 percent per month. Investment B is expected to pay $67
a month forever and make its next payment in 1 month. What is the monthly expected return for
investment B?
investment B?
investment B?
Quantitative: compute present value of two cash flows of different signs
2. You just bought a new car today. What is the present value of your cash flows if the discount
rate is 12.3 percent, you will receive a rebate of $2,000 from the dealer in 2 years, and you will
pay $40,000 to the dealer in 4 years? Note: the correct answer is less than zero.

Quantitative: FV of annuity and payment associated with PV annuity
3. Calvin has nothing in his retirement account. However, he plans to save $10,000 per year in
his retirement account for each of the next 22 years. His first contribution to his retirement
account is expected in 1 year. Calvin expects to earn 9.0 percent per year in his retirement
account, both before and during his retirement. Calvin plans to retire in 22 years, immediately
after making his last $10,000 contribution to his retirement account. In retirement, Calvin plans
to withdraw $100,000 per year for as long as he can. How many payments of $100,000 can
Calvin expect to receive in retirement if he receives annual payments of $100,000 in retirement
and his first retirement payment is received exactly 1 year after he retires?
A. 9.68 (plus or minus .02 payments)
B. 6.29 (plus or minus .02 payments)
C. 8.50 (plus or minus .02 payments)
D. Calvin can make an infinite number of annual withdrawals of $100,000 in retirement
E. D is not correct and neither A, B, nor C is within .02 payments of the correct answer

Quantitative: find PV of delayed annuity
4. Maryland Pharmaceuticals (MP) is developing a new drug that it expects to begin selling in
several years. The first cash flow from the drug is expected in 5 years from today and is forecast
to be $100 million. MP expects to receive $100 million per year for several years. The last of
these annual $100 million cash flows is expected in 12 years from today. After that, the drug will
no longer be patent-protected and MP expects no more cash flows from it. What is the present
value of the drug to MP if the cost of capital is 10.0 percent?

Conceptual and quantitative: present value of a single cash flow and an annuity due
5. The Fairfax Cookie Company just bought 2 tons of chocolate chips from Chantilly Chocolate. Fairfax
Cookie has been offered the 3 possible payment options described in the table. If the discount rate is 10.0%,
which one of the assertions is true?
Terms of payment (amount and timing)
Option
from Fairfax Cookie to Chantilly Chocolate
A
$9,000 today
B
$9,000 in 1 year
A series of annual payments of $2,000, with the first payment due later
C
today and the last payment due in 5 years from today
A. Fairfax Cookie should prefer option B more than option A and Fairfax Cookie should prefer option C more
than option A
B. Fairfax Cookie should prefer option B more than option A and Fairfax Cookie should not prefer option C
more than option A
C. Fairfax Cookie should not prefer option B more than option A and Fairfax Cookie should prefer option C
more than option A
D. Fairfax Cookie should not prefer option B more than option A and Fairfax Cookie should not prefer option
C more than option A
Option
A
$10,000 today
B
$10,000 in 1 year
C
than option A
more than option A
more than option A
Option
A
$11,000 today
B
$11,000 in 1 year
C
than option A
more than option A
more than option A

Quantitative: find monthly rate for loan and then find EAR
6. Bartholomew just borrowed $65,000 to buy a new Lexus automobile. The terms of the loan
require him to make equal month-end payments for 5 years. His first payment is due in one
month from today. If Bartholomew must pay $1,489.62 per month, then what is the EAR of his
loan?
loan?
loan?
Quantitative: price constant-growth stock and then find YTM of annual bond
7. Maya has one share of stock and one bond issued by Note Takers Inc. The total value of the
two securities is $1,300. The stock has an expected return of 11.0 percent per year and pays
annual dividends that are expected to grow forever by 2.0 percent per year. The next dividend is
expected to be $25.38 and paid in one year. The bond has an annual coupon rate of 11.0 percent
and a face value of $1,000; pays annual coupons with the next coupon expected in one year; and
matures in 17 years. What is the yield-to-maturity of the bond?

Quantitative: find expected price based on expected dividend computed from D1 and g
8. Waning Moon Corp. pays an annual dividend on its common stock that is expected to grow by
2.5 percent a year forever. The next dividend is due in 1 year and is expected to be $7.70. If the
expected return on Waning Moon common stock is 13.0 percent per year, then what is the price
of the stock expected to be in 4 years?

Quantitative: find expected price based on current price and expected dividend
9. The common stock of Electric Purple Corporation pays an annual dividend, has an expected
annual return of 16.5 percent, is currently priced at $50.00 per share, and just paid its annual
dividend. The following is some information on the expected price and expected annual
dividend for Electric Purple stock as of several points in time. Note that the following
information is not comprehensive, as expected prices and expected dividends for the stock as of
many points in time in the future are not given.
The stock is expected to pay a dividend of $5.60 in 1 year
The stock is expected to pay a dividend of $8.50 in 2 years
The stock is expected to be priced at $50.00 in 3 years
Given the preceding information, what is the price of Electric Purple stock expected to be in 1 year?

Conceptual: project risk and discount rate
10. The managers of Logical Balance Financial have evaluated five potential projects. Each
project has conventional cash flows and would require an initial investment of $1 million. Based
on the information given in this paragraph and presented in the table, which one of the projects is
the riskiest?
Discounted
Cost of
Net present
Payback
payback
Internal rate
capital
value
period
period
of return
Project
(in %)
(in $ millions)
(in years)
(in years)
(in %)
A
11.0
0.2
7.6
8.1
11.1
B
7.1
53.3
5.6
8.7
13.5
C
13.2
12.6
2.4
3.2
13.4
D
6.7
8.9
5.8
8.2
14.3
E
9.2
-1.5
2.1
8.6
the riskiest?
Discounted
Cost of
Net present
Payback
payback
Internal rate
capital
value
period
period
of return
Project
(in %)
(in $ millions)
(in years)
(in years)
(in %)
A
12.0
0.2
7.7
8.2
12.1
B
14.2
12.5
2.5
3.2
14.4
C
8.1
53.2
5.7
8.9
14.5
D
10.2
-1.4
2.2
9.6
E
7.7
8.8
5.9
8.4
15.3
the riskiest?
Discounted
Cost of
Net present
Payback
payback
Internal rate
capital
value
period
period
of return
Project
(in %)
(in $ millions)
(in years)
(in years)
(in %)
A
8.3
53.4
5.6
8.8
14.6
B
10.5
-1.6
2.1
9.7
C
12.2
0.2
7.6
8.3
12.1
D
14.5
12.3
2.4
3.3
14.5
E
7.9
8.6
5.9
8.4
15.4

Find NPV from relevant cash flows based on given information
Overview: Down Under Cavers provides cave exploration tours in Australia. The firm is considering a
New Zealand project which would involve expanding into New Zealand.
The project, which would last for 2 years, would involve an initial investment of $300,000 for new
equipment that would be hauled away for an after-tax cash flow of $0 at the end of the project in 2 years.
In other words, after taking any relevant taxes into account, the cash flows from capital spending
associated with the sale of the equipment in 2 years would be $0. The equipment would be depreciated to
zero over 2 years using straight-line depreciation.
Down Under management expects annual revenue from New Zealand caving to be $700,000 in the first
year and $900,000 in the second year. Management expects annual costs from New Zealand caving to be
$500,000 in the first year and $600,000 in the second year.
The tax rate is 30 percent and the appropriate cost of capital for the New Zealand project is 8 percent,
which is the same as for all caving activities.
11. What is the net present value (NPV) of the New Zealand Project based on the information provided in
the overview?
the overview?
the overview?

Quantitative: find after-tax cash flow from equipment sale with MACRS depreciation
12. What is the after-tax cash flow from selling equipment expected to be if a company
purchases a piece of equipment today for $680,000, the companys tax rate is 40%, the
equipment is expected to be sold in 3 years for $122,000, and MACRS depreciation is used with
a three-year schedule where the depreciation rates in years 1, 2, 3, and 4 are 33.33%, 44.44%,
14.82%, and 7.41%, respectively?
10

Conceptual: ethics and legality of insider trading
13. According to the class overheads and basic ethics, which one of the following assertions
about insider trading, which is against the law, is true?
A. Insider trading is legal and should be considered as a potential approach to investing
B. Insider trading is legal and should not be considered as a potential approach to investing
C. Insider trading is illegal and should be considered as a potential approach to investing
D. Insider trading is illegal and should not be considered as a potential approach to investing
Quantitative: find risk premium from expected return and risk-free return
14. If Treasury Bills have a return of 5.62% and the expected rate of return for Immunity Idol
Incorporated stock is 12.34%, what is the risk premium on Immunity Idol Incorporated stock?
11

Conceptual: likely actual return from good or bad news based on expectations
15. Alpha Beta Electronics has increased its annual dividend by 3.5 percent a year for each of the past 32
years. However, the company has been growing rapidly in recent months, so, as of this morning, just
before the companys monthly press conference, market experts and investors anticipated that the firm
would announce that its managers expected the firms dividends to increase by 6.2 percent a year forever.
At the press conference, Alpha Beta announced that its managers expected dividends to increase by 5.5
percent a year forever, which would be higher than any annual dividend increase in the companys
history.
The amount of the expected dividend increase was not known by the public before the announcement at
the press conference, so the announcement should be considered the release of new information to the
public. No other news was released to the public today except for the expected dividend increase.
Expectations about the stocks risk remained unchanged all day and the stock market is semi-strong form
efficient.
Given the information in this question, which one of the following sentences is most likely to be true?
A. Today, the actual return for Alpha Beta was more likely to have been greater than its expected
return than it was to have been equal to or less than its expected return.
B. Today, the actual return for Alpha Beta was more likely to have been equal to its expected return
than it was to have been greater than or less than its expected return.
C. Today, the actual return for Alpha Beta was more likely to have been less than its expected return
than it was to have been greater than or equal to its expected return.
D. Today, the actual return for Alpha Beta was equally likely to have been greater than, equal to, or
less than its expected return.
15. Alpha Beta Electronics has increased its annual dividend by 3.5 percent a year for each of the
past 32 years. However, the company has been growing rapidly in recent months, so, as of this
morning, just before the companys monthly press conference, market experts and investors
anticipated that the firm would announce that its managers expected the firms dividends to increase
by 6.2 percent a year forever. At the press conference, Alpha Beta announced that its managers
expected dividends to increase by 5.5 percent a year forever, which would be higher than any annual
dividend increase in the companys history.
efficient.
A. Today, the actual return for Alpha Beta was more likely to have been less than its expected return
B. Today, the actual return for Alpha Beta was more likely to have been equal to its expected return
C. Today, the actual return for Alpha Beta was more likely to have been greater than its expected
12

15. Alpha Beta Electronics has increased its annual dividend by 3.5 percent a year for each of the past 32
years. However, the company has been growing rapidly in recent months, so, as of this morning, just
before the companys monthly press conference, market experts and investors anticipated that the firm
would announce that its managers expected the firms dividends to increase by 6.2 percent a year forever.
At the press conference, Alpha Beta announced that its managers expected dividends to increase by 5.5
percent a year forever, which would be higher than any annual dividend increase in the companys
history.
efficient.
return than it was to have been less than or equal to its expected return.
B. Today, the actual return for Alpha Beta was more likely to have been less than its expected return
C. Today, the actual return for Alpha Beta was more likely to have been equal to its expected return
13

Conceptual and quantitative: find portfolio B beta and compare to market beta and
understand unsystematic risk and diversification
16. Portfolio A is a well-diversified portfolio that is equally-weighted among 5,000 different and
diverse stocks. Portfolio A has an average amount of systematic risk, so it has exactly the same
amount of systematic risk as the market portfolio. Portfolio B consists of 2 stocks: $6,000 worth
of Alpha Technology stock, which has a beta of 0.3, and $5,000 worth of Delta Technology
stock, which has a beta of 1.7. All stocks have the same level of unsystematic risk. Which one
of the following assertions is most likely to be true?
A. Portfolio A has less systematic risk and more unsystematic risk than portfolio B
B. Portfolio A has less systematic risk and less unsystematic risk than portfolio B
C. Portfolio A has more systematic risk and more unsystematic risk than portfolio B
D. Portfolio A has more systematic risk and less unsystematic risk than portfolio B
E. Portfolio A has the same amount of systematic risk or the same amount of unsystematic risk as
portfolio B
A. Portfolio A has more systematic risk and more unsystematic risk than portfolio B
B. Portfolio A has more systematic risk and less unsystematic risk than portfolio B
C. Portfolio A has less systematic risk and more unsystematic risk than portfolio B
D. Portfolio A has less systematic risk and less unsystematic risk than portfolio B
portfolio B
A. Portfolio A has less systematic risk and less unsystematic risk than portfolio B
B. Portfolio A has less systematic risk and more unsystematic risk than portfolio B
C. Portfolio A has more systematic risk and less unsystematic risk than portfolio B
D. Portfolio A has more systematic risk and more unsystematic risk than portfolio B
portfolio B
14

Quantitative: find expected return from CAPM
17. According to the Capital Asset Pricing Model (CAPM), what is the expected return of the
common stock of Grand Goblet, Inc. if the stock has a beta of 0.88, the expected return on the
market is 17.0 percent, and the risk-free rate is 3.0 percent?
15

Quantitative and conceptual: determine appropriate cost of capital and find NPV
18. A number of companies, including Omega Inc. and Gamma Corp., are considering undertaking a
project that is believed by all to have a level of risk that is equal to that of the average-risk project at
Omega Inc. The project would require an initial investment of $50,000 and would then produce
expected cash flows of $30,000 in 1 year, $20,000 in 2 years, and $10,000 in 3 years. The weightedaverage cost of capital for Omega Inc. is 12.50 percent, the weighted-average cost of capital for
Gamma Corp. is 10.00 percent, and the project has an internal rate of return of 11.787 percent.
Which one of the following assertions is true if managers want to maximize value?
A. Gamma Corp. should not pursue the project because the projects NPV is -$507.54 (plus or minus $10)
B. Gamma Corp. should pursue the project because the projects NPV is $1,314.80 (plus or minus
$10)
C. Gamma Corp. should not pursue the project because the projects NPV is -$1,314.80 (plus or
minus $10)
D. Gamma Corp. should be indifferent about pursuing the project because the projects NPV is $0.00
(plus or minus $10)
E. None of the above assertions is true
A. Gamma Corp. should not pursue the project because the projects NPV is -$1,882.21 (plus or
minus $10)
B. Gamma Corp. should pursue the project because the projects NPV is $1,314.80 (plus or minus $10)
minus $10)
(plus or minus $10)
A. Gamma Corp. should not pursue the project because the projects NPV is -$2,543.61 (plus or
minus $10)
B. Gamma Corp. should pursue the project because the projects NPV is $1,314.80 (plus or minus $10)
minus $10)
(plus or minus $10)
16

Quantitative and some conceptual: compute WACC
19. Closers Coffee Corp. has 1,200,000 shares of common equity outstanding that have an
expected return of 15% and a current price of $50 each. The expected return on the market is
11% and the risk-free rate is 3%. Closers Coffee has issued 40,000 bonds with a face value of
$1,000 and a market value of $800 each. The yield to maturity on these bonds is 10% and the
annual coupon rate is 7%. If the corporate tax rate is 40%, what is the weighted-average cost of
capital for Closers Coffee Corp?
17

Quantitative: value of a growing perpetuity and return of a fixed perpetuity
investment B?
A. 0.87% (plus or minus .01 percentage point)
B. 0.74% (plus or minus .01 percentage point)
C. 0.96% (plus or minus .01 percentage point)
D. 0.80% (plus or minus .01 percentage point)
E. None of the above is within .01 percentage point of the correct answer
To solve part a:
1) Find the value of investment A
2) Find the value of investment B as the combined value of both A and B minus the value of A
3) Find the expected return for B
The cash flows represent a growing perpetuity with the first payment in one month
For a growing perpetuity, PV = C1/(r g) and r = (C1/PV) + g
C1 = $56
r = .010
g = .002
PV = $56 / (.010 .002) = $56 / .008 = $7,000
Investment A is worth $7,000
2) Find the value of investment B as the value of both A and B minus the value of A
Value of B = value of A and B value of A
Value of A and B = $14,700
Value of A = $7,000
Value of B = $14,700 $7,000 = $7,700
The cash flows represent a fixed perpetuity with the first payment in one month
For a fixed perpetuity, PV = C/r and r = C/PV
C = $67
PV = $7,700
r = 67/7,700 = 0.00870 = 0.870% 0.87%
The expected return for investment B is 0.87 percent per month
18

investment B?
To solve part a:
C1 = $56
r = .010
g = .003
PV = $56 / (.010 .003) = $56 / .007 = $8,000
Value of A = $8,000
Value of B = $15,500 $8,000 = $7,500
C = $64
PV = $7,500
r = 64/7,500 = 0.00853 = 0.853% 0.85%
19

investment B?
To solve part a:
C1 = $48
r = .010
g = .002
PV = $48 / (.010 .002) = $48 / .008 = $6,000
Value of A = $6,000
Value of B = $15,400 $6,000 = $9,400
C = $62
PV = $9,400
r = 62/9,400 = 0.00660 = 0.660% 0.66%
20

Quantitative: compute present value of two cash flows of different signs
A. -$23,369.23 (plus or minus $10)
B. -$26,736.05 (plus or minus $10)
C. -$33,837.93 (plus or minus $10)
D. -$23,150.17 (plus or minus $10)
E. None of the above is within $10 of the correct answer
PV = C0 + [C1/(1+r)1] + [C2/(1+r)2] + [C3/(1+r)3] + [C4/(1+r)4]
C0 = 0
C1 = 0
C2 = 2,000
C3 = 0
C4 = -40,000
r = .123
PV = 0 +[0/(1.123)] + [2,000/(1.123)2] + [0/(1.123)3] + [-40,000/(1.123)4]
= 0 + 0 + 1,585.88 + 0 + (-25,150.17) = -$23,564.29
Solution financial calculator
Year 0 CF: present value = 0
Year 2 CF: N = 2; FV = 2000; I% = 12.3; PMT = 0; solve for PV = -1,585.88
so the present value of the cash flow = $1,585.88
Year 4 CF: N = 4; FV = -40000; I% = 12.3; PMT = 0; solve for PV = 25,150.17
so the present value of the cash flow = -25,150.17
Total present value of the cash flows = 0 + 0 + 1,585.88 + 0 + (-25,150.17) = -$23,564.29
Note that answers may differ slightly due to rounding
21

A. -$25,542.96 (plus or minus $10)
B. -$28,866.20 (plus or minus $10)
C. -$37,952.34 (plus or minus $10)
D. -$25,308.19 (plus or minus $10)
PV = C0 + [C1/(1+r)1] + [C2/(1+r)2] + [C3/(1+r)3] + [C4/(1+r)4]
C0 = 0
C1 = 0
C2 = 2,000
C3 = 0
C4 = -45,000
r = .133
PV = 0 +[0/(1.133)] + [2,000/(1.133)2] + [0/(1.133)3] + [-45,000/(1.133)4]
= 0 + 0 + 1,558.01 + 0 + (-27,308.19) = -$25,750.18
22

A. -$27,544.65 (plus or minus $10)
B. -$30,825.30 (plus or minus $10)
C. -$41,994.75 (plus or minus $10)
D. -$27,294.43 (plus or minus $10)
PV = C0 + [C1/(1+r)1] + [C2/(1+r)2] + [C3/(1+r)3] + [C4/(1+r)4]
C0 = 0
C1 = 0
C2 = 2,000
C3 = 0
C4 = -50,000
r = .143
PV = 0 +[0/(1.143)] + [2,000/(1.143)2] + [0/(1.143)3] + [-50,000/(1.143)4]
= 0 + 0 + 1,530.87 + 0 + (-29,294.43) = -$27,763.56
23

Quantitative: FV of annuity and payment associated with PV annuity
Step 1: find how much money Calvin will have in 22 years
Step 2: find how many payments can be produced by the amount of money expected in 22 years
If the first investment is made in 1 year and the last investment is made in 22 years, then the
amount of money accumulated in 22 years can be found by finding the future value of a 22-year
annuity, since the first payment will be made in 1 year, there will be 22 expected payments, and all
expected payments will be equal.
FV = C [{(1+r)t 1} / r] where C = $10,000; r = .090; and t = 22
= 10,000 [{(1.090)22 1} / .090] = $628,733.38
END mode
Enter
22
N
9.0
I%
0
PV
-10,000
PMT
Solve for
FV
628,733.38
Calvin expects to have $628,733.38 saved for retirement in 22 years

The first withdrawal is made 1 year after retirement. At retirement, Calvin expects to have
$628,733.38. To find how many payments can be produced, we need to find the number of
payments for an annuity with annual payments of $100,000, a present value of $628,733.38, and a
discount rate of 9.0%. It is an annuity, since the first payment occurs one year after the reference
point, which is at retirement in 22 years.
END mode
Enter
Solve for
N
9.68
9.0
I%
-628,733.38
PV
Calvin can expect to make 9.68 withdrawals in retirement
24
100,000
PMT
0
FV

= 10,000 [{(1.090)24 1} / .090] = $767,898.13
END mode
Enter
24
N
9.0
I%
0
PV
-10,000
PMT
Solve for
FV
767,898.13

END mode
Enter
Solve for
N
13.63
9.0
I%
-767,898.13
PV
25
100,000
PMT
0
FV

= 10,000 [{(1.090)25 1} / .090] = $847,008.96
END mode
Enter
25
N
9.0
I%
0
PV
-10,000
PMT
Solve for
FV
847,008.96

END mode
Enter
Solve for
N
16.67
9.0
I%
-847,008.96
PV
26
100,000
PMT
0
FV

Quantitative: find PV of delayed annuity
A. $364.38 million (plus or minus $0.2 million)
B. $331.26 million (plus or minus $0.2 million)
C. $332.52 million (plus or minus $0.2 million)
D. $302.29 million (plus or minus $0.2 million)
E. None of the above is within $0.2 million of the correct answer
Timeline (in $ millions)
Time
CF
0
0
1
0
2
0
3
0
4
0
5
100
6
100
7
100
8
100
9
100
10
100
11
100
12
100
13
0
The cash flows represent an 8-year delayed annuity with $100 million payments, the first payment
in 5 years, and a discount rate of 10.0%. It is an 8-year annuity, because there are 8 payments (in 5,
6, 7, 8, 9, 10, 11, and 12 years). Because the cash flows from the drug start in 5 years, we can value
them as of year 4 (1 year before the first payment) as a standard annuity.
Therefore take the following 2 steps to find the present value
1) find PV4 as the value of an annuity
2) find PV0 as PV4 /(1+r)4
1) Find PV4 as the value of an annuity
PV4 = (C [(1/r) 1/{r(1+r)t}]) where C = 100 million, r = .100, and t = 8
PV4 = (100 million [(1/.100) 1/{.100(1.100)8}]) = 533,492,620
END mode
Enter
8
N
10.0
I%
PV
-533,492,620
Solve for
100,000,000
PMT
0
FV
2) Find PV0 as PV4 /(1+r)4

To get the present value as of today at (PV0 at time 0), we need to discount PV4 as PV0 = PV4 /(1+r)4
PV0 = 533,492,620/(1.100)4 = $364,382,638
Mode is not relevant, since PMT = 0
Enter
4
N
Solve for
10.0
I%
PV
-364,382,638
0
PMT
533,492,620
FV
The present value of the drug to MP is $364.4 million

Note: the following 3 cash flow patterns have the same present value when r = 10.0%
Time
CF
CF
CF
0
0
0
364.4
1
0
0
0
2
0
0
0
3
0
0
0
4
0
533.5
0
5
100
0
0
6
100
0
0
7
100
0
0
27
8
100
0
0
9
100
0
0
10
100
0
0
11
100
0
0
12
100
0
0
13
0
0
0

Time
CF
0
0
1
0
2
0
3
0
4
0
5
0
6
100
7
100
8
100
9
100
10
100
11
100
12
100
13
0
The cash flows represent a 7-year delayed annuity with $100 million payments, the first payment in
6 years, and a discount rate of 10.0%. It is a 7-year annuity, because there are 7 payments (in 6, 7,
8, 9, 10, 11, and 12 years). Because the cash flows from the drug start in 6 years, we can value them
as of year 5 (1 year before the first payment) as a standard annuity.
PV5 = (100 million [(1/.100) 1/{.100(1.100)7}]) = 486,841,882
END mode
Enter
7
N
10.0
I%
PV
-486,841,882
Solve for
100,000,000
PMT
0
FV

PV0 = 486,841,882/(1.100)5 = $302,290,505
Enter
5
N
Solve for
10.0
I%
PV
-302,290,505
0
PMT
486,841,882
FV

Time
CF
CF
CF
0
0
0
302.3
1
0
0
0
2
0
0
0
3
0
0
0
4
0
0
0
5
0
486.8
0
6
100
0
0
7
100
0
0
28
8
100
0
0
9
100
0
0
10
100
0
0
11
100
0
0
12
100
0
0
13
0
0
0

Time
CF
0
0
1
0
2
0
3
0
4
0
5
0
6
0
7
100
8
100
9
100
10
100
11
100
12
100
13
100
The cash flows represent a 7-year delayed annuity with $100 million payments, the first payment in
7 years, and a discount rate of 10.0%. It is a 7-year annuity, because there are 7 payments (in 7, 8,
9, 10, 11, 12, and 13 years). Because the cash flows from the drug start in 7 years, we can value
them as of year 6 (1 year before the first payment) as a standard annuity.
PV6 = (100 million [(1/.100) 1/{.100(1.100)7}]) = 486,841,882
END mode
Enter
7
N
10.0
I%
PV
-486,841,882
Solve for
100,000,000
PMT
0
FV

PV0 = 486,841,882/(1.100)6 = $274,809,550
Enter
6
N
Solve for
10.0
I%
PV
-274,809,550
0
PMT
486,841,882
FV

Time
CF
CF
CF
0
0
0
274.8
1
0
0
0
2
0
0
0
3
0
0
0
4
0
0
0
5
0
0
0
6
0
486.8
0
7
100
0
0
29
8
100
0
0
9
100
0
0
10
100
0
0
11
100
0
0
12
100
0
0
13
100
0
0

Conceptual and quantitative: present value of a single cash flow and an annuity due
Cookie has been offered the 3 possible payment options described in the table. If the discount rate is
10.0%, which one of the assertions is true?
Option
A
$9,000 today
$9,000 in 1 year
A. Fairfax Cookie should prefer option B more than option A and Fairfax Cookie should prefer option C
more than option A
B. Fairfax Cookie should prefer option B more than option A and Fairfax Cookie should not prefer
option C more than option A
C. Fairfax Cookie should not prefer option B more than option A and Fairfax Cookie should prefer option
D. Fairfax Cookie should not prefer option B more than option A and Fairfax Cookie should not prefer
To answer this question, we need to find the present value of options B and C and compare them to
option A because a firm would be indifferent between paying Ct in t years and paying an amount
equal to the present value of Ct today, prefer to pay an amount today that is less than the present
value of Ct more than it would prefer to pay Ct in t years, and prefer to pay Ct in t years more than
it would prefer to pay an amount today that is greater than the present value of Ct.
C
Option A involves paying 9,000 today, which is a cash flow of -$9,000

Option B involves a single cash flow, so PV0 = Ct (1+r)t where r = .100; t = 1; C1 = -9,000
PV0 = Ct (1+r)t = C1 (1+r)1 = -9,000 (1.100)1 = -8,181.82
Enter
1
10.0
N
I%
Solve for
0
PMT
PV
8,181.82
-9,000
FV
The present value of option B is -8,181.82, which is smaller in magnitude than -$9,000, the payment
associated with A, so Fairfax Cookie should prefer option B more than option A. Intuitively, this makes
sense. The discount rate is positive, so $9,000 in 1 year has less value than $9,000 today.
Option C involves regular, fixed payments with the first one due today, so it is an annuity due where
r = .100; t = 6; and C = -2,000
Note that t = 6 because there are payments at time 0, 1, 2, 3, 4, and 5
BEG Mode
Enter
Solve for
6
N
10.0
I%
-2,000
PMT
PV
9,581.57
0
FV
The present value of option C is -9,581.57, which is greater in magnitude than -$9,000, the payment
associated with A, so Fairfax Cookie should not prefer option C more than option A
Putting it all together: Fairfax Cookie should prefer option B more than option A, but Fairfax
Cookie should not prefer option C more than option A
30

5. The Fairfax Cookie Company just bought 2 tons of chocolate chips from Chantilly Chocolate.
Fairfax Cookie has been offered the 3 possible payment options described in the table. If the
discount rate is 10.0%, which one of the assertions is true?
Option
A
$10,000 today
B
$10,000 in 1 year
A series of annual payments of $2,000, with the first payment

due later today and the last payment due in 6 years from today
A. Fairfax Cookie should prefer option B more than option A and Fairfax Cookie should prefer
B. Fairfax Cookie should prefer option B more than option A and Fairfax Cookie should
not prefer option C more than option A
C. Fairfax Cookie should not prefer option B more than option A and Fairfax Cookie should
prefer option C more than option A
D. Fairfax Cookie should not prefer option B more than option A and Fairfax Cookie should not
C
PV0 = Ct (1+r)t = C1 (1+r)1 = -10,000 (1.100)1 = -9,090.91
Enter
1
10.0
N
I%
Solve for
0
PMT
PV
9,090.91
-10,000
FV
The present value of option B is -9,090.91, which is smaller in magnitude than -$10,000, the payment
r = .100; t = 7; and C = -2,000
Note that t = 7 because there are payments at time 0, 1, 2, 3, 4, 5, and 6
BEG Mode
Enter
Solve for
7
N
10.0
I%
-2,000
PMT
PV
10,710.52
0
FV
The present value of option C is -10,710.52, which is greater in magnitude than -$10,000, the
payment associated with A, so Fairfax Cookie should not prefer option C more than option A
31

5. The Fairfax Cookie Company just bought 2 tons of chocolate chips from Chantilly Chocolate.
Fairfax Cookie has been offered the 3 possible payment options described in the table. If the
discount rate is 10.0%, which one of the assertions is true?
Option
A
$11,000 today
B
$11,000 in 1 year
A series of annual payments of $2,000, with the first payment

due later today and the last payment due in 7 years from today
A. Fairfax Cookie should prefer option B more than option A and Fairfax Cookie should prefer
B. Fairfax Cookie should prefer option B more than option A and Fairfax Cookie should
not prefer option C more than option A
C. Fairfax Cookie should not prefer option B more than option A and Fairfax Cookie should
D. Fairfax Cookie should not prefer option B more than option A and Fairfax Cookie should not
C
PV0 = Ct (1+r)t = C1 (1+r)1 = -11,000 (1.100)1 = -10,000.00
Enter
1
10.0
N
I%
Solve for
0
PMT
PV
10,000
-11,000
FV
The present value of option B is -10,000, which is smaller in magnitude than -$11,000, the payment
r = .100; t = 8; and C = -2,000
Note that t = 8 because there are payments at time 0, 1, 2, 3, 4, 5, 6, and 7
BEG Mode
Enter
Solve for
8
N
10.0
I%
-2,000
PMT
PV
11,736.84
0
FV
The present value of option C is -11,736.84, which is greater in magnitude than -$11,000, the
payment associated with A, so Fairfax Cookie should not prefer option C more than option A
32

Quantitative: find monthly rate for loan and then find EAR
loan?
A. 14.16% (plus or minus .02 percentage points)
B. 13.32% (plus or minus .02 percentage points)
C. 31.25% (plus or minus .02 percentage points)
D. 27.50% (plus or minus .02 percentage points)
E. None of the above is within .02 percentage points of the correct answer
To solve:
1. Find the monthly rate of interest associated with the loan
2. Find the EAR of a loan with the monthly rate from step 1
The payments associated with the loan reflect an ordinary annuity with 60 payments of
$1,489.62 and a present value of $65,000. Therefore, the monthly rate can be found as the
rate such that a 60-period annuity with payments of 1,489.62 has a present value of
$65,000.
The payments reflect an ordinary annuity, because the first one is in 1 month, payments
take place monthly, and they are all equal
There are 60 payments, because monthly payments are made for 5 years and 5 years 12
months = 60 months
The present value is $65,000, because thats the amount of the loan
END Mode
Enter
Solve for
60
N
I%
1.11
65,000
PV
-1,489.62
PMT
EAR= [(1+periodic rate)number of periods in a year] 1
In this case, the periodic rate = monthly rate = 1.11% = .0111
Number of periods in a year = 12
EAR= [(1.0111)12] 1 = .1416 = 14.16%
33
0
FV

loan?
To solve:
$70,000.
months = 60 months
END Mode
Enter
Solve for
60
N
I%
1.13
70,000
PV
-1,612.86
PMT
EAR= [(1.0113)12] 1 = .1444 = 14.44%
34
0
FV

loan?
To solve:
$75,000.
months = 60 months
END Mode
Enter
Solve for
60
N
I%
1.16
75,000
PV
-1,742.01
PMT
EAR= [(1.0116)12] 1 = .1484 = 14.84%
35
0
FV

Quantitative: price constant-growth stock and then find YTM of annual bond
Since we know the bonds coupon payments, time-to-maturity, and face value, we can find
out its YTM if we know its price
We know that bond value + stock value = $1,300
If we find the stock value, we can find the bond value, and we can find YTM
Finding the stock value
Since the stock has a dividend that is expected to grow at a constant rate forever and the next
dividend is expected in 1 year, then P0 = D1/(R g)
Where D1 = 25.38, R = .110, and g = .020
So P0 = D1 / (R g) = 25.38 / (.110 - .020) = 25.38 / .090 = 282.00
Finding the bond value
Since bond value + stock value = $1,300, bond value = $1,300 $282.00 = $1,018.00
Find the YTM of a bond, where
N = 17 years 1 coupon per year = 17
FV = 1,000 = par
PMT = par coupon rate # coupons per year = 1000 11.0% 1 = 110
PV = -1018.00
I% = YTM # coupons per year = YTM 1 YTM = 1 I% = I%
END mode
Enter
Solve for
17
N
I%
10.76
-1,018
PV
110
PMT
Since I% = 10.76, YTM = 1 10.76% = 10.76%
36
1000
FV

Where D1 = 24.48, R = .110, and g = .020
So P0 = D1 / (R g) = 24.48 / (.110 - .020) = 24.48 / .090 = 272.00
FV = 1,000 = par
PV = -1028.00
END mode
Enter
Solve for
17
N
I%
10.64
-1,028
PV
110
PMT
Since I% = 10.64, YTM = 1 10.64% = 10.64%
37
1000
FV

Where D1 = 23.58, R = .110, and g = .020
So P0 = D1 / (R g) = 23.58 / (.110 - .020) = 23.58 / .090 = 262.00
FV = 1,000 = par
PV = -1038.00
END mode
Enter
Solve for
17
N
I%
10.51
-1,038
PV
110
PMT
Since I% = 10.51, YTM = 1 10.51% = 10.51%
38
1000
FV

Quantitative: find expected price based on expected dividend computed from D1 and g
A. $80.95 (plus or minus $0.10)
B. $78.97 (plus or minus $0.10)
C. $82.97 (plus or minus $0.10)
D. $65.38 (plus or minus $0.10)
E. None of the above is within $0.10 of the correct answer
0
1
2
Div
D0
D1
D2
Div
D0
D1
D1 (1+g)
Div
D0
D1
D1 (1+g)
Div
D0
7.70 7.70 (1.025)
Expected annual return = .130
3
D3
D2 (1+g)
D1 (1+g)2
7.70 (1.025)2
4
D4
D3 (1+g)
D1 (1+g)3
7.70 (1.025)3
5
D5
D4 (1+g)
D1 (1+g)4
7.70 (1.025)4
Since the dividends are expected to grow at a constant rate forever as of year 5 (actually
starting sooner), the expected value of the stock in 4 years can be found using the constantgrowth dividend discount model.
P4 = D5 / (R g)
R is the annual return expected on the stock divided by the number of possible dividends
per year = .130 1 = .130
g = .025
In 4 years from today, the next dividend is expected in 5 years from today.
D5 = D1 (1+g)5-1 = D1 (1+g)4
= 7.70 (1.025)4 = 8.50
P4 = $8.50 / (.130 .025)
= $8.50 / .105
= $80.95
Answers may differ slightly due to rounding, especially with respect to the expected dividend
39

A. $83.51 (plus or minus $0.10)
B. $81.47 (plus or minus $0.10)
C. $85.59 (plus or minus $0.10)
D. $68.59 (plus or minus $0.10)
0
1
2
Div
D0
D1
D2
Div
D0
D1
D1 (1+g)
Div
D0
D1
D1 (1+g)
Div
D0
8.70 8.70 (1.025)
3
D3
D2 (1+g)
D1 (1+g)2
8.70 (1.025)2
4
D4
D3 (1+g)
D1 (1+g)3
8.70 (1.025)3
5
D5
D4 (1+g)
D1 (1+g)4
8.70 (1.025)4
P4 = D5 / (R g)
per year = .140 1 = .140
g = .025
D5 = D1 (1+g)5-1 = D1 (1+g)4
= 8.70 (1.025)4 = $9.60
P4 = $9.60 / (.140 .025)
= $9.60 / .115
= $83.48
40

A. $78.49 (plus or minus $0.10)
B. $76.58 (plus or minus $0.10)
C. $80.46 (plus or minus $0.10)
D. $66.23 (plus or minus $0.10)
0
1
2
Div
D0
D1
D2
Div
D0
D1
D1 (1+g)
Div
D0
D1
D1 (1+g)
Div
D0
9.60 9.60 (1.025)
3
D3
D2 (1+g)
D1 (1+g)2
9.60 (1.025)2
4
D4
D3 (1+g)
D1 (1+g)3
9.60 (1.025)3
5
D5
D4 (1+g)
D1 (1+g)4
9.60 (1.025)4
P4 = D5 / (R g)
per year = .160 1 = .160
g = .025
D5 = D1 (1+g)5-1 = D1 (1+g)4
= 9.60 (1.025)4 = $10.60
P4 = $10.60 / (.160 .025)
= $10.60 / .135
= $78.52
41

Quantitative: find expected price based on current price and expected dividend
Given the preceding information, what is the price of Electric Purple stock expected to be in 1
year?
A. $52.65 (plus or minus $0.05)
B. $47.73 (plus or minus $0.05)
C. $50.21 (plus or minus $0.05)
D. $50.00 (plus or minus $0.05)
We want to determine the value of P1
Note that some of the given information is not necessarily needed or relevant
Since we know P0, D1 and R, we can find P1 from P0 = (D1 + P1) / (1 + R)
R = 0.165
D1 = 5.60
D2 = 8.50
P0 = 50.00
P3 = 50.00
Note that D2 and P3 are irrelevant
P0 = (D1 + P1) / (1 + R)
50.00 = (5.60 + P1) / 1.165
50.00 1.165 = (5.60 + P1)
P1 = (50.00 1.165) 5.60
= $52.65
42

year?
A. $63.80 (plus or minus $0.05)
B. $56.74 (plus or minus $0.05)
C. $58.80 (plus or minus $0.05)
D. $60.00 (plus or minus $0.05)
R = 0.165
D1 = 6.10
D2 = 8.50
P0 = 60.00
P3 = 60.00
P0 = (D1 + P1) / (1 + R)
60.00 = (6.10 + P1) / 1.165
60.00 1.165 = (6.10 + P1)
P1 = (60.00 1.165) 6.10
= $63.80
43

year?
A. $74.15 (plus or minus $0.05)
B. $66.44 (plus or minus $0.05)
C. $67.38 (plus or minus $0.05)
D. $70.00 (plus or minus $0.05)
R = 0.165
D1 = 7.40
D2 = 8.50
P0 = 70.00
P3 = 70.00
P0 = (D1 + P1) / (1 + R)
70.00 = (7.40 + P1) / 1.165
70.00 1.165 = (7.40 + P1)
P1 = (70.00 1.165) 7.40
= $74.15
44

Conceptual: project risk and discount rate
the riskiest?
Discounted
Cost of
Net present
Payback
payback
Internal rate
capital
value
period
period
of return
Project
(in %)
(in $ millions)
(in years)
(in years)
(in %)
A
11.0
0.2
7.6
8.1
11.1
B
7.1
53.3
5.6
8.7
13.5
C
13.2
12.6
2.4
3.2
13.4
D
6.7
8.9
5.8
8.2
14.3
E
9.2
-1.5
2.1
8.6
A. Project A
B. Project B
C. Project C
D. Project D
E. Project E
Project C has the highest cost of capital, which is the only relevant piece of information for
answering this question. Higher cost of capital higher risk.
45

the riskiest?
Discounted
Cost of
Net present
Payback
payback
Internal rate
capital
value
period
period
of return
Project
(in %)
(in $ millions)
(in years)
(in years)
(in %)
A
12.0
0.2
7.7
8.2
12.1
B
14.2
12.5
2.5
3.2
14.4
C
8.1
53.2
5.7
8.9
14.5
D
10.2
-1.4
2.2
9.6
E
7.7
8.8
5.9
8.4
15.3
A. Project A
B. Project B
C. Project C
D. Project D
E. Project E
Project B has the highest cost of capital, which is the only relevant piece of information for
46

the riskiest?
Discounted
Cost of
Net present
Payback
payback
Internal rate
capital
value
period
period
of return
Project
(in %)
(in $ millions)
(in years)
(in years)
(in %)
A
8.3
53.4
5.6
8.8
14.6
B
10.5
-1.6
2.1
9.7
C
12.2
0.2
7.6
8.3
12.1
D
14.5
12.3
2.4
3.3
14.5
E
7.9
8.6
5.9
8.4
15.4
A. Project A
B. Project B
C. Project C
D. Project D
E. Project E
Project D has the highest cost of capital, which is the only relevant piece of information for
47

Find NPV from relevant cash flows based on given information
Overview: Down Under Cavers provides cave exploration tours in Australia. The firm is
considering a New Zealand project which would involve expanding into New Zealand.
The project, which would last for 2 years, would involve an initial investment of $300,000 for
new equipment that would be hauled away for an after-tax cash flow of $0 at the end of the
project in 2 years. In other words, after taking any relevant taxes into account, the cash flows
from capital spending associated with the sale of the equipment in 2 years would be $0. The
equipment would be depreciated to zero over 2 years using straight-line depreciation.
Down Under management expects annual revenue from New Zealand caving to be $700,000 in
the first year and $900,000 in the second year. Management expects annual costs from New
Zealand caving to be $500,000 in the first year and $600,000 in the second year.
The tax rate is 30 percent and the appropriate cost of capital for the New Zealand project is 8
percent, which is the same as for all caving activities.
11. What is the net present value (NPV) of the New Zealand Project based on the information
provided in the overview?
A. $89,918 (plus or minus $100)
B. -$177,572 (plus or minus $100)
C. $277,160 (plus or minus $100)
D. $142,387 (plus or minus $100)
48

NPV based on overview
Initial investment
Amount depreciated to
Useful life
Annual depreciation
Revenues
Costs
Annual depreciation
EBIT (revs costs depreciation)
Tax rate
Taxes
Net inc = EBIT taxes
OCF = NI + dep
CF from capital investments made

Sales price of asset sold
Initial cost of asset sold
Accumulated depreciation at sale
Book value of asset at sale
Taxable gain (sales price BV)
Tax rate
Taxes on asset sale
CF from asset sale (sales price taxes)
CF from capital spending (made + sale)
OCF
Cash flow effects from NWC
CF from capital spending
CF from project sale
Terminal value
Opportunity costs
Relevant CF
.080
PV(relevant CF)
NPV
0
300,000
0
2
0
Year
1
300,000
0
2
150,000
2
300,000
0
2
150,000
0
0
0
0
0.30
0
0
0
700,000
500,000
150,000
50,000
0.30
15,000
35,000
185,000
900,000
600,000
150,000
150,000
0.30
45,000
105,000
255,000
0
-300,000
No sale
Year
1
0
No sale
0
-300,000
0
0
2
0
0
300,000
300,000
0
0
0.30
0
0
0
0
0
0
-300,000
0
0
0
-300,000
Year
1
185,000
0
0
0
0
0
185,000
2
255,000
0
0
0
0
0
255,000
0
-300,000
Note: answers may differ somewhat due to rounding
49
Year
1
171,296
89,918
2
218,621

A. $73,045 (plus or minus $100)
B. -$372,771 (plus or minus $100)
C. $385,117 (plus or minus $100)
D. $127,572 (plus or minus $100)
50

Initial investment
Useful life
Annual depreciation
Revenues
Costs
Annual depreciation
Tax rate
Taxes
OCF = NI + dep

Tax rate
Taxes on asset sale
OCF
Terminal value
Opportunity costs
Relevant CF
.080
PV(relevant CF)
NPV
0
500,000
0
2
0
Year
1
500,000
0
2
250,000
2
500,000
0
2
250,000
0
0
0
0
0.30
0
0
0
900,000
500,000
250,000
150,000
0.30
45,000
105,000
355,000
700,000
400,000
250,000
50,000
0.30
15,000
35,000
285,000
0
-500,000
No sale
Year
1
0
No sale
0
-500,000
0
0
2
0
0
500,000
500,000
0
0
0.30
0
0
0
0
0
0
-500,000
0
0
0
-500,000
Year
1
355,000
0
0
0
0
0
355,000
2
285,000
0
0
0
0
0
285,000
0
-500,000
51
Year
1
328,704
73,045
2
244,342

A. $51,372 (plus or minus $100)
B. -$572,771 (plus or minus $100)
C. $488,272 (plus or minus $100)
D. $105,898 (plus or minus $100)
52

Initial investment
Useful life
Annual depreciation
Revenues
Costs
Annual depreciation
Tax rate
Taxes
OCF = NI + dep

Tax rate
Taxes on asset sale
OCF
Terminal value
Opportunity costs
Relevant CF
.080
PV(relevant CF)
NPV
0
700,000
0
2
0
Year
1
700,000
0
2
350,000
2
700,000
0
2
350,000
0
0
0
0
0.30
0
0
0
900,000
400,000
350,000
150,000
0.30
45,000
105,000
455,000
700,000
300,000
350,000
50,000
0.30
15,000
35,000
385,000
0
-700,000
No sale
Year
1
0
No sale
0
-700,000
0
0
2
0
0
700,000
700,000
0
0
0.30
0
0
0
0
0
0
-700,000
0
0
0
-700,000
Year
1
455,000
0
0
0
0
0
455,000
2
385,000
0
0
0
0
0
385,000
0
-700,000
53
Year
1
421,296
51,371
2
330,075

Quantitative: find after-tax cash flow from equipment sale with MACRS depreciation
A. $93,355 (plus or minus $100)
B. $73,200 (plus or minus $100)
C. $141,200 (plus or minus $100)
D. $42,967 (plus or minus $100)
CF from asset sale = sales price of asset taxes paid on sale of asset
Taxes on asset sale = (sales price of asset book value of asset) tax rate = taxable gain
tax rate
Book value = initial price of asset accumulated depreciation
Accumulated depreciation equals depreciation in year 1 + depreciation in year 2 +
depreciation in year 3
Depreciation in year 1 = 33.33% 680,000 = 226,644
Accumulated depreciation = 226,644 + 302,192 + 100,776 = 629,612
Book value = 680,000 629,612 = 50,388
Taxes on sale of asset = (122,000 50,388) 0.40 = 71,612 0.40 = 28,644.80
CF from asset sale = 122,000 28,644.80 = 93,355.20
54

A. $101,134 (plus or minus $100)
B. $79,200 (plus or minus $100)
C. $153,200 (plus or minus $100)
D. $46,300 (plus or minus $100)
tax rate
Book value = 740,000 685,166 = 54,834
55

A. $113,726 (plus or minus $100)
B. $91,200 (plus or minus $100)
C. $167,200 (plus or minus $100)
D. $57,410 (plus or minus $100)
tax rate
Book value = 760,000 703,684 = 56,316
56

Conceptual: ethics and legality of insider trading
13. According to the class overheads and basic ethics, which one of the following assertions
about insider trading, which is against the law, is true?
A. Insider trading is legal and should be considered as a potential approach to investing
B. Insider trading is legal and should not be considered as a potential approach to investing
C. Insider trading is illegal and should be considered as a potential approach to investing
D. Insider trading is illegal and should not be considered as a potential approach to
investing
57

Quantitative: find risk premium from expected return and risk-free return
A. 6.72% (plus or minus 0.05 percentage points)
B. 17.96% (plus or minus 0.05 percentage points)
C. 6.36% (plus or minus 0.05 percentage points)
D. 18.65% (plus or minus 0.05 percentage points)
E. None of the above is within 0.05 percentage points of the correct answer
Risk premium for stock = expected return for stock return on risk-free asset
= .1234 .0562 = .0672 = 6.72%
58

= .1325 .0582 = .0743 = 7.43%
59

= .1426 .0792 = .0634 = 6.34%
60

Conceptual: likely actual return from good or bad news based on expectations
The amount of the expected dividend increase was not known by the public before the
announcement at the press conference, so the announcement should be considered the release of new
information to the public. No other news was released to the public today except for the expected
dividend increase. Expectations about the stocks risk remained unchanged all day and the stock
market is semi-strong form efficient.
Given the information in this question, which one of the following sentences is most likely to be
true?
B. Today, the actual return for Alpha Beta was more likely to have been equal to its expected
return than it was to have been greater than or less than its expected return.
C. Today, the actual return for Alpha Beta was more likely to have been less than its
expected return than it was to have been greater than or equal to its expected return.
D. Today, the actual return for Alpha Beta was equally likely to have been greater than, equal to,
or less than its expected return.
Answer: C. Today, the actual return for Alpha Beta was more likely to have been less than
its expected return than it was to have been greater than or equal to its expected return.
Although, after the announcement of expected increased dividends, dividends would be
expected to grow by 5.5 percent forever, which would be a company record, the growth is less
than the 6.2 percent that was expected by investors before the announcement. Therefore, even
though the firm will increase the dividend growth rate, it is actually by a smaller amount than
expected, which is bad news, which is likely to lead to an actual return that is less than the
expected return.
In semi-strong form markets, prices reflect all public information. Before the announcement,
the stock price reflected expected dividend growth of 6.2 percent, but after the announcement,
the stock price reflected expected dividend growth of 5.5 percent, which is lower and would be
associated with a lower price and an actual return less than the expected return.
61

anticipated that the firm would announce that its managers expected the firms dividends to
increase by 6.2 percent a year forever. At the press conference, Alpha Beta announced that its
managers expected dividends to increase by 5.5 percent a year forever, which would be higher
than any annual dividend increase in the companys history.
true?
A. Today, the actual return for Alpha Beta was more likely to have been less than its
B. Today, the actual return for Alpha Beta was more likely to have been equal to its expected
C. Today, the actual return for Alpha Beta was more likely to have been greater than its expected
Answer: A. Today, the actual return for Alpha Beta was more likely to have been less than
expected return.
62

true?
return than it was to have been less than or equal to its expected return.
B. Today, the actual return for Alpha Beta was more likely to have been less than its
C. Today, the actual return for Alpha Beta was more likely to have been equal to its expected
Answer: B. Today, the actual return for Alpha Beta was more likely to have been less than
expected return.
63

Conceptual and quantitative: find portfolio B beta and compare to market beta and
understand unsystematic risk and diversification
A. Portfolio A has less systematic risk and more unsystematic risk than portfolio B
B. Portfolio A has less systematic risk and less unsystematic risk than portfolio B
C. Portfolio A has more systematic risk and more unsystematic risk than portfolio B
portfolio B
Systematic risk: compare betas
For portfolio A: p = 1, since the market portfolio has a beta of 1
For portfolio B: p = x11 + x22 = xATAT + xDTDT
Value of Alpha stock = $6,000
Value of Delta stock = $5,000
Total value of portfolio = $6,000 + $5,000 = $11,000
Weight for Alpha stock = xAT = $6,000 / $11,000
Weight for Delta stock = xDT = $5,000 / $11,000
AT = 0.3
DT = 1.7
For portfolio B: p = [(6,000/11,000) 0.3] + [(5,000/11,000) 1.7] = .1636 + .7727 = .9361
A = 1.00 > B = 0.9361, so portfolio A has more systematic risk than portfolio B
Unsystematic risk:
Portfolio A is well-diversified with 5,000 stocks, so it has no unsystematic risk
Portfolio B only has 2 stocks, which are both technology stocks, so it is not very welldiversified. Therefore, portfolio B is likely to have unsystematic risk, so portfolio A is likely
to have less unsystematic risk than portfolio B
Answer:
64

A. Portfolio A has more systematic risk and more unsystematic risk than portfolio B
C. Portfolio A has less systematic risk and more unsystematic risk than portfolio B
D. Portfolio A has less systematic risk and less unsystematic risk than portfolio B
portfolio B
AT = 0.4
DT = 1.6
For portfolio B: p = [(5,000/9,000) 0.4] + [(4,000/9,000) 1.6] = .222 + .711 = .933
Unsystematic risk:
Answer:
65

A. Portfolio A has less systematic risk and less unsystematic risk than portfolio B
B. Portfolio A has less systematic risk and more unsystematic risk than portfolio B
D. Portfolio A has more systematic risk and more unsystematic risk than portfolio B
portfolio B
AT = 0.5
DT = 1.5
For portfolio B: p = [(4,000/7,000) 0.5] + [(3,000/7,000) 1.5] = .286 + .643 = .929
Unsystematic risk:
Answer:
66

Quantitative: find expected return from CAPM
E. None of the above answers is within 0.10 percentage points of the correct answer
E(Ri) = Rf + (i [E(RM) Rf])
E(Ri) = .030 + (0.88 [.170 .030]) = .030 + (0.88 .140)
= .030 + .1232 = .1532 = 15.32%
67

E. None of the above answers is within 0.10 percentage points of the correct answer
E(Ri) = .040 + (0.88 [.180 .040]) = .040 + (0.88 .140)
= .040 + .1232 = .1632 = 16.32%
68

E(Ri) = .050 + (0.88 [.160 .050]) = .050 + (0.88 .110)
= .050 + .0968 = .1468 = 14.68%
69

Quantitative and conceptual: determine appropriate cost of capital and find NPV
18. A number of companies, including Omega Inc. and Gamma Corp., are considering
undertaking a project that is believed by all to have a level of risk that is equal to that of the
average-risk project at Omega Inc. The project would require an initial investment of $50,000
and would then produce expected cash flows of $30,000 in 1 year, $20,000 in 2 years, and
$10,000 in 3 years. The weighted-average cost of capital for Omega Inc. is 12.50 percent, the
weighted-average cost of capital for Gamma Corp. is 10.00 percent, and the project has an
internal rate of return of 11.787 percent. Which one of the following assertions is true if
managers want to maximize value?
A. Gamma Corp. should not pursue the project because the projects NPV is -$507.54 (plus
or minus $10)
B. Gamma Corp. should pursue the project because the projects NPV is $1,314.80 (plus or
minus $10)
minus $10)
D. Gamma Corp. should be indifferent about pursuing the project because the projects NPV is
$0.00 (plus or minus $10)
NPV = C0 + [C1 / (1+r)1] + [C2 / (1+r)2] + [C3 / (1+r)3]
C0 = -$50,000; C1 = $30,000; C2 = $20,000; C3 = $10,000
r = Omegas WACC = .1250, since the project is believed by all to have a level of risk that is
equal to that of the average-risk project at Omega. Gammas WACC is not relevant.
NPV = -50,000 + [30,000/(1.1250)] + [20,000/(1.1250)2] + [10,000/(1.1250)3]= -$507.54 < 0, so Gamma
should not pursue the project
npv(12.50,-50000,{30000,20000,10000}) -507.54
70

A. Gamma Corp. should not pursue the project because the projects NPV is -$1,882.21
(plus or minus $10)
minus $10)
minus $10)
NPV = C0 + [C1 / (1+r)1] + [C2 / (1+r)2] + [C3 / (1+r)3]
C0 = -$50,000; C1 = $30,000; C2 = $20,000; C3 = $10,000
NPV = -50,000 + [30,000/(1.1450)] + [20,000/(1.1450)2] + [10,000/(1.1450)3]= -$1,882.21 < 0, so Gamma
npv(14.50,-50000,{30000,20000,10000}) -1,882.21
71

A. Gamma Corp. should not pursue the project because the projects NPV is -$2,543.61
(plus or minus $10)
minus $10)
minus $10)
NPV = C0 + [C1 / (1+r)1] + [C2 / (1+r)2] + [C3 / (1+r)3]
C0 = -$50,000; C1 = $30,000; C2 = $20,000; C3 = $10,000
NPV = -50,000 + [30,000/(1.1550)] + [20,000/(1.1550)2] + [10,000/(1.1550)3]= -$2,543.61 < 0, so Gamma
npv(15.50,-50000,{30000,20000,10000}) -2,543.61
72

Quantitative and some conceptual: compute WACC
WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
V=E+D
Expected returns
RE = .150 = 15.0%
RD = YTM = .100 = 10.0% = pre-tax cost of debt
Values
E = number of shares market price (value) per share = 1,200,000 $50 = $60,000,000
D = number of bonds market price (value) per bond = 40,000 $800 = $32,000,000
V = E + D = $60,000,000 + $32,000,000 = $92,000,000
Taxes
Tc = 0.40
WACC
WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
= [(60m/92m) .150] + [(32m/92m) .100 (1 .40)]
= .0978 + .0209
= .1187 = 11.87%
Answers may differ slightly due to rounding
73

WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
V=E+D
Expected returns
RE = .160 = 16.0%
Values
V = E + D = $60,000,000 + $32,000,000 = $92,000,000
Taxes
Tc = 0.40
WACC
WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
= [(60m/92m) .160] + [(32m/92m) .120 (1 .40)]
= .1044 + .0250
= .1294 = 12.94%
74

WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
V=E+D
Expected returns
RE = .170 = 17.0%
Values
V = E + D = $60,000,000 + $32,000,000 = $92,000,000
Taxes
Tc = 0.40
WACC
WACC = [(E/V) RE] + [(D/V) RD (1 Tc)]
= [(60m/92m) .170] + [(32m/92m) .140 (1 .40)]
= .1109 + .0292
= .1401 = 14.01%
75

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FNAN 301, fall 2009, final, solutions

Quantitative: value of a growing perpetuity and return of a fixed perpetuity

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

Calvin expects to have $628,733.38 saved for retirement in 22 years

Calvin can expect to make 9.68 withdrawals in retirement

FNAN 301, fall 2009, final, solutions

Calvin expects to have $767,898.13 saved for retirement in 24 years

Calvin can expect to make 13.63 withdrawals in retirement

FNAN 301, fall 2009, final, solutions

Calvin expects to have $847,008.96 saved for retirement in 25 years

Calvin can expect to make 16.67 withdrawals in retirement

FNAN 301, fall 2009, final, solutions

2) Find PV0 as PV4 /(1+r)4

The present value of the drug to MP is $364.4 million

FNAN 301, fall 2009, final, solutions

2) Find PV0 as PV5 /(1+r)5

The present value of the drug to MP is $302.3 million

FNAN 301, fall 2009, final, solutions

2) Find PV0 as PV6 /(1+r)6

The present value of the drug to MP is $274.8 million

FNAN 301, fall 2009, final, solutions

Option A involves paying 9,000 today, which is a cash flow of -$9,000

FNAN 301, fall 2009, final, solutions

A series of annual payments of $2,000, with the first payment

FNAN 301, fall 2009, final, solutions

A series of annual payments of $2,000, with the first payment

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

Since I% = 10.76, YTM = 1 10.76% = 10.76%

FNAN 301, fall 2009, final, solutions

Since I% = 10.64, YTM = 1 10.64% = 10.64%

FNAN 301, fall 2009, final, solutions

Since I% = 10.51, YTM = 1 10.51% = 10.51%

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions

FNAN 301, fall 2009, final, solutions