Corporate Finance FINC-UB.

0007
Professor Cecilia Parlatore
Practice Midterm 1

Last Name: ____________________________________ First Name: _________________

“My signature below certifies that I have complied with the NYU Stern Code of Conduct in
completing this exam. I understand that any failure to comply with the Code of Conduct will
result in severe penalties, such as an automatic failing grade for the course and referral to the
appropriate office.”

Signature: __________________________________________________________________

READ THE FOLLOWING INSTRUCTIONS

1. There are TBD total points; points per question will indicated below.
2. This is a closed book, closed notes exam. You are allowed to use one double-sided,
handwritten cheat sheet and a calculator. No gadgets with wireless connection ability are
allowed.
3. Verify that your exam consists of 12 pages. Please answer all of the questions on the exam.
Write your answers in the space provided. For all questions enter your final answer in the
summary sheet on the second page of this exam.
4. Hand in all pages. Hand in your cheat sheet. Hand in your blue book, even if it is empty.
Failure to hand in everything will result in failure of the exam. The blue book is scratch
paper, which you may find entirely unnecessary. We will not grade anything in the blue
book. Do not write your answers in the blue book. Sign it and hand it in anyway.
5. Please, make an effort to write in a clear handwriting. Answers that are not legible will
receive 0 credit.
6. For math based questions, show your work! You will not get full credit unless you do so,
and I can’t give you partial credit if you don’t show your work! Multiple-choice questions
will not receive partial credit. There is no need to show additional work for multiple-choice
questions.
7. I would prefer that you round to the nearest dollar, although there won’t be any
deductions for rounding errors as long as I can identify them as such.
8. You can ask clarifying questions during the first 60 minutes of the exam. No questions will
be answered during the last 15 minutes.
9. Allocate your time carefully and good luck!
 Summary Sheet: Write your final answers here!
Be careful to get correct alignment!

Multiple choice questions

1.
2.
3.
4.
5.
6.
7.
8.
9.

Numerical Problems
1.
2.
3a.
3b.
4a.
4b.
5a.
5b..
5c.
6a.
6b.
7. NPV=
(year 0)
(year 1)
(year 2)
(year 3)
(year 4)
(year 5)
Multiple choice questions

1. Which of the following investment rules may not use all possible cash flows in its
calculations?
a. NPV
b. Internal Rate of Return
c. Discounted payback
d. Real options
2. The real interest rate is 3% and the inflation rate is 5%. What is the nominal interest
rate?
a. 3%
b. 5%
c. 8%
d. 8.15%
3. Net working capital is the: (I) Shor-term assets, (II) Short-term liabilities, (III) Long-
term assets, (IV) Long-term liabilities
a. I only
b. I and II
c. I and III
d. III and-IV
4. The naïve IRR rule (invest if the opportunity cost of capital is lower than the IRR)
makes the correct investment decision for
a. Borrowing projects
b. Lending projects
c. All projects with one IRR
d. All projects
5. You are considering investing $1,000 today in a project that will pay $500 a year
from now and $8,000 in two years with certainty. There is another project that
requires $1,000 initial investment that has a yearly return of 8%. The risk free rate is
5%. Should you invest?
a. Yes
b. No
c. I don’t have enough information to answer the question
6. You are managing a team in charge of a merger. In their valuation calculations, your
team forgot to include the possibility of geographically expanding that arises only if
the merger occurs. The NPV of the merger is
a. Higher than the one your team computed
b. Lower than the one your team computed
c. At least as high as the one your team computed
7. Winning the lottery gives $1,500,000 divided in equal installments over 5 years. The
risk-free rate is 4%. The value of winning the lottery is
a. $1,500,000
b. Greater than $1,500,000
c. Lower than $1,500,000
8. One of your friends in considering investing in a project. The project’s initial cash
flow is 100 dollars. The cash flows from period 1 onwards (starting at the end of
period 1) represent a perpetuity paying -20 dollars each period. Based on this
information only, what recommendation would you give your friend?
a. Invest if the discount rate is less than the IRR
b. Invest if the discount rate is greater than the IRR
c. Invest if the discount rate is equal to the IRR
d. I don’t have enough information to give a recommendation
9. An investor offers you a $1M loan with an IRR of 3%. The investor, who breaks even,
offers you the following repayment plan: one initial payment of $0.5M at the end of
year 1 and 3 equal annual installments at the end of years 2, 3 and 4. What is the
annual repayment in years 2, 3 and 4? (rounded to the nearest 2 decimals)
a. $0.19
b. $0.17
c. $0.51
d. None of the above
Numerical problems

Problem 1. You have a total budget of 500. You can carry out the following projects. Your cost
of capital is 10%. The projects are ranged by internal rate of return. What is the optimal
project mix in order to maximize the total net present value?

Project Investment Outlay Net Present Value (at 10%) Internal Rate of Return
A 400 110 40.25%
B 300 75 3705%
C 200 40 32%
D 50 1 12%
E 200 -9.1 5%

Problem 2. Dean Henry is expected to retire in 30 years and he wishes to accumulate

$800,000 in his retirement fund by that time (t=30). If the interest rate is 12% per year, how
much should Dean Henry put into the retirement fund each year (at the end of each year,
from t=1 to t=30) in order to achieve this goal?

Problem 3. You just graduated from Stern and got hired at your dream job. You are tired of
living in a small apartment with 4 roommates and are considering purchasing your own place.
However, real estate in your area is expensive and you do not have enough savings for a down
payment yet. You need $200,000 more than what you already have. Your savings account has
a return of 5%.

a) How much should you save each year to be able to buy an apartment 6 years from now
(you would pay for the apartment at the end of year 6).

b) You have a very generous aunt who is willing to help you out. She is willing to contribute
$100,000 towards the down payment once your savings reach $100,000. If you save the same
amount per year that you found in part a), how many years would it take you to buy your own
apartment?

Problem 4. Imagine that you are the producer of James Bond movies. You are trying to decide
whether to film the next two James Bond movies at the same time. If you film them both at
once, you can save money on production costs, but you could lose a lot of money if the first
one flops and no one goes to see the second one. Specifically, if you film them both at once,
it will cost a total of $300 million today (t=0), but if you film them separately, they will cost
$200 million each (at t=0 and t=1). If the first one is successful, it will have revenues of $1
billion one year from now (t=1) and the second one will have revenues of$1.5 billion two years
from now t=2). If the first one fails, it will only have revenues of $150 million (t=1) and the
second one will have revenues of only 50 million (t=2). If you decide to film them separately
and the first one flops, you don't have to film the second one. The first film has 50% chance
of succeeding and 50% chance of failing. Assume the cost of capital is 0%and ignore taxes.
a) What is the NPV of filming the movies at the same time?

b) What is the NPV of filming the movies sequentially?

Problem 5. You are thinking of buying a chain of coffee shops and operating it for exactly one
year. The purchase price is $70M. The end-of-year cash flows, which include both operating
profits and resale value, depend on how successful you are at establishing your brand, which
in turn depends on consumers’ tastes. With probability 0.5 consumers love your brand, in
which case the cash flow is $75M. However, with probability 0.5 consumers merely like your
brand, in which case the cash flow is only $40M. The opportunity cost of capital is 5%.

a) Should you buy the coffee shops?

b) Due to your established brand name you have the opportunity to expand into the sale of
muffins one year from now. By that time, you will know the consumers’ attitude towards your
brand. The expansion costs $10M and generates $60M if consumers love your brand and $5M
if they merely like it. Given that you have already invested in the coffee shop, should you
expand into the muffin business?

c) Considering that you have the option to expand a year from now, should you invest in the
coffee shops in the first place?

Problem 6. Assume you are thinking about the following decision at the beginning of year t=0:

Your firm bought six buses ten years ago for a total of $2M. At that time, IRS rules prescribed
that the buses be fully depreciated over 20 years in a straight line.

The IRS has recently changed its depreciation rule for buses. The new rule prescribes that
buses be fully depreciated over six years in a straight line. However, this new rule is not
retroactive. It only applies to buses purchased after the new rule became effective.
The current market value of the six busses is $1.7M. Your firm expects to use the busses
forever. Maintenance costs for the busses are $0.1M per year.
A bank approaches you and suggests the following deal: It will buy the buses from you at their
current market value and then immediately sell them back to you at the same price. Since
you would be selling and buying buses today, you would be eligible for the new depreciation
rule already this year, i.e., the depreciation tax shield at this year’s end would be based on
the new depreciation schedule.
Your firm has a corporate tax rate of 35% and you pay taxed at the end of the year. Your cost
of capital is 10%.

a) What is the NPV of the transaction?

b) Suppose the transaction (selling the buses to the banks and buying them back) does not
occur at market prices. Specifically, suppose the bank proposes a price of $1.6M. Again, what
is the NPV of the transaction?
Problem 7. You are considering leaving your current job to set up a restaurant. Your current
(after tax) salary is $70,000 and, if you do not go ahead with the restaurant project, you will
work 4 more years. In that case, you will receive your salary at t=1,2,3,4. If you go ahead with
the restaurant project, you plan to be in business forever (i.e., either you expect to live forever
or you expect the restaurant will be in your family for many generations). You have come up
with the following information:
• The locale for the restaurant will cost $500,000 today (t=0) and will be fully
depreciated in a straight line over 5 years according to the IRS rules.
• The main cost will be the chef’s salary. Her salary will be $100,000 annually (paid at
the end of each year).
• The revenues of the restaurant are expected to be $250,000 per year and other costs
(not including depreciation or the chef’s salary) are expected to be $50,000 annually.
Revenues and costs are paid at the end of each year.

The tax rate is 35% and the discount rate is 10% (both constant over time). Compute the cash
flows for the first five years (t=0,1,2,3,4,5). What is the NPV of your restaurant?
 Annuity Table: Present value of $1 per period for each of t periods = (1/r) x [ 1 - 1/(1+r)t ]

Interest Rate per Period

Number of
Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791

6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145

11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606

16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.818 9.129 8.514

25 22.023 19.523 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077
30 25.808 22.396 19.600 17.292 15.372 13.765 12.409 11.258 10.274 9.427