Your exam will be closed book/notes consisting of an objective (choice) section (roughly 25-30 qts.) worth roughly 50 points and a problem/short essay section.  The time value tables will be supplied.  The formulas you will need to remember are the basic compounding equation ((1+r)^n), PV of a perpetuity (e.g., preferred stock), constant-growth discounted dividend model for common stocks, the CAPM, and that the portfolio beta is a weighted average of betas of the portfolio's component assets. All other formulas will be given if needed. 

For the essay/prob. section, make sure to know constant growth stock valuation; capital budgeting (the expansion prob. - Kangaroo handed out in class), and CAPM/portfolio theory prob./questions... 

CHOOSE THE BEST ANSWER TO EACH QUESTION. 

1. The organizational form which gives the owner(s) limited liability is the 
a. Corporation.
b. Partnership. 
c. Sole proprietorship. 

2. Sole proprietorships resolve the issue of agency problems by: 

a.  avoiding excessive expense accounts.
b.  discharging those who violate the rules.
c.  allowing owners to share the cost of their actions with others. 
d.  forcing owners to bear the full cost of their actions. 
 

3.  A basic reason why corporate managers may generally pursue different corporate policies than their shareholders is that managers are typically 
a. less diversified than shareholders. 
b. more diversified than shareholders. 
c. not as well educated and as nice as shareholders. 
d. concerned primarily about longer term results. 

[4-5] Tammy Tomato has just taken out a $50,000 mortgage at an annual interest rate of 8%.  The mortgage calls for 20 equal annual installments. 

4.  What is the amount of each installment? 
a. $ 3,962.0 
b. $20,000.0 
c. $10,185.0 
d. $25,725.5 
e. $5,092.61 

5.  What would be the loan balance at the end of year 18? 
a. Between $9,000 and $9,100. ( = PV of payments (annuity) for the next 2 annual periods) 
b. Between $9,100 and $9,200. 
c. Between $9,400 and $9,500. 
d. Between $9,500 and $9,501. 
e. A figure outside the ranges given above. 

6. You deposited $1,000 in a savings account that pays 8 percent 
      interest, compounded quarterly, planning to use it to finish your last 
      year in college. Nine months later, you decide to go to the Rocky 
      Mountains to become a ski instructor rather than continue in school, 
      so you close out your account. How much money will you receive? 

      a. $1,171 
      b. $1,126 
      c. $1,082 
      d. $1,061  = 1000*(1+.02)^3 
      e. $1,008 

7.  Which of the following bonds is most sensitive to interest rate changes? 
a.  5%-coupon bond due year 2000. 
b.  5%-coupon bond due year 2001. 
c.  5%-coupon bond due year 2002. 
d.  5%-coupon bond due year 2003. (Bond with the longest maturity and smallest coupon is most sensitive.)

8.  Suppose that we can buy a bond today for $985.  The bond has a 4-year life, a coupon rate of 14%, par value of $1000 and pays interest semi-annually.  What is the yield to maturity on the bond? 

a.  14% 
b.   6% 
c.   7% 
d.  13% 
e.  None of the above 

9. You are given the following information about Merenda Corp.'s bonds: Par value is $1,000; coupon rate is 12%; years to maturity = 6; and interest is paid annually.  What is the price if the required rate was 14%? 
a.  $ 1620 
b.    1088.60 
c.    1087.14 
d.    1000.00 
e.    None of the above within $1. 

10. DIV1 = $10, P1 = $60, r = .15. What is the current price? 

     a. $43.48 
     b. $52.17 
     c. $60.87 

 11.   Other things being equal, which one of the following would be consistent with a relatively low price/earnings ratio for a firm? 

a.  The stock’s beta is high. 
b.  The rate of return on equity is high. 
c.  The growth rate of earnings is high. 
d.  The debt/equity ratio is low and the debt is rated AAA. 

12. Under the straight line method (SLM), Tomato Corp. wrote off $2,000 as depreciation, but under the ACRS method it reported a depreciation expense of $3,500.  If Tomato's marginal corporate income tax rate was 30%, the additional tax shield of ACRS over SLM would be: 
a. $150 
b. $300 
c. $350 
d. $450 

 13. Projects A and B have the following cash flows: 

              t=0        t=1        t=2        t=3       t=4 
     A   -180      +100       +80       +80       +50 
     B   -200         +70      +70       +60       +60 

     If a company uses the payback rule with a cutoff period of 2 years, 
     which projects would it accept? 

     a. Project A. 
     b. Project B. 
     c. Both. 
     d. Neither. 

14. The opportunity cost of capital is 12 percent. Projects A and B both cost $1,000 and both have an NPV of $42. A has an IRR of 14 percent and B of 15 percent. What is the IRR on the incremental cash flows? 

     a. 0 percent. 
     b. 12 percent. (IRR of the incre. project: Where NPV-A is = to  NPV-B; it is at 12%)
     c. 16 percent. 
     d. Need more information to solve. 

Note: At 12%, A and B have the same NPVs. So, at 12%, NPV of A-B (or B-A) would be zero. (NPV has the adding up quality, so we can add/subtract NPVs from each other.)  IRR of the incremental project is then 12% (the rate that gives an NPV of zero).  How about that!
15. A company has a limit of $200 million to invest and has the following possible investment opportunities. The cost of capital is 8%. 

                        Investment,          NPV,           IRR, 
     Project            Millions          Millions        Percent 

        A                  100                140              15 
        B                    20                  20              15 
        C                    50                  65              43 
        D                    50               - 10                5 
        E                  150                  30              10 
        F                    40                  32              50 
        G                    20                 18              30 

Given the limited amount of investment, what is the maximum NPV that the company can obtain? 

     a. $200 million. 
     b. $243 million. 
     c. $283 million. 
     d. Need more information to solve. 

16. You have developed the following data on three stocks: 

                Stock       Standard Deviation         Beta 
                 A              0.15                 0.79 
                 B              0.25                 0.61 
                 C              0.20                 1.29 

If you are a risk minimizer, you should choose Stock _____ if it is to be held in isolation and Stock _____ if it is to be held as part of a well-diversified portfolio. 
a. A; A 
b. A; B
c. B; A 
d. C; A 
e. C; B 

17. Stock X and the "Market" had the following returns during the last two years, and the same relative volatility is expected to exist in the future: 
                   Year          Market           Stock X 
                      1             10.0%           15.0% 
                      2               5.0                5.0 
                      3               0.0             - 5.0 
       What is Stock X's beta? 
a. -1.0 
b.  0.5 
c.  0.0 
d.  1.0 
e.  2.0 

18. The expected return on the market portfolio is 12%, and the risk-free rate of return is 4%. An investment has a beta of .6.  Its expected return is 8%. 
a. This is a good investment because its expected return exceeds the market rate of return. 
b. This is a good investment because its expected return exceeds its required rate of return. 
c. This is a bad investment because its expected return is less than its required rate of return.

19. Inflation, recession, and wars are economic/political events which are characterized as 
a. Company specific risk that can be diversified away. 
b. Market risk.
c. Unique risk. 
d. Diversifiable risk. 

20.  Diversification of risk by holding securities in portfolios: 
a.  eliminates the market risk of holding securities 
b.  increases the expected level of returns of the portfolio 
c.  decreases the expected level of returns of the portfolio 
d.  reduces risk only if assets were perfectly positively correlated 
e.  reduces the unique (unsystematic) risk of the portfolio 

21. Firms operating in this industry are characterized by low beta: 
a.  Automobile manufacturing 
b.  Electric power 
c.  Dow Jones Industrials 
d.  Computer software 

22. If two stocks were perfectly positively correlated: 
a.  there would be no need to include both in a portfolio since they would contribute nothing to diversification 
b.  they would be the perfect stocks to form a two-stock portfolio since all risk is diversified away. 
c.  they would have to sell at the same price 
d.  they would have to sell at different prices 
e.  none of the above. 

23.  Which of the following would be the WORST stock to be combined with Stock X if the objective was to minimize the portfolio’s risk? 
a.  a stock with a correlation coefficient of -1 with X. 
b.  a stock with a correlation coefficient of 0.0 with X. 
c.  a stock with a correlation coefficient of +1 with X. 
d.  a stock with a correlation coefficient of +2 with X. (ticky! Correlation coef. cannt be larger than +1) 

24. What is the standard deviation of a well-diversified portfolio of stocks with an average beta of 1.21? 

     a. 1.1 times the standard deviation of the market. 
     b. 1.21 times the standard deviation of the market. 
     c. The same as the standard deviation of the market. 
     d. Can't say without knowing the correlation between the stocks. 

25. What is the standard deviation of a poorly diversified portfolio of  stocks with an average beta of .8? 

     a. Less than .8 times the standard deviation of the market portfolio. 
     b. More than .8 times the standard deviation of the market portfolio.
     c. The same as the standard deviation of the market portfolio. 
     d. Can't say. 

26.  Ignoring the case of borrowing, in general if the calculated NPV is negative, then which of the following must be true? 
a.  The discount rate used is equal to the internal rate of return. 
b.  The discount rate used is too high.
c.  The discount rate used is too low. 
d.  The discount rate used is greater than the internal rate of return.
e. The discount rate used is less than the internal rate of return. 

27.  Other things being equal, which of the following factors may cause an increase in the market price of a security? 
a. An increase in the risk aversion of the market. 
b. A decrease in the risk aversion of the market.  (Rm -Rf) decreases, so the required rate decreases; price increases.
c. An increase in the risk-free rate of return. 
d. An increase in the stock's beta. 

28. A and B are mutually exclusive projects.  The incremental project B-A has a negative NPV and an IRR below the required rate.  To maximize shareholders' wealth, the firm should choose: 

a. A 
b. B 

29. Free cash flow is defined as: 

     a. Cash revenues - cash costs - investments 
     b. Cash revenues + cash costs - investments 
     c. Cash revenues - cash costs + investments 

30.  Cash flows for a proposed project are as follows: 

Year-end  Cash Flow 
  0     +100 
  1     +120 
  2      - 288 

The project's IRR is 20%.  You would accept this project if the opportunity cost of capital (required rate) was _______  20%. 

a.  Greater than 
b.  Less than 
c.  Equal to 

SAMPLE Problems:

1. (Emphasis added) Co. X just paid a dividend of $1.6 per share. Its dividends and earnings are expected to grow abnormally at 20% per year for the next two years. The growth rate will then reach a normal level of 6% and stays there for the foreseeable future.  At a required rate of 10%, how much would you pay for the shares today? 

Year                                0              1          2             3
DIV                                 $1.60   $1.92   $2.30     $2.44 
Pice at t=2(resale)                                      61.06 
CFs (Div + Resale)                      $1.92   $63.36 
PV at 10%                                     1.75     52.36 
   Total PV                    $54.11 

2. (Emphasis added) The Test Company is evaluating the proposed acquisition of a new milling machine.  The machine’s base price is $108,000, and it would cost another $12,500 to modify it for special use by your firm.  The machine falls into the MACR 3-year class, and it would be sold after 3 years for $65,000.  (Look up the book for MACRS recovery allowance percentages.)  The machine would require an increase in net working capital (inventory) of $5,500.  The milling machine would have no effect on revenues, but it is expected to save the firm $44,000 per year in before-tax operating costs, mainly labor.  Test’s marginal tax rate is 35 percent. 
a. What is the net cost of the machine for capital budgeting purposes? (That is, what is the Year 0 net cash flow?)
b. What are the net operating cash flows in Years 1, 2, and 3?
c. What is the terminal year cash flow?
d. If the project’s cost of capital is 12 percent, should the machine be purchased? 

3.  (CFA Test Question) Historically, RR Corporation has retained 60% of its profits in the business and generated a rate of return on equity of 12.5%.  This is expected to continue.  The risk-free rate is 8%, RPm (market risk premium) is 5%, and beta is about 1.3.  The present dividend (paid yesterday) was $2.50, and the stock is selling at $45.  Should you buy or sell the stock? Emphasis added.

P =  Div1/ (r - g)

g= roe * Plaowback = .125 * .60 = 7.5%
r = Rf + (Rm - Rf) * Beta = Rf + (RPm) * Beta = .08 + (.05)*1.3 = 14.5%
DIV1 = DIV0 (1+g) = 2.50 * (1 + .075) = 2.6875
P = $2.6875 / (.145 - .075) = $38.
NPV = - $45 + 38 = Negative NPV. 

4. Problems from Brealey Myers, plus the handout probs. (Ch. 5: Rye Food; Ch. 4: Valuation problem using data from Value-Line; 

Short Questions

1.  Last year the market returned 16%.  Two managers, Mr. K and Ms. Q, earned returns of 20% and 15%, respectively.  K outperformed Q?  Would depend on the risk taken!

2.  Given the CAPM and the portfolio theory, is it possible to find two stocks such that the one with the higher variance has a lower expected return?  Yes, because return is a function of only the market risk, not the total risk (variance)!

3.  Historically, gold stocks have had low returns but they have been very volatile.  Rational investors should not buy such stocks. As in 2 above, investors look at the market risk, i.e., how the asset belends (correlates) with other assets in the market/portfolio. What matters is not variance or standard deviation; rather, how a stock covaries with other assets in the portfolio. Gold is negatively correlated with other assets in general. When things get back, gold pays off! It is like an insurance policy: The policy only makes sense when combined with a car. When there is an accident and the car declines in value, the insurance policy pays off. The car is like Asset A and the policy is like asset C in the lecture problem on portfolio theory.) 

4.  An undiversified portfolio with a beta of 2 is less than twice as risky as the market portfolio. False! it already as a market risk of two times larger than S&P!

5.  Given the portfolio theory, the same brokerage fees and no special information, managers should not invest in their own companies’ shares.

6.  Given the portfolio theory, investors should prefer “diversified” companies. False. They could do the same more cheaply on their own.

7.  According to the capital market theory, to create a portfolio with a beta=.5 one should invest in a large number of stocks with beta =.5. False!  Mix T-bill with S&P 500...