Mid-sem answers and solutions

ANSWER AND SOLUTION TO MID-SEMESTER 2004

1. You have determined the profitability of a planned project by finding the present value of all the cash flows from that project. Which of the following would cause the project to look more appealing in terms of the present value of those cash flows?

a. The discount rate decreases.b. The cash flows are extended over a longer period of time, but the

total amount of the cash flows remains the same.c. The discount rate increases.d. Answers b and c above.e. Answers a and b above.

2. Which of the following statements is most correct?

a. If the discount (or interest) rate is positive, the future value of an expected series of payments will always exceed the present value of the same series.

b. To increase present consumption beyond present income normally requires either the payment of interest or else an opportunity cost of interest foregone.

c. Disregarding risk, if money has time value, it is impossible for the present value of a given sum to be greater than its future value.

d. Disregarding risk, if the present value of a sum is equal to its future value, either k = 0 or t = 0.

e. Each of the statements above is true.


a. A 5-year $100 annuity due will have a higher present value than a 5- year $100 ordinary annuity.

b. A 15-year mortgage will have larger monthly payments than a 30-year mortgage of the same amount and same interest rate.

c. If an investment pays 10 percent interest compounded annually, its effective rate will also be 10 percent.

d. Statements a and c are correct.e. All of the statements above are correct.

4. The future value of a lump sum at the end of five years is $1,000. The nominal interest rate is 10 percent and interest is compounded semiannually. Which of the following statements is most correct?

a. The present value of the $1,000 is greater if interest is compounded monthly rather than semiannually.

b. The effective annual rate is greater than 10 percent.c. The periodic interest rate is 5 percent.

1. PV and discount rate Answer: a Diff: E

2. PV versus FV Answer: e Diff: E

3. Time value concepts Answer: e Diff: E

d. Both statements b and c are correct.e. All of the statements above are correct.

5. A $10,000 loan is to be amortized over 5 years, with annual end-of-year payments. Given the following facts, which of these statements is most correct?

a. The annual payments would be larger if the interest rate were lower.b. If the loan were amortized over 10 years rather than 5 years, and if

the interest rate were the same in either case, the first payment would include more dollars of interest under the 5-year amortization plan.

c. The last payment would have a higher proportion of interest than the first payment.

d. The proportion of interest versus principal repayment would be the same for each of the 5 payments.

e. The proportion of each payment that represents interest as opposed to repayment of principal would be higher if the interest rate were higher.


a. The first payment under a 3-year, annual payment, amortized loan for $1,000 will include a smaller percentage (or fraction) of interest if the interest rate is 5 percent than if it is 10 percent.

b. If you are lending money, then, based on effective interest rates, you should prefer to lend at a 10 percent nominal, or quoted, rate but with semiannual payments, rather than at a 10.1 percent nominal rate with annual payments. However, as a borrower you should prefer the annual payment loan.

c. The value of a perpetuity (say for $100 per year) will approach infinity as the interest rate used to evaluate the perpetuity approaches zero.

d. Statements a, b, and c are all true.e. Statements b and c are true.

7. Find the present value of an income stream which has a negative flow of $100 per year for 3 years, a positive flow of $200 in the 4th year, and a positive flow of $300 per year in Years 5 through 8. The appropriate discount rate is 4 percent for each of the first 3 years and 5 percent for each of the later years. Thus, a cash flow accruing in Year 8 should be discounted at 5 percent for some years and 4 percent in other years. All payments occur at year-end.

a. $ 528.21b. $1,329.00c. $ 792.49d. $1,046.41e. $ 875.18

8. You are saving for the college education of your two children. One child will enter college in 5 years, while the other child will enter

Chapter 2 -

college in 7 years. College costs are currently $10,000 per year and are expected to grow at a rate of 5 percent per year. All college costs are paid at the beginning of the year. You assume that each child will be in college for four years.

You currently have $50,000 in your educational fund. Your plan is to contribute a fixed amount to the fund over each of the next 5 years. Your first contribution will come at the end of this year, and your final contribution will come at the date at which you make the first tuition payment for your oldest child. You expect to invest your contributions into various investments which are expected to earn 8 percent per year. How much should you contribute each year in order to meet the expected cost of your children's education?

a. $2,894b. $3,712c. $4,125d. $5,343e. none of the above

9. A young couple is planning for the education of their two children. They plan to invest the same amount of money at the end of each of the next 16 years, i.e., the first contribution will be made at the end of the year and the final contribution will be made at the time the oldest child enters college.

The money will be invested in securities that are certain to earn a return of 8 percent each year. The oldest child will begin college in 16 years and the second child will begin college in 18 years. The parents anticipate college costs of $25,000 a year (per child). These costs must be paid at the end of each year. If each child takes four years to complete their college degrees, then how much money must the couple save each year?

a. $ 9,612.10b. $ 5,071.63c. $12,507.29d. $ 5,329.45e. none of the above

10. Your subscription to Her World Monthly is about to run out and you have the choice of renewing it by sending in the $10 a year regular rate or of getting a lifetime subscription to the magazine by paying $100. Your cost of capital is 7 percent. How many years would you have to live to make the lifetime subscription the better buy? Payments for the regular subscription are made at the beginning of each year. (Round up if necessary to obtain a whole number of years.)

a. 15 yearsb. 10 yearsc. 18 yearsd. 7 yearse. none of the above

11. Suppose you put $100 into a savings account today, the account pays a nominal annual interest rate of 6 percent, but compounded semiannually, and you withdraw $100 after 6 months. What would your ending balance be 20 years after the initial $100 deposit was made?

a. $226.20b. $115.35c. $ 62.91d. $ 9.50e. none of the above

12. You are contributing money to an investment account so that you can purchase a house in five years. You plan to contribute six payments of $3,000 a year--the first payment will be made today (t = 0), and the final payment will be made five years from now (t = 5). If you earn 11 percent in your investment account, how much money will you have in the account five years from now (at t = 5)?


13. Jamilah is 30 years old and is saving for her retirement. She is planning on making 36 contributions to her retirement account at the beginning of each of the next 36 years. The first contribution will be made today (t = 0) and the final contribution will be made 35 years from today (t = 35). The retirement account will earn a return of 10 percent a year. If each contribution she makes is $3,000, how much will be in the retirement account 35 years from now (t = 35)?


14. You have just borrowed $20,000 to buy a new car. The loan agreement calls for 60 monthly payments of $444.89 each to begin one month from today. If the interest is compounded monthly, then what is the effective annual rate on this loan?

a. 12.68%b. 14.12%c. 12.00%d. 13.25%e. none of the above

15. You have just taken out a 10-year, $12,000 loan to purchase a new car. This loan is to be repaid in 120 equal end-of-month installments. If each of the monthly installments is $150, what is the effective annual interest rate on this car loan?

Chapter 2 -

a. 6.5431%b. 7.8942%c. 8.6892%d. 9.0438%e. none of the above

16. A soccer player with Kelab MPPJ is offered a 5-year contract which pays him the following amounts:

Year 1: $1.2 millionYear 2: 1.6 millionYear 3: 2.0 millionYear 4: 2.4 millionYear 5: 2.8 million

Under the terms of the agreement all payments are made at the end of each year.

Instead of accepting the contract, the baseball player asks his agent to negotiate a contract which has a present value of $1 million more than that which has been offered. Moreover, the player wants to receive his payments in the form of a 5-year annuity due. All cash flows are discounted at 10 percent. If the team were to agree to the player's terms, what would be the player's annual salary (in millions of ringgit)?

a. $1.500b. $1.659c. $1.989d. $2.343e. none of the above

17. Ali and Abu (2 brothers) are each trying to save enough money to buy their own cars. Ali is planning to save $100 from every paycheck (he is paid every 2 weeks.) Abu plans to put aside $150 each month but has already saved $1,500. Interest rates are currently quoted at 10 percent. Ali's bank compounds interest every two weeks while Abu's bank compounds interest monthly. At the end of 2 years they will each spend all their savings on a car (each brother buys a car). What is the price of the most expensive car purchased?

a. $5,744.29b. $5,807.48c. $5,703.02d. $5,797.63e. None of the above

18. An investment pays $100 every six months (semiannually) over the next 2.5 years. Interest, however, is compounded quarterly, at a nominal rate of 8 percent. What is the future value of the investment after 2.5 years?

a. $520.61b. $541.63

c. $542.07d. $543.98e. none of the above

19. You have just bought a security which pays $500 every six months. The security lasts for ten years. Another security of equal risk also has a maturity of ten years, and pays 10 percent compounded monthly (that is, the nominal rate is 10 percent). What should be the price of the security that you just purchased?

a. $6,108.46b. $6,175.82c. $6,231.11d. $6,566.21e. none of the above

20. You have been offered an investment that pays $500 at the end of every 6 months for the next 3 years. The nominal interest rate is 12 percent; however, interest is compounded quarterly. What is the present value of the investment?

a. $2,458.66b. $2,444.67c. $2,451.73d. $2,463.33e. none of the above

21. You recently purchased a 20-year investment which pays you $100 at t = 1, $500 at t = 2, $750 at t = 3, and some fixed cash flow, X, at the end of each of the remaining 17 years. The investment cost you $5,544.87. Alternative investments of equal risk have a required return of 9 percent. What is the annual cash flow received at the end of each of the final 17 years, that is, what is X?

a. $600b. $625c. $650d. $675e. none of the above

22. Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital as it applies to capital budgeting?

a. Long-term debt.b. Common stock.c. Accounts payable.d. Preferred stock.e. All of the above are considered capital components for WACC and

capital budgeting purposes.

Chapter 2 -

23. You observe the following information regarding Company X and Company Y:

Company X has a higher expected mean return than Company Y. Company X has a lower standard deviation than Company Y. Company X has a higher beta than Company Y.

Given this information, which of the following statements is most correct?

a. Company X has a lower coefficient of variation.b. Company X has more company-specific risk.c. Company X is a better stock to buy.d. Statements a and b are correct.e. Statements a, b, and c are correct.


a. The beta coefficient of a stock is normally found by running a regression of past returns on the stock against past returns on a stock market index. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta.

b. It is theoretically possible for a stock to have a beta of 1.0. If a stock did have a beta of 1.0, then, at least in theory, its required rate of return would be equal to the riskless (default-free) rate of return, rRF.

c. If you found a stock with a zero beta and held it as the only stock in your portfolio, you would by definition have a riskless portfolio. Your 1-stock portfolio would be even less risky if the stock had a negative beta.

d. The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks.

e. All of the statements above are true.

25. Assume that a new law is passed which restricts investors to holding only one asset. A risk-averse investor is considering two possible assets as the asset to be held in isolation. The assets' possible returns and related probabilities (i.e., the probability distributions) are as follows:

Asset X Asset Y P r P r 0.10 -3% 0.05 -3% 0.10 2 0.10 2 0.25 5 0.30 5 0.25 8 0.30 8 0.30 10 0.25 10

Which asset should be preferred?

a. Asset X, since its expected return is higher.b. Asset Y, since its beta is probably lower.c. Either one, since the expected returns are the same.d. Asset X, since its standard deviation is lower.e. Asset Y, since its coefficient of variation is lower and its expected

return is higher.

26. Given the following probability distribution, what is the expected return and the standard deviation of returns for Security J?

State Pi rJ

_____ ____ ____

1 0.2 10% 2 0.6 15 3 0.2 20

a. 15%; 6.50%b. 12%; 5.18%c. 15%; 3.16%d. 15%; 10.00%e. none of the above

27. One of the basic relationships in interest rate theory is that, other things held constant, for a given change in the required rate of return, the the time to maturity, the the change in price.

a. longer; smaller.b. shorter; larger.c. longer; greater.d. shorter; smaller.e. Answers c and d are correct.

25?. Expected return Answer: e Diff: M

= 0.10(-3%) + 0.10(2%) + 0.25(5%) + 0.25(8%) + 0.30(10%) = 6.15%.

Chapter 2 -


a. All else equal, long-term bonds have more interest rate risk than short term bonds.

b. All else equal, higher coupon bonds have more reinvestment risk than low coupon bonds.

c. All else equal, short-term bonds have more reinvestment risk than do long-term bonds.

d. Statements a and c are correct.e. All of the statements above are correct.


a. If a bond’s yield to maturity exceeds its annual coupon, then the bond will be trading at a premium.

b. If interest rates increase, the relative price change of a 10-year coupon bond will be greater than the relative price change of a 10-year zero coupon bond.

c. If a coupon bond is selling at par, its current yield equals its yield to maturity.

d. Both a and c are correct.e. None of the answers above is correct.

= 0.05(-3%) + 0.10(2%) + 0.30(5%) + 0.30(8%) + 0.25(10%) = 6.45%.

= 0.10(-3% - 6.15%)2 + 0.10(2% - 6.15%)2 + 0.25(5% - 6.15%)2

30. A 10-year corporate bond has an annual coupon payment of 9 percent. The bond is currently selling at par ($1,000). Which of the following statements is most correct?

a. The bond’s yield to maturity is 9 percent.b. The bond’s current yield is 9 percent.c. If the bond’s yield to maturity remains constant, the bond’s price

will remain at par.d. Both answers a and c are correct.e. All of the answers above are correct.


a. Rising inflation makes the actual yield to maturity on a bond greater than the quoted yield to maturity which is based on market prices.

b. The yield to maturity for a coupon bond that sells at its par value consists entirely of an interest yield; it has a zero expected capital gains yield.

c. On an expected yield basis, the expected capital gains yield will always be positive because an investor would not purchase a bond with an expected capital loss.

d. The market value of a bond will always approach its par value as its maturity date approaches. This holds true even if the firm enters bankruptcy.

e. All of the statements above are false.


a. The current yield on Bond A exceeds the current yield on Bond B; therefore, Bond A must have a higher yield to maturity than Bond B.

b. If a bond is selling at a discount, the yield to call is a better measure of return than the yield to maturity.

c. If a coupon bond is selling at par, its current yield equals its yield to maturity.

d. Both a and b are correct.e. Both b and c are correct.

33. Assume that all interest rates in the economy decline from 10 percent to 9 percent. Which of the following bonds will have the largest percentage increase in price?

a. A 10-year bond with a 10 percent coupon.b. An 8-year bond with a 9 percent coupon.c. A 10-year zero coupon bond.d. A 1-year bond with a 15 percent coupon.e. A 3-year bond with a 10 percent coupon.

34. Which of the following has the greatest price risk?

a. A 10-year, $1,000 face value, 10 percent coupon bond with semiannual interest payments.

+ 0.25(8% - 6.15%)2 + 0.30(10% - 6.15%)2 = 15.73; = 3.97.

Chapter 2 -

b. A 10-year, $1,000 face value, 10 percent coupon bond with annual interest payments.

c. A 10-year, $1,000 face value, zero coupon bond.d. A 10-year $100 annuity.e. All of the above have the Leoe price risk since they all mature in 10

years.

35. Assume that you wish to purchase a bond with a 30-year maturity, an annual coupon rate of 10 percent, a face value of $1,000, and semiannual interest payments. If you require a 9 percent nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond?

a. $905.35b. $1,102.74c. $1,103.19d. $1,106.76e. none of the above

36. Tan Ling Ling recently inherited some bonds (face value $100,000) from

her father, and soon thereafter she became engaged to Leo Samuel, a University of Florida marketing graduate. Leo wants Ling Ling to cash in the bonds so the two of them can use the money to "live like royalty" for two years in Monte Carlo. The 2 percent annual coupon bonds mature on January 1, 2024, and it is now January 1, 2004. Interest on these bonds is paid annually on December 31 of each year, and new annual coupon bonds with similar risk and maturity are currently yielding 12 percent. If Ling Ling sells her bonds now and puts the proceeds into an account which pays 10 percent compounded annually, what would be the largest equal annual amounts she could withdraw for two years, beginning today (i.e., two payments, the first payment today and the second payment one year from today)?


37. GMZ Berhad recently issued 10-year bonds at a price of $1,000. These bonds pay $60 in interest each six months. Their price has remained stable since they were issued, i.e., they still sell for $1,000. Due to additional financing needs, the firm wishes to issue new bonds that would have a maturity of 10 years, a par value of $1,000, and pay $40 in interest every six months. If both bonds have the same yield, how many

CVX = 3.97/6.15 = 0.645.

= 0.05(-3% - 6.45%)2 + 0.10(2% - 6.45%)2 + 0.30(5% - 6.45%)2

+ 0.30(8% - 6.45%)2 + 0.25(10% - 6.45%)2

= 10.95; = 3.31.CVY = 3.31/6.45 = 0.513.

new bonds must GMZ issue to raise $2,000,000 cash?

a. 2,400b. 2,596c. 3,000d. 5,000e. none of the above

38. Your client has been offered a 5-year, $1,000 par value bond with a 10 percent coupon. Interest on this bond is paid quarterly. If your client is to earn a nominal rate of return of 12 percent, compounded quarterly, how much should she pay for the bond?

a. $ 800b. $ 926c. $1,025d. $1,216e. none of the above

Therefore, Asset Y has a higher expected return and lower coefficient of variation and hence it would be preferred.

26?. Expected return Answer: c Diff: M

= (0.2)(0.10) + (0.6)(0.15) + (0.2)(0.20) = 0.15 = 15.0%.Expected return = 15.0%.

= (0.2)(0.10 - 0.15)2 + 0.6(0.15 - 0.15)2 + (0.2)(0.20 - 0.15)2 = 0.001.

Standard deviation = = 0.0316 = 3.16%.27. Interest rates Answer: e Diff: E

4. Time value concepts Answer: d Diff: E

Statements b and c are correct; therefore, statement d is the correct choice. The present value is smaller if interest is compounded monthly rather than semiannually.

5. Time value concepts Answer: e Diff: M

If the interest rate were higher, the payments would all be higher, and all of the increase would be attributable to interest. So, the proportion of each payment that represents interest would be higher. Note that statement b is false because interest during Year 1 would be the interest rate times the beginning balance, which is $10,000. With the same interest rate and the same beginning balance, the Year 1 interest charge will be the same, regardless of whether the loan is amortized over 5 or 10 years.

6?. Time value concepts Answer: d Diff: T

7. PV of an uneven CF stream Answer: c Diff: T

Chapter 2 -

39. You just purchased a 15-year bond with an 11 percent annual coupon. The bond has a face value of $1,000 and a current yield of 10 percent. Assuming that the yield to maturity of 9.7072 percent remains constant, what will be the price of the bond 1 year from now?


40. A corporate bond with a $1,000 face value pays a $50 coupon every six

Numerical solution:PV = -$100(PVIFA4%,3) + $200(PVIF5%,1)(PVIF4%,3) + $300(PVIFA5%,4)(PVIF5%,1)(PVIF4%,3) = -$100[(1-(1/1.043)/.04] + $200(1/1.05)(1/1.043) + $300[(1-(1/1.054)/.05](1/1.05)( 1/1.043) = -$100(2.7751) + $200(0.9524)(0.8890) + $300(3.5460)(0.9524)(0.8890) = -$277.51 + $169.34 + $900.70 = $792.53.

Financial calculator solution:Inputs: CF0 = 0; CF1 = -100; Nj = 3; I = 4. Output: NPV = -277.51.Calculate the PV of CFs 4-8 as of time = 3 at i = 5%Inputs: CF0 = 0; CF1 = 200; CF2 = 300; Nj = 4; I = 5. Output: NPV3 = $1,203.60.Calculate PV of the FV of the positive CFs at Time = 3Inputs: N = 3; I = 4; PMT = 0; FV = -1,203.60. Output: PV = $1,070.Total PV = $1,070 - $277.51 = $792.49.

Note: Numerical solution differs from calculator solution due to interest factor rounding.

8. Required annuity payments Answer: b Diff: T

College Cost Today = $10,000, Inflation = 5%.CF0 = $10,000 (1.05)5 = $12,762.82 1 = $12,762.82.CF1 = $10,000 (1.05)6 = $13,400.96 1 = $13,400.96.CF2 = $10,000 (1.05)7 = $14,071.00 2 = $28,142.00.CF3 = $10,000 (1.05)8 = $14,774.55 2 = $29,549.10.CF4 = $10,000 (1.05)9 = $15,513.28 1 = $15,513.28.CF5 = $10,000 (1.05)10 = $16,288.95 1 = $16,288.95.

Numerical solution:Find PV of college costs in Year 5:

months. The bond will mature in ten years, and has a nominal yield to maturity of 9 percent. What is the price of the bond?

a. $ 634.86b. $1,064.18c. $1,065.04d. $1,078.23e. none of the above

41. Ayamperak Berhad recently issued 20-year bonds. The bonds have a coupon

PV = $12,762.82 + $13,400.96(0.9259) + $28,142(0.8573) + $29,549.10(0.7938) + $15,513.28(0.7350) + $16,288.95(0.6806) = $95,241.50.Find FV of educational fund in 5 years:$50,000(1.08)5 = $73,466.40.Now, find net amount needed in Year 5:$95,241.50 – $73,466.40 = $21,775.10.Finally, find PMT needed to accumulate $21,775.10 in Year 5:FVA5 = PMT(FVIFA8%,5)$21,775.10 = PMT[(1.085-1)/0.08]$21,775.10 = PMT(5.8666)PMT = $3,711.71.Note: Numerical solution differs from calculator solution due to interest factor rounding.

Financial calculator solution:Enter cash flows in CF register:I = 8; solve for NPV = $95,244.08.Calculate annuity: N = 5 I = 8 PV = -50,000 FV = 95,244.08PMT = ? = $3,712.15.

9

?. Required annuity payments Answer: b Diff: T

Numerical solution:Calculate the present value of college costs at t = 16:PV = $25,000(0.9259) + $25,000(0.8573) + $50,000(0.7938) + $50,000(0.7350) + $25,000(0.6806) + $25,000(0.6302)PV = $153,790.Calculate the annual required deposit: FVA16 = PMT(FVIFA8%,16)$153,790 = PMT[(1.0816-1)/0.08] (30.324)$153,790 = PMT(30.324) PMT = $5,071.56.Note: Numerical solution differs from calculator solution due to interest factor rounding.

Financial calculator solution:Step 1 Calculate the present value of college costs at t = 16:

Chapter 2 -

rate of 8 percent and pay interest semiannually. Also, the bonds are callable in 6 years at a call price equal to 115 percent of par value. The par value of the bonds is $1,000. If the yield to maturity is 7 percent, what is the yield to call?

a. 8.33% b. 7.75% c. 9.89% d. 10.00% e. none of the above

Remember, costs are incurred at end of year.t = 16: CF0 = 0t = 17: CF1 = 25,000t = 18: CF2 = 25,000t = 19: CF3 = 50,000t = 20: CF4 = 50,000t = 21: CF5 = 25,000t = 22: CF6 = 25,000I = 8; Solve for NPV = $153,793.54.

Step 2 Calculate the annual required deposit:N = 16I = 8PV = 0FV = -153,793.54Solve for PMT = $5,071.63.

10. Number of periods for an annuity Answer: a Diff: M

Time Line: 0 7% 1 2 3 n = ? Years ├───────────┼───────────┼─────────────┼────────────┤

CFLifetime = 100 0 0 0 0

CFAnnual= 10 10 10 10 10

Tabular solution: Set PVLifetime = PVAnnual, solve for n.$100 = $10 + $10(PVIFA7%,n) $90 = $10(PVIFA7%,n) 9 = PVIFA7%,n

n 15 years.

Financial calculator solution:Inputs: I = 7; PV = -90; PMT = 10; FV = 0. Output: N = 14.695 15 years.

11

?. FV of a sum Answer: d Diff: M

42. Assume that Satay Kajang and Satay Mas have similar $1,000 par value bond issues outstanding. The bonds are equally risky. The Satay Mas bond has an annual coupon rate of 8 percent and matures 20 years from today. The Satay Kajang bond has a coupon rate of 8 percent, with interest paid semiannually, and it also matures in 20 years. If the nominal required rate of return, rd, is 12 percent, semiannual basis, for both bonds, what is the difference in current market prices of the two bonds?

a. No difference.b. $ 2.20c. $ 3.77d. $17.53e. none of the above

Tabular/Numerical solution: Solve for amount on deposit at the end of 6 months.Step 1 FV = $100(FVIF3%,1) - $100 = $3.00.

FV = $100(1 + 0.06/2) - $100 = $3.00.Step 2 Compound the $3.00 for 39 periods at 3%

FV = $3.00(FVIF3%,39) = $9.50.Since table does not show 39 periods, use numerical/calculator exponent method.FV = $3.00(1.03)39 = $9.50.

Financial calculator solution: (Step 2 only)Inputs: N = 39; I = 3; PV = -3.00; PMT = 0. Output: FV = $9.50.

12. FV of annuity due Answer: d Diff: M

There are a few ways to do this. One way is shown below.To get the value at t = 5 of the first 5 payments:BEGIN modeN = 5I = 11PV = 0PMT = -3,000FV = $20,738.58

Now add on to this the last payment that occurs at t = 5.$20,738.58 + $3,000 = $23,738.58 $23,739.

13. FV of an annuity Answer: c Diff: M

To calculate the solution to this problem, change your calculator to BEGIN mode. Then enter N = 35, I = 10, PV = 0, and PMT = 3000. Solve for FV = $894,380. Add the last payment of $3,000, and the value at t = 35 is $897,380.

14

?. Effective annual rate Answer: a Diff: M

Chapter 2 -

Tabular solution:$20,000 = $444.89(PVIFAi,60)PVIFAi,60 = 44.9549

i = 1%.EAR = (1.01)12 - 1.0 = 1.12681 - 1.0 = 0.1268 = 12.68%.

Financial calculator solution:Calculate periodic rate and nominal rateInputs: N = 60; PV = -20,000; PMT = 444.89; FV = 0.Output: I = 1.0. NOM% = 1.0% 12 = 12.00%.Use interest rate conversion featureInputs: P/YR = 12; NOM% = 12.0. Output: EFF% = EAR = 12.68%.

15. Effective annual rate Answer: e Diff: M

Given: Loan Value = $12,000; Loan Term = 10 years (120 months);Monthly Payment = $150.

N = 120PV = -12,000PMT = 150FV = 0Solve for I/YR = 0.7241 12 = 8.6892%. However, this is a nominal rate. To find the effective rate, enter the following:NOM% = 8.6892P/YR = 12Solve for EFF% = 9.0438%.

16

?. Required annuity payments Answer: c Diff: M

Enter CFs:CF0 = 0CF1 = 1.2CF2 = 1.6CF3 = 2.0CF4 = 2.4

43. You are considering investing in a security that matures in 10 years with a par value of $1,000. During the first five years, the security has an 8 percent coupon with quarterly payments (i.e., you receive $20 a quarter for the first 20 quarters). During the remaining five years the security has a 10 percent coupon with quarterly payments (i.e., you receive $25 a quarter for the second 20 quarters). After 10 years (40 quarters) you receive the par value.

CF5 = 2.8I = 10%; NPV = $7.2937 million.$1 + $7.2937 = $8.2937 million.

Now, calculate the annual payments. BEGIN modeN = 5; I/YR = 10; PV = -8.2937; FV = 0; PMT = ? = $1.989 million.

17. FV under non-annual compounding Answer: d Diff: M

First, find the FV of Ali's savings as: N = 2 26 = 52, I = 10/26 = 0.3846, PV = 0, PMT = -100, and FV = ? = $5,744.29. Abu's savings will have two components, a lump sum contribution of $1,500 and his monthly contributions. The FV of his regular savings is: N = 2 12 = 24, I = 10/12 = 0.8333, PV = 0, PMT = -150, and FV = ? = $3,967.04. The FV of his previous savings is: N = 24, I = 0.8333, PV = -1,500, PMT = 0, and FV = ? = $1,830.59. Summing the components of Abu's savings yields $5,797.63 which is greater than Ali's total savings. Thus, the most expensive car purchased costs $5,797.63.

18?. FV under quarterly compounding Answer: c Diff: M

The effective rate is given by:NOM% = 8P/YR = 4Solve for EFF% = 8.2432%.

The nominal rate on a semiannual basis is given by:EFF% = 8.2432P/YR = 2Solve for NOM% = 8.08%.

The future value is given by:N = 2.5 2 = 5I = 8.08/2 = 4.04PV = 0PMT = -100Solve for FV = $542.07.

19. PV under monthly compounding Answer: b Diff: M

Start by calculating the effective rate on the second security:P/YR = 12NOM% = 10

Chapter 2 -

Another 10-year bond has an 8 percent semiannual coupon (i.e., the coupon payment is $40 every six months). This bond is selling at its par value, $1,000. This bond has the same risk as the security you are thinking of purchasing. Given this information, what should be the price of the security you are considering purchasing?

a. $ 898.65b. $1,060.72c. $1,037.61d. $ 943.22e. none of the above

Solve for EFF% = 10.4713%.Then, convert this effective rate to a semiannual rate:EFF% = 10.4713P/YR = 2NOM% = 10.2107%.Now, calculate the value of the first security as follows:N = 10 2 = 20, I = 10.2107/2 = 5.1054, PMT = 500, FV = 0, thus, PV = -$6,175.82.

20

?. PV under non-annual compounding Answer: c Diff: M

First, find the effective annual rate for a nominal rate of 12% with quarterly compounding: P/YR = 4, NOM% = 12, and EFF% = ? = 12.55%. In order to discount the cash flows properly, it is necessary to find the nominal rate with semiannual compounding that corresponds to the effective rate calculated above. Convert the effective rate to a semiannual nominal rate as P/YR = 2, EFF% = 12.55, and NOM% = ? = 12.18%. Finally, find the PV as N = 2 3 = 6, I = 12.18/2 = 6.09, PMT = 500, FV = 0, and PV = ? = -$2,451.73.

21?. Value of missing payments Answer: d Diff: M

Find the FV of the price and the first three cash flows at t = 3.To do this first find the present value of them.CF0 = -5,544.87CF1 = 100CF2 = 500CF3 = 750I = 9; solve for NPV = -$4,453.15.

N = 3I = 9PV = -4,453.15PMT = 0 FV = $5,766.96.

Now solve for X.N = 17I = 9

44. An increase in a firm's expected growth rate would normally cause the firm's required rate of return to

a. Increase.b. Decrease.c. Fluctuate.d. Remain constant.e. Possibly increase, possibly decrease, or possibly remain unchanged.

PV = -5,766.96FV = 0Solve for PMT = $675.

22. Capital components Answer: c Diff: E

23. Risk measures Answer: a Diff: E

Statement a is true, since the coefficient of variation is equal to the standard deviation divided by the mean. The remaining statements are false.

24. Beta coefficient Answer: a Diff: M

28. Interest rate and reinvestment risk Answer: e Diff: E

Statements a, b, c, and d are all correct. Therefore, the answer is e.

29. Bond concepts Answer: c Diff: E

Statement c is correct; the other statements are false. If a bond’s YTM > annual coupon, then it will trade at a discount. If interest rates increase, the 10-year zero coupon bond’s price change is greater than the 10-year coupon bond’s.

30. Bond concepts Answer: e Diff: E

All the statements are true; therefore, the correct statement is e. Since the bond is selling at par, its YTM = coupon rate. The current yield is calculated as $90/$1,000 = 9%. If YTM = coupon rate, the bond will sell at par. So, if the bond’s YTM remains constant the bond’s price will remain at par.

31. Bond yield Answer: b Diff: M

32. Bond yield Answer: c Diff: M

Statement c is correct; the other statements are false. By definition, if a coupon bond is selling at par its current yield will equal its

Chapter 2 -

45. A stock’s dividend is expected to grow at a constant rate of 5 percent a year. Which of the following statements is most correct?

a. The expected return on the stock is 5 percent a year.b. The stock’s dividend yield is 5 percent.c. The stock’s price one year from now is expected to be 5 percent

higher.d. Statements a and c are correct.e. All of the statements above are correct.


yield to maturity. If we let Bond A be a 5-year, 12% coupon bond that sells at par, its current yield equals its YTM which equals 12%. If we let Bond B be a 5-year, 10% coupon bond (in a 12% interest rate environment) the bond will sell for $927.90. Its current yield equals 10.78% ($100/$927.90), but its yield to maturity equals 12%. The YTC is a better measure of return than the YTM if the bond is selling at a premium.

33. Price risk Answer: c Diff: M

Statement c is correct; the other statements are incorrect. Long-term, low-coupon bonds are most affected by changes in interest rates; therefore, of the bonds listed the 10-year zero coupon bond will have the largest percentage increase in price.

34. Price risk Answer: c Diff: M

The correct answer is c; the other statements are false. Zero coupon bonds have greater price risk than either of the coupon bonds or the annuity.

35. Bond value - semiannual payment Answer: c Diff: E

Numerical solution:VB = $50((1- 1/1.04560)/0.045) + $1,000(1/1.04560) = $50(20.6380) + $1,000(0.071289) = $1,103.19 $1,103.

Financial calculator solution:Inputs: N = 60; I = 4.5; PMT = 50; FV = 1,000. Output: PV = -$1,103.19; VB $1,103.

36

a. Assume that the required rate of return on a given stock is 13 percent. If the stock’s dividend is growing at a constant rate of 5 percent, its expected dividend yield is 5 percent as well.

b. The dividend yield on a stock is equal to the expected return less the expected capital gain.

c. A stock’s dividend yield can never exceed the expected growth rate.d. All of the answers above are correct.e. Answers b and c are correct.

47. An ordinary share has just paid a dividend of $3.00. If the expected

?. Bond value - annual payment Answer: a Diff: M

Numerical solution:Step 1 Calculate PV of the bonds

VB = $2,000(PVIFA12%,20) + $100,000(PVIF12%,20) = $2,000((1- 1/1.1220)/0.12) + $100,000(1/1.1220)

= $2,000(7.4694) + $100,000(0.1037) = $25,308.80.Step 2 Calculate the equal payments of the annuity due.

PMT = =

=$25,308.80

(1.7355)(1.10) = $13,257.27.

Financial calculator solution: Calculate the PV of the bondsInputs: N = 20; I = 12; PMT = 2,000; FV = 100,000. Output: PV = -$25,305.56.Calculate equal annuity due paymentsBEGIN mode Inputs: N = 2; I = 10; PV = -25,305.56; FV = 0. Output: PMT = $13,255.29 $13,255.

37. Bond value - semiannual payment Answer: b Diff: M

Chapter 2 -

long-run growth rate for this stock is 5 percent, and if investors require an 11 percent rate of return, what is the price of the share?

a. $50.00b. $50.50c. $52.50d. $53.00e. $63.00

48. You are given the following data:

Numerical solution:Since the old bond issue sold at its maturity (or par) value, and still sells at par, its yield (and the yield on the new issue) must be 6 percent semiannually. The new bonds will be offered at a discount: VB = $40(PVIFA6%,20) + $1,000(PVIF6%,20) = $40((1- 1/1.0620)/0.06) + $1,000(1/1.0620)

= $40(11.4699) + $1,000(0.3118) = $770.60.Number of bonds = $2,000,000/$770.60 = 2,595.38 2,596.

Financial calculator solution:Inputs: N = 20; I = 6; PMT = 40; FV = 1,000. Output: PV = -$770.60; VB = $770.60.Number of bonds: $2,000,000/$770.60 2,596 bonds.*

*Rounded up to next whole bond.

38. Bond value - quarterly payment Answer: b Diff: M

Numerical solution: VB = $25(PVIFA3%,20) + $1,000(PVIF3%,20) = $25((1- 1/1.0320)/0.03) + $1,000(1/1.0320)

= $25(14.8775) + $1,000(0.5537) = $925.64 $926.

Financial calculator solution:Inputs: N = 20; I = 3; PMT = 25; FV = 1,000. Output: PV = -$925.61; VB $926.

39. Future value of bond Answer: c Diff: M

The YTM = Current yield + Capital GainThus: Capital gain = YTM - Current yield = 9.7072% - 10% = -0.2928%.

The price in 1 year = Price now (1 + CG%).

Price now:Current yield = Annual coupon/PriceThus: Price = Annual coupon/Current yield

(1) The risk-free rate is 5 percent.(2) The required return on the market is 8 percent.(3) The expected growth rate for the firm is 4 percent.(4) The last dividend paid was $0.80 per share.(5) Beta is 1.3.

Now assume the following changes occur:

(1) The inflation premium drops by 1 percent.(2) An increased degree of risk aversion causes the required return on

the market to go to 10 percent after adjusting for the changed

= $110/0.10 = $1,100.

Price in one year = $1,100 (1 + CG%) = $1,100 (1 - 0.002928) (Remember to express the = $1,096.78 $1,097. capital gain as a decimal.)

40. Bond value - semiannual payment Answer: c Diff: E

N = 10 2 = 20I = 9/2 = 4.5PMT = 50FV = 1,000Solve for PV = -$1,065.04.

41?. Yield to call Answer: b Diff: M

First, calculate the price of the bond as follows: N = 20 2 = 40, I = 7/2 = 3.5, PMT = 8%/2 1,000 = 40, FV = 1,000, and solve for PV = ? = -$1,106.78. Now, we can calculate the YTC as follows, recognizing that the bond can be called in 6 years at a call price of 115% 1,000 = 1,150: N = 6 2 = 12, PV = -1,106.78, PMT = 40, FV = 1,150, and solve for I = ? = 3.8758% 2 = 7.75%.

42

?. Bond value Answer: d Diff: T

Financial calculator solution:Burger King VB

Calculate EAR to apply to Burger King bonds using interest rate conversion feature, and calculate the value, VBK, of Burger King bonds:Inputs: P/YR = 2; NOM% = 12. Output: EFF% = EAR = 12.36%.Inputs: N = 20; I = 12.36; PMT = 80; FV = 1,000. Output: PV = -$681.54.

Chapter 2 -

inflation premium.(3) The expected growth rate increases to 6 percent.(4) Beta rises to 1.5.

What will be the change in price per share, assuming the stock was in equilibrium before the changes?

a. +$12.11b. -$ 4.87c. +$ 6.28d. -$16.97e. +$ 2.78

McDonalds VB

Inputs: N = 40; I = 6; PMT = 40; FV = 1,000. Output: PV = $699.07.Calculate the difference between the two bonds' PVsDifference: VB(McD) - VB(BK) = 699.07 - 681.54 = $17.53.

43. Bond value and effective annual rate Answer: b Diff: T

Since the securities are of equal risk, they must have the same effective rate. Since the comparable 10-year bond is selling at par, its nominal yield is 8 percent, the same as its coupon rate. Because it is a semiannual coupon bond, its effective rate is 8.16 percent. Using your calculator, enter NOM% = 8; P/YR = 2; and solve for EFF%. (Don't forget to change back to P/YR = 1.) So, since the bond you are considering purchasing has quarterly payments, its nominal rate is calculated as follows: EFF% = 8.16; P/YR = 4; and solve for NOM%. NOM% = 7.9216%. To determine the bond's price you must use the cash flow register because the payment amount changes. CF0 = 0, CF1 = 20; Nj = 20; CF2 = 25; Nj = 19; CF3 = 1025; I = 7.9216/4 = 1.9804; solve for NPV. NPV = $1,060.72.

44. Required return Answer: e Diff: E

45. Constant growth model Answer: c Diff: E

Statement c is correct, the others are false. Statement a would only be true if the dividend yield were zero. Statement b is false; we've been given no information about the dividend yield. Statement c is true; the constant rate at which dividends are expected to grow is also the expected growth rate of the stock’s price.

46. Dividend yield and g Answer: b Diff: M

Statement b is correct; the other statements are false. The stock's required return must equal the sum of its expected dividend yield and constant growth rate. A stock's dividend yield can exceed the expected growth rate.

47?. Constant growth stock Answer: c Diff: E

P0 = = $52.50.

49. A share of stock has a dividend of D0 = $5. The dividend is expected to grow at a 20 percent annual rate for the next 10 years, then at a 15 percent rate for 10 more years, and then at a long-run normal growth rate of 10 percent forever. If investors require a 10 percent return on this stock, what is its current price?

a. $100.00b. $ 82.35c. $195.50d. $212.62e. The data given in the problem are internally inconsistent, i.e., the

situation described is impossible in that no equilibrium price can be produced.

48?. Equilibrium stock price Answer: b Diff: M

Numerical solution:Before: r = 5% + (8% - 5%)1.3 = 8.9%.

= = $16.98.

After: rs = 4% + (10% - 4%)1.5 = 13%.

= $0.80(1.06)

0.130 - 0.06 = $12.11.

Hence, we have $12.11 - $16.98 = -$4.87.

49

Chapter 2 -

50. Over the past few years, Ghazal Berhad has retained, on the average, 70 percent of its earnings in the business. The future retention rate is expected to remain at 70 percent of earnings, and long-run earnings growth is expected to be 10 percent. If the risk-free rate, rRF, is 8 percent, the expected return on the market, rM, is 12 percent, Ghazal's beta is 2.0, and the most recent dividend, D0, was $1.50, what is the most likely market price and P/E ratio (P0/E1) for Ghazal's stock today?

a. $27.50; 5.0b. $33.00; 6.0c. $25.00; 5.0d. $22.50; 4.5e. $45.00; 4.5

?. Supernormal growth stock Answer: e Diff: M

The data in the problem are unrealistic and inconsistent with the requirements of the growth model; r less than g implies a negative stock price. If r equals g, the denominator is zero, and the numerical result is undefined. r must be greater than g for a reasonable application of the model.

50. Stock price and P/E ratios Answer: a Diff: M

Step 1 Calculate the required rate of returnrs = 8% + 2.0(12% - 8%) = 16%.

Step 2 Calculate the current market price

Step 3 Calculate the earnings and P/E ratioD1 = $1.50(1.10) = $1.65 = 0.30E1.E1 = $1.65/0.30 = $5.50.

= = 5.0.

SOLUTIONS

Chapter 2 -

Mid-sem answers and solutions

Documents

Transcript of Mid-sem answers and solutions