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Professor Paseka and Zheng Sections A01, A02, and A03
FIN 2200 —Midterm Exam (Version A) Page 1 of 11

Multiple Choice Questions: 30 questions worth 2 points per question = 60 points. (The exam has a
total of 100 points.) Answer on the computer response sheet provided.
Choose the one best answer. Use the same decimal places as the choices.

1. A bank quotes interest rates as the rate per year compounded quarterly. Its most recent quotation is
8%. If you convert this rate into the rate per year compounded semi-annually, it will become
a) 8.08%
b) 8.2432%
c) 8.16%
d) 7.8461%
e) 4.04%
f) none of the above

2. Which of the following statements is correct?

a) One advantage of forming a corporation is that you have limited liability.
b) Corporations face fewer regulations than sole proprietorships.
c) One disadvantage of being a sole proprietor is that you have to pay corporate taxes, even though
you don’t realize the benefits of being a corporation.
d) Statements b and c are correct.
e) None of the statements above is correct.

3. Lincoln Corporation has agreed to extinguish its $8 million debt to CIBC. If the value of Lincoln’s
assets is $7 million just before the loan is paid off, then the payoff to Lincoln’s debt holders and the
value left for Lincoln’s equity holders will respectively be
a) $8 million; $7 million.
b) $8 million; $0 million.
c) $8 million; -$1 million.
d) $7 million; $7 million.
e) $7 million; $0 million.
f) $7 million; -$1 million.
g) None of the above.

4. Corporate securities are contingent claims because:

a) they don't represent a direct claim on the firm.
b) the firm may be bought out.
c) the securities value is derived from the total value of the firm.
d) book value can be negative.
e) none of the above.

5. An individual with no investment opportunities has income of $15,000 in period 0 and income of
$10,000 in period 1. If the interest rate is 7%, which of the following points is on the individual's
consumption opportunities line?
a) $ 3,000 in period 0 and $21,215 in period 1
b) $ 4,000 in period 0 and $21,116 in period 1
c) $10,000 in period 0 and $15,350 in period 1
d) $16,000 in period 0 and $ 9,000 in period Ignore #5 and #6
e) $18,800 in period 0 and $ 6,200 in period 1.

6. In the two-period model, an investment should be made in period 0 if:

a) desired consumption in period 0 is less than income.
b) desired consumption in period 1 is greater than income
c) return on the investment is greater than the interest rate
d) return on the investment is less than the interest rate.
e) both a & b.

7. According to the net present value rule, an investment should be made if:
a) the net present value has no risk
b) the net present value is greater than the cost of investment
c) the net present value is greater than present value
d) the net present value is more desired than consumption
e) the net present value is positive.
FIN 2200 —Midterm Exam Page 2 of 11

8. Jim Mayer has deposited $7,000 in a guaranteed investment account with a promised rate of 7%
compounded annually. He plans to leave it there for 4 full years when he will make a down payment
on a car after graduation. How much of a down payment will he be able to make?
a) $8,960.00
b) $1,960.00
c) $2,175.57
d) $9,175.57
e) None of the above.

9. You are currently investing your money in a bank account that has a nominal annual rate of 7
percent, compounded monthly. How many years (round to two decimal places) will it take for you to
double your money?
a) 8.67
b) 9.15
c) 9.50
d) 9.93
e) 10.25
f) None of the above

10. Today, Bruce and Brenda each have $150,000 in an investment account. No other contributions will
be made to their investment accounts. Both have the same goal: They each want their account to
reach $1 million, at which time each will retire. Bruce has his money invested in risk-free securities
with an expected annual return of 5 percent. Brenda has her money invested in a stock fund with an
expected annual return of 10 percent. How many years (round to one decimal place) after Brenda
retires will Bruce retire?
a) 12.6
b) 19.0
c) 19.9
d) 29.4
e) 38.9
f) None of the above

11. Bond A has a coupon rate of 12% and 10 years until maturity. Bond B has a coupon rate of 10% and
14 years until maturity. Bond C has a coupon rate of 15% and 18 years until maturity. If the yield to
maturity for all the bonds is 12%, then the bonds will sell respectively at
a) a discount; a discount; a discount
b) a discount; a par; a premium
c) par; par; par
d) par; par; a discount
e) par; a discount; a premium
f) a premium; a discount; par
g) a premium; a premium; a premium
h) a discount; a premium; a par
i) none of the above

12. You plan to open a restaurant and estimate that the initial investment at the beginning is $20,000. If
the PI of this project is 1.25, how much is the NPV of the project?
a) $5,000
b) $25,000
c) $45,000
d) $16,000
e) Not enough information to estimate
f) None of the above

13. Overland has just paid a dividend of $2.25 on its common stock. The dividends are paid annually
and are expected to grow at a rate of 5% per year in the foreseeable future. The risk of this company
suggests that future cash flows should be discounted at a rate of 11% per year. Which of the
following amounts is closest to what should be paid for Overland common stock?
a) $39.375.
b) $37.50
c) $21.48
d) $20.45
e) None of the above.
FIN 2200 —Midterm Exam Page 3 of 11

14. Projects X and Y are both normal investment projects. Project X has an internal rate of return of 20
percent. Project Y has an internal rate of return of 15 percent. Both projects have positive net present
values. Which of the following statements is correct?
a) Project X must have a higher PI than Project Y.
b) If the two projects have the same discount rate, Project X must have a higher net present value.
c) Project X must have a shorter payback than Project Y.
d) Statements b and c are correct.
e) None of the statements above is correct.

15. Assume that the pure expectations hypothesis holds. Which of the following statements about the
term structure of current spot rates is correct?
a) If 2-year rates exceed 1-year rates, then the market expects future interest rates to rise.
b) If 2-year rates are 7 percent, and 3-year rates are 7 percent, then 5-year rates must also be 7
percent.
c) If 1-year rates are 6 percent and 2-year rates are 7 percent, then the market expects 1-year rates
to be 6.5 percent in one year.
d) Statements a and c are correct.
e) Statements b and c are correct.

16. You observe the following term structure for discount bonds:
Maturity Yield
1 year 5.1%
2 years 5.4
3 years 5.6
4 years 5.7
5 years 6.0

Assume that the expectations theory holds. What does the market expect will be the yield on 2-year
discount bonds issued three years from today?
a) 5.4%
b) 6.6%
c) 6.8%
d) 7.6%
e) 5.8%

17. You have won the lottery. You have the choice to receive annual payments of $200,000 a year for
the next 25 years with the first payment starting in one year, or you can choose to get a lump sum
payment of $1,000,000 dollars today. If the annual discount rate is 10%, you should prefer the
______. If the annual discount rate is 20%, you should prefer the ______.
a) lump sum; lump sum
b) annual payments; annual payments
c) lump sum; annual payments
d) annual payments; lump sum
e) none of the above

18. Walker’s daughter is 8 now and he expects that he needs to prepare $150,000 for her college
expenses in 10 years. How much does Walker need to save each year beginning today and ending
with year 10 (rounded to the nearest dollar)? Assume that his annual savings are constant and his
savings earn 8% per year.
a) $9,011
b) $10,354
c) $8,344
d) $9,587
e) $8,421
f) None of the above
FIN 2200 —Midterm Exam Page 4 of 11

19. You’ve taken out a loan of $32,000 to buy a new Saturn. The loan will be paid off in monthly
installments starting in one month over the next 4 years (48 payments). The quoted interest rate on
the loan is 8% per year compounded quarterly. How much is each monthly loan payment?
a) $731.26
b) $780.42
c) $784.13
d) $777.03
e) $667.75
f) none of the above

20. Assume the effective annual interest rate is 11%. Consider a growing annuity where the first annual
payment (of $12,000) is in one year, each subsequent payment is 3.25% greater than the previous
payment, and there are 24 payments in all. The future value of this annuity in 35 years is
a) $1,561,483.73
b) $4,994,830.65
c) $4,921,417.73
d) $4,816,893.74
e) $4,746,519.70
f) none of the above.

21. Assume the effective annual interest rate is 11%. The present value today of an annuity of 12 annual
payments where the first payment is in 4 years and each payment is $5,000 is
a) $32,461.78
b) $23,735.77
c) $21,383.58
d) $19,264.48
e) none of the above.

22. You wish to build an independent fund of at least $1 million for your retirement. You feel that you
can contribute $2,400/year into a fund that will earn 12%/year effective. If you start contributing on
your 25th birthday, on what birthday will you first have achieved your retirement goal?
a) 57th
b) 58th
c) 59th
d) 60th
e) none of the above.

23. Assume the effective annual interest rate is 10%. The present value of a perpetuity of annual
payments where the first payment is today and each payment is $8,800 is
a) $72,000
b) $80,000
c) $88,000
d) $96,800
e) not determinable from the information given.
f) none of the above.

24. Which of the following amounts is closest to the end value of investing $9,000 for 7 years at a
continuously compounded rate of 11%?
a) $18,685.44
b) $19,437.90
c) $19,369.83
d) $15,930.00
e) None of the above

25. The present value today of a growing annuity of 6 annual payments where the first payment of
$12000 is today, each subsequent payment is 10% greater than the previous payment, and the
effective annual discount rate is 10% is
a) $65,551.43
b) $72,000.00
c) $68,454.23
d) $67,771.55
e) not determinable since the growth rate equals the discount rate
FIN 2200 —Midterm Exam Page 5 of 11

26. The director of capital budgeting at Suvig Corp. has found a one-year project that will have a cash flow
of $700 in 1 year, and will result in a positive NPV of $80. She estimates the one-year return on this
project to be 20%. What is the discount rate for the project?
a) 5.528%
b) 20%
c) 25%
d) 10%
e) 11.056%
f) None of the above

27. The managers of a firm are considering four independent investment projects below (all $ numbers
in the table are in millions):

Project A B C D
Initial Investment $10 $10 $20 $30
NPV $5 $4 $9 $10
PI 1.5 1.4 1.45 1.33
IRR 24% 25% 26% 23%

The firm has $30 million available for investment this year. Project A requires additional future
investment in year 2. Which project(s) should it choose?
a) Project D
b) Project A and C if the firm has capital to invest in year 2.
c) Project B and C if the firm does not have capital to invest in year 2.
d) Both b and c are correct.
e) Project A, B, C, and D
f) None of the above

28. Which type of cash flow below is NOT included in project cash flow analysis?
a) Sunk costs
b) Opportunity costs
c) Side effects
d) Interest expense
e) a and d
f) All of the above
g) None of the above

29. Which of the following actions are likely to reduce agency conflicts between stockholders and
managers?
a) Paying managers a large fixed salary.
b) Increasing the threat of corporate takeover.
c) Placing restrictive covenants in debt agreements.
d) All of the statements above are correct.
e) Statements b and c are correct.
f) None of the above

30. A Government of Canada $1,000 face value bond with 14 years to maturity and an 8.4% coupon
(coupons paid semi-annually) recently sold for $1,067.36. The yield to maturity of this bond is
a) 3.804800% per year compounded semi-annually.
b) 7.609601% per year compounded semi-annually.
c) 8.400000% per year compounded semi-annually.
d) 8.656277% per year compounded semi-annually.
e) 8.665209% per year compounded semi-annually.
f) none of the above
FIN 2200 —Midterm Exam Page 6 of 11

Long-Answer Questions (40 points): Answer in the space provided. Show your work (this means you
are to show the correct numbers used appropriately in the formulas) unless specified otherwise. Do not
indicate which calculator buttons you pressed (no credit will be given for this). Do not round
intermediate results. Final dollar answers should be shown to two decimal places (e.g., $1,234,567.89).
Other answers should be shown to four decimal places (e.g., 0.1234 or 12.34%).

Question 1.

An individual has income of $20,000 in period 0 and $42,000 in period 1. An investment opportunity
that costs $15,000 in period 0 is worth $18,000 in period 1. The market interest rate is 6%. What is the
maximum possible consumption in period 1 if the individual consumes $16,000 in period 0 and follows
the NPV rule? (5 points)

The investment opportunity has positive NPV and should be taken. (1 point)
In period 0, the individual has to borrow $15,000 + $16,000 - $20,000 = $11,000 (1 point)
In period 1, he has to repay $11,000 * (1+6%) = $11,660 (1 point)
The amount left for consumption in period 1 is
$42,000 + $18,000 - $11,660 = $48,340 (2 points)

Ignore Long-Answer #1
FIN 2200 —Midterm Exam Page 7 of 11

Question 2

You have just negotiated a 5 year mortgage on $100,000 amortized over 30 years at a mortgage rate of
5.5%. The mortgage will be renegotiated every 5 years.

a) What interest rate do you need to do the time value calculations for this mortgage? Calculate the exact
rate. (1 point)

Effective monthly rate “r” = (1.0275)1/6 – 1 = 0.453168%

b) Assume the correct rate from (a) is 0.45%, what is the amount of your monthly mortgage payment
based on this rate?
(2 points)

c) Assume that the correct answer to (b) is $550 and the correct rate from (a) is 0.45%. Based on these
inputs, how much of your 2nd monthly payment goes toward reducing principal? (2 points)

Interest charged in the 1st month: $100,000*0.45% = $450

Principal reduction from the 1st payment: $550 - $450 = $100
Principal outstanding after the 1st payment: $100,000 - $100 = $99,900
Interest charged in the 2nd month: $99,900*0.45% = $449.55
Principal reduction from the 2nd payment: $550 - $449.55 = $100.45

d) Assume that the correct answer to (b) is $550 and the correct rate from (a) is 0.45%. Based on these
inputs, what is the amount left at the expiry of the mortgage contract at the end of 5th year? (2 points)

Amount left after 60 payments have been made

FIN 2200 —Midterm Exam Page 8 of 11

Question 3

Based on an effective annual discount rate of 12%, the present value today of a series of cash flows is
$68320. This cash flow series consists of 12 annual payments with the first five payments being $9000
each, starting today. Determine the value of each of the remaining payments assuming they are each of
equal size. (5 points)

PV of the 5 payment annuity =

= $36,336.1441

PV at time 0 of the 7 payment annuity = $68,320 - $36,336.1441 = $31,983.8559

PV at time 4 of the 7 payment annuity = $31,983.8559 * (1+12%)4 = $50,327.2164

Therefore , solve for C

C = $11,027.59
FIN 2200 —Midterm Exam Page 9 of 11

Question 4

A real estate development company is considering the following two mutually exclusive projects with
similar risk. Projects of this risk level are normally evaluated using an opportunity cost of capital of 10%
(per year effective). Cash flows of the two projects are as indicated in the table below:

Year 0 1-2 3-10

Cash flows of -$74,000 +$12,500/year +$20,000/year
Project A
Cash flows of -$30,000,000 +$4,100,000/year +$6,800,000/year
Project B

(a) Calculate the IRR of the two projects. Based on the IRR criterion alone, which project looks better?
(2 points)

A: 19.42% B: 14.79%

(b) Calculate the PI of the two projects. Based on the PI criterion alone, which project looks better?
(2 points)

A: 1.4848 B: 1.2366

(c) Calculate the NPV of the two projects. Based on the NPV criterion alone, which project looks better?
(2 points)

A: $35,874.81 B: $7,097,105.91

(d) How much is IRRB-A in an incremental cash flow analysis about taking B instead of A? (2 points)

Year 0 1-2 3-10

B–A -$29,926,000 +$4,087,500 +$6,780,000

IRR of B-A: 14.78%

(e) Which project should be taken? Why? (1 points)

B, higher NPV or IRR>10% in incremental cash flow analysis.

FIN 2200 —Midterm Exam Page 10 of 11

Question 5

Spot rates of interest for zero-coupon Government of Canada bonds are observed for different terms to
maturity as follows:
1-year spot rate 6%
2-year spot rate 7%
3-year spot rate 8%

A 2-year bond and a 3-year bond are issued today. They both have face value of $1,000 and coupon rate
of 7%. They pay coupon annually.

a) What the market value of the 3-year bond today? (2 points)

Bond price =

= $976.58

b) If you believe in the pure expectations theory of the term structure, what do you expect the 2-year
bond's price to be one year from today? (2 points)

=8.009434%

Expected future bond price =

= $990.65

c) If you believe in the liquidity preference theory and estimate that all forward rates have a liquidity
premium of 0.25%, what do you expect the 3-year bond's price to be 2 years from today? (3 points)

=10.028125%
%

Expected future bond price =

= $974.69

Ignore part c
FIN 2200 —Midterm Exam Page 11 of 11

Question 6

Down-the-Drain Plumbing Co. has decided that its dividend policy should reflect company growth.
They indicate that the first quarterly dividend they intend to pay will be $2.20 per share 3 years from
today. The dividends will then increase at a rate of 2% per quarter until the beginning of year 9 from
now. Thereafter, they will grow at 1.5% per quarter. Given the risk of this company, the discount rate is
10% per year compounded annually.
a) What is the discount rate that you can plug into the appropriate time value of money formula to
find the price of the stock? Calculate the exact rate. (1 point)

= 2.41%

b) Assume the correct answer from (a) is 2.4%. Based on this discount rate, what share price should
you pay for the above stock? (6 points)
High growth stage:

N=32 – 12 +1 = 21

=$43.3976
= $33.4323

Low growth stage:

$368.6801

$172.6041

Stock Price = $33.4323 + $172.6041 = $206.04