I.D.

: ____________________________

The Interdisciplinary Center Herzliya

Fundamentals of Finance
Dr. Erez Levy

July, 2019

Final Exam – Computer science - solution

Please Read:
1. IDC Honor Code applies in the exam.
2. Do not go beyond this page until you are instructed to begin.
3. You are allowed up to 3 hours to complete this exam.
4. When you are instructed to stop writing, please stop writing immediately.
5. Please write your student identification number.
6. You should write your answers on this exam. There should be plenty of space to show your
work. Extra space is on page 11.
7. Please do not unstaple your exam booklet.
8. Please show all work required to obtain each answer. Answers without justification will
receive no credits, unless otherwise instructed in the question.
9. There are 5 questions. The points for each part of each question are indicated. There are a total
of 100 possible points.
10. This exam is close book, close notes but you may use two sheets of writings (on both sides,
total 4 pages). You may use a calculator in the exam.
11. If you make any additional assumptions, state them clearly.
12. Good luck!

DO NOT START THE EXAM UNTIL YOU ARE INSTRUCTED TO DO SO

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 Question 1 (25 points)
Recently, you were hired as the CEO of U.S Week Inc., a weekly entertainment magazine. In order
to grow the firm’s customer base and increase profitability, you have decided to examine a new
project: distribution of a daily newspaper. In order to analyze the project, you hired a famous
consultant to analyze the project. Today, you received the consultant’s report containing the
analysis and NPV calculation of the proposed project. You would like to examine his analysis of
the proposed project. You know the following data:
• The new project is expected generate cash flows over a period of 5 years.
• The project requires an initial investment of $15 million in new machines today, which can
be depreciated for tax purposes over 3 years with no salvage value.
• The firm plans to borrow the $15 million initial investment cost from the bank at a 5%
effective annual rate. The loan will be a balloon loan for 5 years with annual payments of
consist only from interest payments while the capital will be paid at maturity of the loan.
• The data are based on the output of some initial research. The research, that determined
whether this project is technically feasible, cost the firm $1 million.
• The firm’s cost of capital, used for the project, is 12%.
• Annual expected revenues will be $12 million in year one and increase by 20% each year until
the end of the project.
• Annual expected operating costs will be 50% of the revenues.
• The launch of the new project will increase the sales and consequently the operating profits
of the weekly magazines by $1 million per year in every year of the project.
• The firm’s tax on operations and tax on capital gains is 25% .
• At the end of the project’s life, the firm expects to sell the used machines for $2 million.
• Working capital is needed at the beginning of each production year and will be fully recovered
at the end of the project. The working capital needed is 12% of the following year’s revenues.
• The firm has other profitable projects.
The following table presents the hired consultant’s analysis and the NPV calculation:
(all numbers in millions)
year 0 year 1 year 2 year 3 year 4 year 5
Revenues 12.00 14.40 17.28 20.74 24.88
2
Operating costs (1.00) (6.00) (7.20) (8.64) (10.37) (12.44)
Depreciation (3.00) (3.00) (3.00) (3.00) (3.00)
Interest expenses6 (0.60) (0.60) (0.60) (0.60) (0.60)
1
Tax (0.60) (0.84) (1.13) (1.47) (1.89)
Capital expenditure (15.00)
Working Capital (1.44) (0.29) (0.35) (0.41) 0
Cash from selling the machines 2.00
Free Cash flow4 (17.44) 1.51 2.41 3.50 4.80 11.94
NPV5 = (1.85)
1
Taxes = 0.25×(revenues-costs-depreciation-interest expenses).
2
Value of existing structure.
3
Feasibility Research.
4
Revenue – costs – depreciation – interest expenses – taxes – capital expenditures.
5
Discounted at 12%.
6
Interest expenses= 0.05×(loan amount).

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The question:
Identify the capital budgeting mistakes in the analysis. Briefly explain why each is a problem and
explain how each mistake biases the NPV calculation (you should explain the direction of the bias
rather than the actual magnitude). No formal calculations are necessary.

Capital Budgeting Mistakes:

• The feasible research is a sunk cost. This leads to overassessment of the NPV
• The initial investment cost of the project ($15 million) is depreciated incorrectly for two
reasons:
(1) It is depreciated over 5 years instead of 3.
(2) The depreciation should be added back to get net cash flow.
This is an understatement of NPV due to discounting
• Interest expenses should be ignored
• Synergy (the profit from the other project) was ignored. This leads to underestimation of the
NPV
• Cash from selling the machine – the tax on capital gains was not taken into consideration
• Working Capital:
o The change in working capital should start at year 0 (the working capital in the amount of
the following year’s revenues).
o The working capital was not recovered
This overestimate the NPV

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Question 2 (20 points)
You would like to purchase a car listed for $20,000. However, you only have $10,000 in cash
and therefore, you must finance the additional $10,000 with a loan. After thorough investigation,
you have narrowed the field of banks to two:
Bank A offers you a one-year loan with an APR of 7% compounded semi-annually. The first
payment will be made in 6 months. Furthermore, the bank is asking for an additional payment of
$250 with the last payment at the maturity of the loan (at the end of the year).
Bank B offers you a one-year loan with an APR of 6% compounded semi-annually. The first
payment will be made in 6 months. Furthermore, the bank is asking for an opening loan account
fee of $250 when you take the loan (today).
a. What is the semi-annual payment for the loan offered by bank A?
Answer: The semi-annual payment for the loan offered by bank A is: $ _______

𝑃𝑃𝑃𝑃 = 10,000
𝑛𝑛 = 2
APR = 7%
0.07
𝑟𝑟𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = = 3.5%
2

𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃
10,000 = + => PMT = 5,264.00
(1 + 3.5%)1 (1 + 3.5%)2

b. What is the semi-annual payment for the loan offered by bank B?

Answer: The semi-annual payment for the loan offered by bank B is: $ _______

𝑃𝑃𝑃𝑃 = 10,250 note, in this case you need 10,250 in order to get 10,000
𝑛𝑛 = 2
APR = 6%
0.06
𝑟𝑟𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = = 3%
2

𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃
10,250 = + => PMT = 5,356.76
(1 + 3%)1 (1 + 3%)2

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c. What is the effective annual interest rate (EAR) of the loan offered by bank A?
Answer: The EAR of the loan offered by bank A is: $ _______

5,264.00 5,264.00 + 250

10,000 = +
(1 + 𝑟𝑟𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 )1 (1 + 𝑟𝑟𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 )2
𝑟𝑟𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = 5.10%
𝐸𝐸𝐸𝐸𝐸𝐸 = 10.47%

d. What is the effective annual interest rate (EAR) of the loan offered by bank B?
Answer: The EAR of the loan offered by bank B is: $ _______

5,356.76 5,356.76
10,250 = +
(1 + 𝑟𝑟𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 )1 (1 + 𝑟𝑟𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 )2
𝑟𝑟𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = 4.72%
𝐸𝐸𝐸𝐸𝐸𝐸 = 9.66%

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Question 3 (20 points)
Luigi Inc. has recently issued a ten-year inflation-linked bond with face value of $1,000. The bond
has an annual stated real interest rate of 6% and pays quarterly coupons. Assume that the YTM on
similar nominal bonds is 7%, and the expected annual inflation rate for the next five years is 2%.
a. What was the price of the bond at issuance?
Answer: The price of the bond at issuance was $ .

𝐹𝐹𝐹𝐹 = 1,000
𝑛𝑛 = 170 × 2 = 20
𝑌𝑌𝑌𝑌𝑌𝑌𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 = %
𝟎𝟎.𝟎𝟎𝟎𝟎
The semi-annual coupon payment = = 𝟏𝟏. 𝟓𝟓%
𝟒𝟒
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 = 𝐹𝐹𝐹𝐹 × 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = 1,000 × 2.5% = 25
The real time line
0 1 2 … 39 40
Coupon 15 15 15 15
Face Value 1,000
total CF: 15 15 15 1,015
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
1 + 𝑌𝑌𝑌𝑌𝑌𝑌𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 1.07
𝑌𝑌𝑌𝑌𝑌𝑌𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = −1= − 1 = 4.90%
1 + 𝐸𝐸(𝐼𝐼𝐼𝐼𝐼𝐼) 1.02
1
𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠
𝑌𝑌𝑌𝑌𝑌𝑌𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = (1 + 4.90%)4 − 1 = 1.2%
The price of the bond:
15 1 1,000
𝑃𝑃𝑃𝑃0 = �1 − �+ = 1,093.66
1.2% (1 + 1.2%) 40 (1 + 1.2%)40

b. Suppose that 6 months after the bond was issued, the YTM on similar nominal bonds remained
7%, however, the expected inflation increased to 2.5%. What is the price of the bond now (6
months after it was issued) if the actual inflation in the last 6 months was 1.5% ?
Answer: The price of the bond is $ .

𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
1 + 𝑌𝑌𝑌𝑌𝑌𝑌𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 1.07
𝑌𝑌𝑌𝑌𝑌𝑌𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = −1= − 1 = 4.39%
1 + 𝐸𝐸(𝐼𝐼𝐼𝐼𝐼𝐼) 1.025
1
𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠
𝑌𝑌𝑌𝑌𝑌𝑌𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = (1 + 4.39%)4 − 1 = 1.08%
Calculate the price of the bond:
40 1 1,000
𝑃𝑃𝑃𝑃𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = �1 − � + = 1,130.36
1.08% (1 + 1.08%)38 (1 + 1.08%)38
𝑃𝑃𝑃𝑃 = 𝑃𝑃𝑃𝑃𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 × (1 + 𝑖𝑖𝑖𝑖𝑖𝑖𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 )
𝑃𝑃𝑃𝑃 = 1,130.36 × (1 + 1.5%) = 1,147.31

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c. Assume that you bought the bond when it was issued and sold it after 6 months. What is the
annual nominal realized return from your investment in the bond? Show the expected
payments.
Answer: The annual nominal realized return from the investment in the bond is %

Calculation:

The nominal return is:

1
15×(1+1.5%)2 1,147.31+15×(1+1.5%)
1,093.66 = 1 + 2
�1+𝐼𝐼𝐼𝐼𝐼𝐼𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞−𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 � �1+𝐼𝐼𝐼𝐼𝐼𝐼𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞−𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 �

⇒ 𝐼𝐼𝐼𝐼𝐼𝐼𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞− 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = 3.79%

⇒ 𝐼𝐼𝐼𝐼𝐼𝐼𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎− 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = 16.06%

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Question 4 (20 points)
Part A:
You are considering purchasing stocks of the following two companies:
Fun station Inc.- a company manufacturing video games and other gadgets.
Simple Bread Inc. - a company producing standard (cheap) bread.
Additionally, you know the following information:
The expected price of the stock of each company in one year is $100. Further, you found that the
standard deviation of the returns of these two companies is equal to 15%.
a. Which of the two companies will have a higher price per share today? Explain your logic
Answer: the price of Fun Station Inc. / Simple Bread Inc. is higher today (circle one).
(Hint: this question requires more thinking than number crunching)

Since both firms have the same standard deviation.

Fun Station Inc has a higher beta (the sensitivity of its operation to the market is higher).
Therefore, the expected return of the firm (cost of capital) is higher. Since the price of these two
stocks will be equal in one year ($100), Simple Bread Inc’s price today is higher (discounted by
a lower expected return)

b. Which of the two companies will have a higher specific risk? Explain your logic
Answer: the specific risk of Fun Station Inc. / Simple Bread Inc. is higher today (circle one).
(Hint: this question requires more thinking than number crunching)

Since, Fun Station Inc has a higher beta (see a) and both firms have the same standard deviation
The specific risk of Fun Station Inc. is lower

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Part B:
Mark the right answer (no need for explanations):
(1) According to the CAPM model we do not get compensation for the systematic risk of the
asset
(2) According to the CAPM model we do not get compensation for the idiosyncratic risk of
the asset
(3) According to the CAPM model we get compensation for the idiosyncratic and the
systematic risk of the asset
(4) According to the CAPM model we do not get compensation for neither risks, the
idiosyncratic nor the systematic risk of the asset

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Question 5 (15 points):
You are the CFO of a technology firm, and you have been asked to evaluate two potential projects
for your firm. Below, you are given the following information on the projects’ expected cash flows.
The cost of capital of the firm is 7%.
0 1 2 3 4 5
Project 1 -746,350 500,000 250,000 100,000
Project 2 -703,014 0 75,000 75,000 325,000 500,000

a. What is the Internal Rate of Return (IRR) on Project 1?

(1) 6%
(2) 7%
(3) 8%
(4) 9%
Answer: the Internal Rate of Return (IRR) on Project 1:____________%

The IRR of project 1 is 9%

b. What is the IRR on Project 2?

(1) 6%
(2) 7%
(3) 8%
(4) 9%
Answer: the Internal Rate of Return (IRR) on Project 2:____________%

The IRR of Project 2 is 8%

c. Assuming that we can only choose one of the projects, which one should we choose?
Answer: we should choose project ____________

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NPV of project 1 is $20,929.19 and the NPV of Project 2 is $28,150.28. The firm should take
Project 2

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