INSTRUCTIONS

You have 2 hours to complete this exam. This exam is strictly closed book
and closed notes, except for one sheet of A4-sized paper with your
notes/formulas written on one side only.

You are NOT allowed to use any electronic devices such as cell phones,
PDAs, laptops, MP3 players, iPods, iPads etc. during the exam. Calculators
are allowed, but you must NOT use any calculator-related apps on your
electronic devices.

There are 15 questions for a total of 100 points. Use your time wisely.

IMPORTANT: YOU NEED TO CIRCLE THE CORRECT ANSWER

AND SHOW YOUR WORK & CALCULATION TO GET FULL
CREDIT!!!

To ensure fairness, you are requested to stop writing promptly at the end of
the exam.

Please do not turn over this cover page, until requested.

1. You are considering the following project. The project costs $2000 in year 0 and it
generates a cash flow of $1600 per year in years 1 through 5. From year 6 to year 8, the
project generates no positive cash flows, but you have to pay a $600 maintenance cost per
year. The discount rate to use is 10%. What is the NPV of the project? (Choose the
answer below that is closest to the value you computed.)

(A) 2580
(B) 3140
(C) 3470
(D) 4160
(E) 4390

Answer: (B)
5 8
1600 −600
𝑁𝑃𝑉 = −2000 + ∑ + ∑
1.1𝑡 1.1𝑡
𝑡=1 𝑡=6
1600 1 1 600 1
= −2000 + × (1 − 5
)− 5
× × (1 − )
0.1 1.1 1.1 0.1 1.13
= 3138.8 ≈ 3140
2. Company Amazing is expected to produce a (free) cash flow of $100 in year 1, $200 in
year 2, and $300 in year 3. After that, the (free) cash flows are expected to grow at a
constant rate of 8% per year forever (stable growth, thus the cash flow in year 4 would be
$324, ... and so on). Assume the appropriate discount rate is 10%. Today is year 0.
What is the value of the company at today? (Choose the answer below that is closest to
the value you computed.)

(A) 12010
(B) 12180
(C) 12300
(D) 12540
(E) 12650

Answer: (E)
100/1.1+200/1.1^2+300/1.1^3+300/0.02*1.08/1.1^3 = 12652.89
3. Consider a company in stable growth. The company produces (free) cash flows that
grow at the constant rate of 2% every year. Assume the discount rate to use is 10%.
Today is year 0. Suppose the cash flow of the company in year 1 is $1000. What is the
value of the company at today?

(A) 1000
(B) 10000
(C) 12500
(D) 15000
(E) 20000

Answer: (C)

1000
Value = = 12500
0.1 − 0.02
4. The R&D department of Horizon invented a new technology. The company can start
a project by adopting the new technology; the CEO of the company must decide when to
start the project. The project is assumed to be perpetual (i.e. the project lives forever) and
the discount rate is 10%.
Today is year 0. If the company begins the project in year 1, the initial cost will be $2000
in year 1 and the project will earn $300 each year, starting in year 2.
If the company begins the project in year 2, the initial cost will be $1500 in year 2 and the
project will earn $270 each year, starting in year 3.
If the company begins the project in year 3, the initial cost will be $1000 in year 3 and the
project will earn $238 each year, starting in year 4.
If the company begins the project in year 4, the initial cost will be $500 in year 4 and the
project will earn $199 each year, starting in year 5.
Which year is the best time to start the project so that it has the highest NPV?

(A) Year 1
(B) Year 2
(C) Year 3
(D) Year 4
(E) Don’t do the project since the project does not have a positive NPV

Answer: (C)
Year 1: NPV = 1/1.1 × (–2000 + 300/0.1) = 909.1
Year 2: NPV = 1/1.1^2 × (–1500 + 270/0.1) = 991.7
Year 3: NPV = 1/1.1^3 × (–1000 + 238/0.1) = 1036.8
Year 4: NPV = 1/1.1^4 × (–500 + 199/0.1) = 1017.7
hence Year 3 is the best time to start the project since it has the highest NPV
5. This question is concerned with finding the payment amount on a mortgage. Suppose
we have a 2-year, 8% fixed mortgage of $100,000 (8% is the annual interest rate). We
need to make quarterly payments on the mortgage (that is, we are paying 4 times a year).
What is the quarterly payment on the mortgage then? (Choose the answer below that is
closest to the value you computed.)

(A) 10650
(B) 11650
(C) 12650
(D) 13650
(E) 14650

Answer: (D)
100000*0.02/(1-1/1.02^8) = 13650.98
6. If the (zero-coupon) yield curve shifts up by 1%, the price of a zero-coupon bond with
a maturity of 15 years and a YTM of 3% will approximately

(A) Increase by 3%
(B) Increase by 15%
(C) Decrease by 3%
(D) Decrease by 15%
(E) Does not change

Answer: (D)

Macaulay duration of the zero-coupon bond = 15 (since the Macaulay duration of a zero-
coupon bond equals its maturity)

Hence % change in the zero-coupon bond price = – modified duration × 1%

= – 15/1.03 × 1%

≈ – 15% (i.e. price decreases by 15%)

7. A bond has an annual coupon rate of 10% (the first coupon will be paid 1 year from
now), a face-value of $100, and a maturity of 3 years. The bond is paying coupons
annually. Yield-to-maturity is 10% (annual). What is the Macaulay duration of the bond?
(Choose the answer below that is closest to the value you computed.)

(A) 2.5
(B) 2.7
(C) 3.0
(D) 3.5
(E) 3.8

Answer: (B)

Notice because the bond's YTM equals its coupon rate, the bond is trading at par, i.e. the
price of the bond = its face value = 100 (we discussed why this is the case in the class)
3
10/1.1𝑡 100/1.13
Macaulay Duration = ∑ (𝑡 × )+ 3× = 2.736 ≈ 2.7
100 100
𝑡=1
8. Junk food Inc. has a corporate bond that matures on 12/30/2016. Steve just bought
this bond at the end of today. Today is 12/30/2014. The bond is paying coupons semi-
annually, so the first coupon payment for Steve will be on 06/30/2015, the second on
12/30/2015, and so on (Steve did not get paid a coupon today). Hence the first coupon
payment for Steve is exactly 0.5 year away from today. Assume the bond has a face
value of $100, an annual coupon rate of 10%, and the cost of debt is 4% (annual). We
also know that the bond has a default probability of 10% and a recovery rate of 80%.
What is the price of this corporate bond based on the above information? (Choose the
answer below that is closest to the value you computed.)

(A) 101.5
(B) 105.5
(C) 109.5
(D) 111.5
(E) 119.5

Answer: (C)

Notice the expected payment at maturity = 105*0.9 + 105*0.8*0.1 = 102.9

Also the cost of debt is just the YTM of the corporate bond when there is (probability of)
default

Therefore,
3
100 × 0.1/2 102.9
𝑃 = ∑[ 𝑡
]+ = 109.48 ≈ 109.5
(1 + 0.04/2) (1 + 0.04/2)4
𝑡=1
9. Junk King Inc. has a corporate bond that matures on 12/30/2016. Today is 12/30/2014.
The bond is paying coupons annually, so the first coupon payment will be on 12/30/2015
and so on (we did not get paid a coupon today). Hence the first coupon payment for us is
exactly 1 year away from today. Assume the bond has a face value of $100 and an
annual coupon rate of 20%. We also know that the bond has a default probability of 20%
1
and a recovery rate of . The bond is trading at a (dirty) price of $80 today.
6
What is the (2-year) cost of debt for Junk King Inc. based on the above information?
(Choose the answer below that is closest to the value you computed.)

(A) 5%
(B) 10%
(C) 15%
(D) 20%
(E) 25%

Answer: (E)
Expected final payment = 0.8*120 + 0.2*120/6 = 100
Now here comes the part where you need some thinking instead of solving a quadratic
equation in the cost of debt:
The bond’s first year payment is 20, then in the second year its expected payment is 100
= 20 + 80. This is equivalent to a bond which has a face value of 80 and an annual
coupon payment of 20, i.e. an annual coupon rate of 20/80 = 25%. Notice that our Junk
King bond is trading at a price of 80. As we have discussed in the class, if a bond’s
market price is the same as its face value (80 in our case), i.e. trading at par, then the
YTM of the bond must be equal to its coupon rate. Hence we immediately have the
answer 25%.
10. We have two firms, firm A and firm B. Firm A has a beta of 1, while firm B has a
beta of 1.5. Suppose the risk-free rate is 2% and the expected market return is 6%.
According to CAPM, the equity cost of capital (or expected total return) of firm A,
compared to that of firm B, is

(A) 2% lower than firm B's equity cost of capital

(B) 2% higher than firm B's equity cost of capital
(C) 3% lower than firm B's equity cost of capital
(D) 3% higher than firm B's equity cost of capital
(E) The equity costs of capital are the same for all firms according to CAPM

Answer: (A)

𝑟𝐴 = 2% + 1 × (6% − 2%) = 6%

𝑟𝐵 = 2% + 1.5 × (6% − 2%) = 8%

Hence 𝑟𝐴 is 2% lower than 𝑟𝐵

11. A firm paid a dividend $1 this year (year 0) and its current stock price P0 is $10. The
constant growth rate of dividends is 10%. What is the expected total return of the stock
(i.e. the cost of equity) based on the dividend discount model? (The firm pays dividends
every year and is never acquired)

(A) 10%
(B) 12%
(C) 20%
(D) 21%
(E) 22%

Answer: (D)

Since the DDM gives

𝐷𝑖𝑣1 𝐷𝑖𝑣0 × (1 + 𝑔)
𝑃0 = =
𝑟𝐸 − 𝑔 𝑟𝐸 − 𝑔

we have 𝑟𝐸 = 𝑔 + 𝐷𝑖𝑣0 × (1 + 𝑔)/𝑃0 = 10% + 1 × 1.1/10 = 21%

12. Nike, Inc (NKE) designs, develops, markets and sells footwear, apparel and
equipment for men, women and children worldwide. NKE has an earnings per share of
$2.5 over the past 12 months. Its current stock price is $50, and its equity Beta is 1.05.
The current risk-free rate is 2.8%, and we assume a market risk premium of 4%.
Suppose that NKE's earnings grow at a constant rate of 4%. What fraction of earnings
does NKE need to pay out to justify its current stock price? (Choose the answer below
that is closest to the value you computed.)

(A) 11.7%
(B) 35.7%
(C) 48.7%
(D) 57.7%
(E) 60.7%

Answer: (D)

The cost of equity 𝑟𝐸 for NKE is = 2.8% + 1.05×4% = 7%

Under the total payout model, the current price 𝑃0 of NKE is

𝑃0 = 𝐸𝑃𝑆1 × total payout rate / (𝑟𝐸 − 𝑔𝑒 ) = 𝐸𝑃𝑆0 × (1 + 𝑔𝑒 )× total payout rate / (𝑟𝐸 − 𝑔𝑒 )

Thus total payout rate = 50×(7% – 4%) / (2.5×1.04) = 0.5769 ≈ 57.7%

13. Downward Corporation is expected to pay a dividend in year 1 of $1.5 and the
dividends are expected to decline at a rate of 2% per year afterwards. An appropriate
required rate of return for the stock is 8%. What should be the stock price of the
company at year 0?

(A) $9
(B) $13
(C) $15
(D) $18
(E) $21

Answer: (C)

1.5
P0   15
0.08  ( 0.02)
14. Suppose company QQQ has an equity cost of capital of 10%, market capitalization
of $10.8 billion, and an enterprise value of $14.4 billion. Assume that QQQ’s debt cost
of capital is 6% and the tax rate is 40%. QQQ has no cash. What is QQQ’s after-tax
WACC? (Choose the answer below that is closest to the value you computed.)

(A) 6.8%
(B) 7.2%
(C) 7.6%
(D) 8.0%
(E) 8.4%

Answer: (E)
Debt value = 14.4 – 10.8 = 3.6

10.8 3.6
WACC   10%   6%  0.6  8.4%
14.4 14.4
15. Callaway Golf is considering an introduction of a new high performance ball.
Because of its unique characteristics, the new product is to be marketed under the name
“super-ball”. What is the super-ball project’s NPV, given the following information?
(Choose the answer below that is closest to the value you computed.)
• The machine that makes super-balls costs $8 million in year 0, and it is
depreciated over two years with a straight-line depreciation method
• The sales are expected to be $30 million in years 1 and 2. Costs of sales are
estimated to be 50% of sales in every year
• The cost of erosion of Callaway’s other balls from the introduction of the super-
ball is estimated at $6 million in the first year. No other costs are required
• The tax rate is 25%
• There are no inventory requirements, but accounts receivable from the sales of
super-balls are expected to be $10 million in year 1 and 2. There are no accounts payable
• The discount rate is 10%
• The super-ball project ends at the end of year 2 (i.e. nothing happens after the end
of year 2)

(A) $0.1 million

(B) $1 million
(C) $1.5 million
(D) $2 million
(E) $2.5 million

Answer: (A)

Hence NPV ≈ 0.1 million