9.220 —Midterm Exam II7 p.m.-9 p.m.Page 1 of 108
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MMultiple Choice Questions: 20 questions worth 2 marks per question = 40 marks. each. (The exam has a total of 100 marks.) Answer on the computer response sheet provided.
Choose the best answer.
1)You buy 100 shares at a price of $50 per share at the beginning of the year. During the next year you receive a dividend of $2 per share. At the end of the year your position in this stock is worth $4,500. What was the one-year rate of return on this investment?
a)-10.0%
b)-6.0%
c)0.0%
d)4.0%
e)None of the above is correct to 1 decimal place.
2)All of the following should be treated as incremental cash flows when evaluating whether to invest in a new manufacturing plant except:
a)the market value of the site and existing buildings.
b)lost earnings on other products due to executive time spent in the new facility.
c)the reduction in the corporation’s tax bill resulting from the capital cost allowance.
d)the initial investment in inventories of raw materials.
e)money already spent on the engineering design of the new plant.
3)An investor would get the largest reduction in risk in a portfolio composed of stocks A and B if:
a)ρAB = -∞
b)ρAB = -2
c)ρAB = -1
d)ρAB = -0.5
e)ρAB = 0
f)ρAB = +0.5
g)ρAB = +1
h)ρAB = +2
i)ρAB = +∞
j)the two stocks have no correlation.
4) Expected Stock Expected Stock
Return if MarketReturn if Market
StockReturn is -10%Return is +10%
A-10%+10%
B-25%+15%
C-17.5%+12.5%
D-2.5%+7.5%
E-32.5%+17.5%
The stock in the above chart that has a beta of 1.5 is:
a)A
b)B
c)C
d)D
e)E
f)none of the above
5)Three of the portfolios below are efficient and two are not. The inefficient ones are:
PortfolioABCDE
Expected Return, %1012.5151617
Standard deviation, %2321252929
a)A and D.
b)B and E.
c)C and E.
d)A and B.
e)B and C.
1)6)A retirement annuity will pay Grandpa Berger nominal cash flows of $100,000 per year. The expected inflation rate per year is 5%. What is the expected growth rate in Grandpa Berger’s real cash flows?
a)95.2%
b)5%
c)–5%
d)4.82%
e)–4.82%
f)4.76%
g)–4.76%
2)7)Using the data from the previous question, if the nominal discount rate for Grandpa Berger’s cash flows is 12.875% per year, then the relevant rate for discounting Grandpa Berger’s real cash flows is
a)7%
b)7.25%
c)7.5%
d)7.75%
e)7.875%
f)12.875%
3)8)In Chapter 12, the text discusses three determinants of beta. Which one of these determinants primarily affects the firm’s equity beta but not its asset beta?
a)cyclicity of revenues
b)operating leverage
c)financial leverage
d)managerial leverage
e)cyclicity of assets
f)cyclicity of leverage
g)leverage of cyclicity
9)Declines in a company’s management ability, marketing strategies, and product distribution channels may be characterized as:
a)market-wide risk that cannot be diversified away
b)systematic risk that is diversifiable
c)non-diversifiable risk
d)unsystematic risk that may be diversified away
e)firm specific risk that cannot be diversified away
f)none of the above
10)Given the following probability distribution what is the expected return for the market, E(RM)?
State iProb(i)RM
10.1-10%
20.510%
30.430%
a)3.33%
b)9.5%
c)10.0%
d)13.0%
e)16.0%
f)18.0%
g)None of the above.
11)Which one of the following statements is WRONG?
a)The additional return required by risk-averse individuals to invest in risky assets is known as the risk premium.
b)The contribution of a stock to the risk of a well-diversified portfolio depends on the stock’s market risk.
c)Investors prefer a well-diversified portfolio of stocks to an undiversified portfolio because there is less risk.
d)If several risky securities have zero correlation coefficients with each other, then a portfolio’s variance of returns can be eliminated by the random selection of at least 25 of these securities.
e)If two securities' returns are perfectly positively correlated, then any combination of the two does not reduce total risk for a given level of return.
f)A perfectly diversified portfolio with a beta of 2.0 is twice as risky as the market portfolio.
g)Portfolio X is a perfectly efficient portfolio; therefore ρXM = +1.0.
h)If two securities' returns are perfectly negative correlated, risk can be eliminated by some combination of the two.
i)An undiversified portfolio with a beta of 2.0 is more than twice as risky as the market portfolio.
j)All of the above statements are correct.
12)Strategic Steel (SS) is evaluating a new project that has 10% less systematic risk than its portfolio of existing investments. Suppose that SS uses its current WACC to determine the NPV of this new project. Which of the following is likely to occur?
a)By using a discount rate that is too low, SS may incorrectly accept the project.
b)By using a discount rate that is too low, SS may incorrectly reject the project.
c)By using a discount rate that is too high, SS may incorrectly accept the project.
d)By using a discount rate that is too high, SS may incorrectly reject the project.
e)By using a discount rate equal to the WACC, SS will correctly accept the project.
f)By using a discount rate equal to the WACC, SS will correctly reject the project.
g)a and d
h)b and c
13)Which of the following public announcements would clearly increase the total market value of the firm's equity if the market were strong-form efficient:
a)A public announcement that earnings are much higher than the previous year.
b)A public announcement of a previously unpublicized lawsuit against firm.
c)A public announcement that the company is now required to include its exposure to derivatives in its published financial statements.
d)A public announcement of a two-for-one stock split.
e)A public announcement that dividends will be doubled from the next dividend payment.
f)None of these public announcements would clearly increase the stock price given strong-from informational efficiency.
14)You wish to be exposed to the same systematic risk as the market portfolio. Unfortunately, you are only able to invest in two portfolios (A & B): βA=1.150 and βB =0.775. What investment weights in A and B will achieve your desired level of systematic risk?
a)xA = 45%;xB = 55%
b)xA = 60%;xB = 40%
c)xA = 70%;xB = 30%
d)xA = 82%;xB = 18%
e)xA = 88%;xB = 12%
f)xA = 110%;xB = -10%
15)If you realized the following annual returns during a four-year holding period then what was your holding-period rate of return expressed as an effective rate per year (geometric average rate of return)?
Year / 1 / 2 / 3 / 4Return / 40% / 0% / 30% / -20%
a)0.00%
b)5.00%
c)5.85%
d)9.00%
e)12.50%
f)None of the above are correct to two decimal places.
16)Your job is to analyse annual reports of Canadian banks. You have found that on the day a report is released you are able to use the report’s data to make a trade recommendation — buy, sell or hold. If you follow the buy or sell recommendations by trading within 30 minutes after the report is made public you are able to consistently earn positive abnormal returns. If the usefulness of this trading strategy persists over the long run, then which form of informational efficiency is contradicted?
a)weak form
b)semi-weak form
c)semi-strong form
d)strong form
e)quasi form
f)none of the above – the market is efficient
g)a and b
h)b and c
i)c and d
j)d and e
17)The efficient market hypothesis (informational efficiency) assumes that:
a)there are no taxes.
b)there are no transaction costs.
c)only all-equity companies can benefit from market informational efficiency.
d)very astute investors can expect abnormal returns.
e)competition between investors results in market informational efficiency.
18)If the market is informationally efficient then the theory states that positive abnormal (excess) returns
a)will never occur
b)will rarely occur
c)will persist over the long run.
d)are not expected
e)are expected for short time periods (e.g., one week)
f)none of the above.
19)A firm with high financial leverage has:
a)revenues that fluctuate greatly with market cycles.
b)high levels of fixed costs in its production process.
c)low levels of fixed costs in its production process.
d)high levels of debt financing compared to equity financing.
e)high levels of equity financing compared to debt financing.
f)none of the above.
20)Ideally, the 'true' market portfolio is
a)the TSE300 index.
b)a portfolio composed of every risky asset in the world. Individual portfolio weights would be determined according to the total market value of the individual asset divided by the total market value of all risky assets.
c)a portfolio composed of all stock market indices in the world. The weight invested in each index would be determined according to the total market value of the stocks in an individual index divided by the total market value of all stocks in all the indices.
d)a portfolio composed of every risky asset in the world, plus some suitable risk-free asset. Individual portfolio weights would be determined according to the total market value of the individual asset divided by the total market value of all assets.
e)a portfolio composed of every risky asset in Canada, plus some suitable risk-free asset. Individual portfolio weights would be determined according to the total market value of the individual asset divided by the total market value of all assets.
f)the Dow Jones Industrial Average.
g)none of the above.
4)
9.220 —Midterm Exam II7 p.m.-9 p.m.Page 1 of 108
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Long Answer Questions: Show all relevant work (e.g., numbers in equations and answers). Incorrect answers without valid supporting work will receive a mark of zero.
Do not indicate which buttons were pressed on your calculator — this will not receive any credit. Equations without relevant numbers will not receive any credit either. Final answers with no supporting work will only receive partial credit.
Do not round intermediate calculations. Final dollar answers may be rounded to 2 decimal places (e.g., $543.21). All other answers may be rounded to 8 decimal places (e.g., 0.12345678 or 12.345678%).
1)A company is exploring a project with the following expected nominal cash flows.
Year / 0 / 1 / 2 / 3Cash Flow / -$300,000 / $200,000 / $0 / $500,000
Inflation over the life of the project is expected to be 4% per year. The company believes that a real discount rate of 12% is appropriate given the risk of the cash flows.
a)Determine the real cash flows of the project.
(3 points)
b)Determine the NPV of the project using nominal values.
(4 points)
c)If we correctly calculate the NPV of the project using real values, will the result be higher or lower than the correct answer to (b)?
(1 point)
2)The following data has been provided for two securities.
Security / Expected Return / Standard Deviation1 / .30 / .50
2 / .10 / .20
a)Assume ρ12= 0.40. What are the portfolio weights for the minimum variance portfolio composed of securities 1 and 2. Show all your work. Hint: calculus or appropriate formula.
(3 points)
b)Assume ρ12= -1.00.
i)What is the standard deviation of the minimum variance portfolio composed of securities 1 and 2. (You do not need to show any work.)
(2 point)
ii)What are two sets of portfolio weights that will result in a portfolio standard deviation of 0.10?
(4 points)
iii)On the graph below, plot the feasible set of portfolios of securities 1 and 2 (assuming nonnegative weights for each security).
(3 points)
3)Tarnished Silver Mining Company (TSMC) is considering a project to bring the proposed “Flin Flon First” mine (FFF) into production phase. If FFF is accepted, the project will start immediately and continue for the next 5 years. Assume the applicable corporate tax rate is 40%.
a)Use the following information to calculate the WACC (after tax) of TSMC.
Type of Financing / Market Value Outstanding / BetaDebt / $700 million / 0.50
Equity / $300 million / 1.89
Currently risk-free T-bills return 4% per year and the expected risk premium for the Market Portfolio is 6% per year.
(4 points)
b)Briefly specify the condition necessary to use this WACC as the discount rate for the FFF project.
(1 points)
For the remainder of this question, assume the relevant opportunity cost of capital is 12% per year (effective) and TC=40%.
c)Use the table below to determine the yearly cash inflows and outflows related to net working capital requirements. Fill in the table that follows.
Working capital requirements if the FFF project is accepted:
Working Capital Items / Initial RequirementYear 0 / Year 1 / Year 2 / Year 3 / Year 4 / Year 5
accounts payable / $0 / $70,000 / $70,000 / $70,000 / $70,000 / $0
accounts receivable / $0 / $250,000 / $250,000 / $250,000 / $250,000 / $0
inventory / $0 / $80,000 / $80,000 / $80,000 / $50,000 / $0
taxes payable / $0 / $25,000 / $25,000 / $25,000 / $25,000 / $0
(4 points)
Year 0 / Year 1 / Year 2 / Year 3 / Year 4 / Year 5Cash
Flow
d)What is the NPV of the working-capital cash flows?
(1 point)
For the remainder of this question, assume the relevant opportunity cost of capital is 12% per year (effective) and TC=40%.
e)To get the FFF mine producing, excavation equipment is needed. Excavation equipment was purchased 2 years ago for $15 million for a different project that was subsequently cancelled. Inco has offered to purchase the excavation equipment for $6 million today. This excavation equipment can be used for the FFF project. At the end of the project, the excavation equipment may be sold for salvage of $1 million. The CCA rate applicable is 30% for excavation equipment. Fill in the table below; assume the initial incremental CCA amount relevant to the FFF project is subject to Revenue Canada’s half-year rule.
(5 points)
Incremental Yr. -2 Cash Flow (Outflows should be negative) / Incremental Yr. 0 Cash Flow (Outflows should be negative) / IncrementalPV of CCA tax shields / PV of Incremental
Yr. 5 Cash Flow / NPV of incremental cash flows related to the use of the assets.
Excavation
Equipment
f)Each year the FFF mine is in operation, it will produce incremental revenues of $45 million and expenses of $12 million. (Assume these before-tax amounts occur at the beginning of each of the 5 years.) What is the NPV of the after-tax revenues less expenses?
(3 points)
g)A labour shortage will result if the FFF project is accepted. This will result in increased labour costs at other TSMC mines. The additional expenses at the other mines will be $1 million at the end of the first year and will grow by 5% each year. These additional expenses last 5 years. How does this affect the NPV of the FFF project? Show supporting numbers and calculations.
(3 points)
h)What is the NPV of the FFF project? What is your recommendation; should the FFF project be accepted? (You do not need to show any work for this part.)
(1 point)
NPV = ______ the project should be ______.
4)An investor has explored investing in T-bills that have a return of 3.5% and the market portfolio that has an expected return of 16.5%. The investor has wealth of $20,000 to invest but chooses to short sell $5,000 of the T-bills and invest the balance in the market portfolio.
a)What are the portfolio weights in T-bills and the Market Portfolio?
(3 points)
b)Determine the investor’s expected return.
(2 point)
5)An investor believes that the following economic states are possible and has estimated the following information regarding the overall market and a stock known as Spar Aerospace.
State of EconomyProbabilityMarket ReturnSpar’s Return
Depression0.05-0.09-0.05
Recession0.20-0.010.01
Normal0.500.150.18
Boom0.250.260.45
The expected return of the market has been calculated as 0.1335 and the expected return of Spar has been calculated as 0.202. The standard deviation of the market’s returns is 0.10369546759.
a)Determine the covariance between Spar’s returns and the Market’s returns.
(5 points)
b)What is the beta of Spar’s stock?
(2 points)
Note: the following question requires NO CALCULATIONS if you know your finance theory. (If you don’t know the theory you may want to do the calculations to get the answers.)
6)You are considering investing all your wealth; two assets are available with the following characteristics:
Asset / Expected Return / Standard Deviation of ReturnsA / .08 / .2
B / .09 / .2
a)If A and B are mutually exclusive, which asset would you choose to buy? Briefly explain.
(2 points)
b)Suppose ρAB is +1.0. Which set of portfolio weights would be optimal?
i)xA = 1 xB = 0
ii)xA = 0 xB = 1
iii)xA = .5 xB = .5
Briefly explain.
(2 points)
c)Suppose σAB is +0.028. Which set of portfolio weights would be optimal?
i)xA = 1 xB = 0
ii)xA = 0 xB = 1
iii)xA = .5 xB = .5
Briefly explain.
the NPV rate of the project is negative if the +500
discount rate is 20%.
at a discount rate of 0%, project’s NPV is r = 14.7%
500.
the project should be accepted if the 0rate
discount rate is 10%.
if the graph were continued to higher interest
rates, there would be a second IRR
determined.
Suppose that the balance sheet of Bre-Y Inc. appears as follows:
AssetsLiabilitiesOwner's Equity
$490,000$440,000$50,000
All amounts are recorded at their market values. The $490,000 in assets is composed of only one item, 1400 ounces of gold bullion, and the $440,000 liability is an outstanding bond. If the market price of gold drops to $310.00 per ounce and the bonds are now due (at maturity), how would this affect Bre-Y's shareholders?
equity account remains at $50,000 and bondholders lose $56,000
equity account falls to zero and the firm is bankrupt
equity account falls to -$6000 and this becomes an additional liability
equity account increases to $56,000
equity account increases to $156,000
insufficient information to assess the impact on shareholders
The separation theorem states that
finance is separate from accounting
investment decisions are independent of capital budgeting decisions
investment decisions are independent of consumption decisions
financing decisions are independent of borrowing decisions
financing decisions are independent of security issuance decisions
none of the above
A 5-year annuity pays $60 at the end of each year. If the effective annual rate is 8%, what is the future value of this annuity at the end of year 8?
$362.00
$443.41
$239.56
$301.78
$300.00
none of the above is correct within 1 cent
Suppose that the IRR of a "financing or borrowing" project is calculated to be 22%. The company's discount rate (hurdle rate) is 17%. As capital budgeting director of the firm, your recommendation should be:
to accept the project
to reject the project
to suggest ways of increasing the IRR
to suggest ways of decreasing the firm's discount rate
to borrow funds at the discount rate of 17% and lend them out at the IRR of 22%
Long Answer Questions: Show all relevant work (e.g., numbers in equations). Incorrect answers without valid supporting work will receive a mark of zero.
Do not indicate which buttons were pressed on your calculator — this will not receive any credit. Final answers with no supporting work will only receive partial credit.
Do not round intermediate calculations. Final dollar answers may be rounded to 2 decimal places. All other answers may be rounded to 8 decimal places.
The following data has been provided for two securities.
Security / Expected Return / Standard Deviation1 / .30 / .50
2 / .10 / .20
Assume ρ12= 0.40. What are the portfolio weights for the minimum variance portfolio composed of securities 1 and 2. Show all your work. Hint: calculus is required.
(4 points)
Assume ρ12= -1.00.
What is the standard deviation of the minimum variance portfolio composed of securities 1 and 2. (You do not need to show any work.)