Last Name: First Name:M.I.T. ID# or S.S.#:Section E (1-2:30pm): Section F (2:30-4pm):15.401 Midterm ExamG. MansoFall 2006Instructions:• Please fill in your name, ID number and check your section number: E (1-2:30 pm) orF (2:30-4pm)• The exam lasts 80 minutes. It consists of five questions. Please answer all of them.• Credit f or a question is exactly in pro portion to the time recommended.Question points (minutes)1 182 123 204 125 18Total 80• You are allowed one 812”×11” sheet of formulas and one calculator.• Answer these questions without consulting anyone.• Use the space provided. If more space is needed, use the other side.• Be neat and show your work. Answers without work receive no credit. Wrong answerswith partially correct work may receive partial credit.• Allocate your time optimally.Good luck!1. (18 Minutes) True, false or “it depends”? Give a brief explanation for each a nswer.(a) “Managers should maximize the firm’s current market value, but only when max-imization does not create unacceptable risks for shareholders.”(b) “The cost of capital of a firm decreases with the amount of cash it has in hand.”(c) “Term structure of interest rates must be always upward sloping because long ermaturity bonds are riskier.”1(d) “Bonds with higher coupon rates have more interest rate risk.”(e) “PV is sometimes calculated by discounting free cash flow for several years, sayfrom year 1 to T , and then discounting a forecasted terminal value at horizon dateT . The choice of the horizon date can have a significant effect on PV, particularlyfor rapidly growing firms.”(f) “When we choose between two alternative projects, the one with the higher IRRalways dominates.”22. (12 minutes)The Wall Street Journal gives the following prices for STRIPS (with a principal of100):Bond Maturity Year PriceA 1 95.92B 2 92.01C 3 87 .0 0(a) Determine the 1-, 2- and 3-year spot interest rates from the given prices.(b) Compute the annual forward rate from year two to year three, i.e., f3(or f2,3).(c) Compute the yield to maturity of a 2-year coupon bond with a principal of 100and a coupon rate of 4.25%. Assume annual coupon payments.343. (20 minutes)As a mid-size company, you have a pension plan which pays out $10 million a yearforever. The first payment is exactly one year fr om now. The term structure is currentlyflat at 5%.(a) Compute the present value of your pension liabilities.(b) Suppose that the interest ra t e goes down by 0.1%. How does the value of yourliability change?(c) Given your answer to (b), what is the modified duration of your pension liability?(d) Suppose that the pension plan is fully funded (i.e., the value of your assets equalthe value of pension liabilities). You want to invest all your assets in bonds toavoid any interest rat e risk. What should the duration of your bond portfolio be?(e) Suppose that this portfolio is a single zero-coupon bond. What should its maturityand total par value be?564. (12 minutes)MW Co. expects earnings of $1.25 per share next year, out of which $0.50 will be paidout as dividends. Earnings and dividends are expected to grow at a constant rate geach year afterwards. MW shares are now traded at $20. The cost of capital for MWCo. is 10%.(a) What is the expected growth rate of earnings g?(b) What is the ROE for MW?(c) Is MW a growth company? Justify your answer.785. (18 minutes)You are running a start-up company, MyWay. MyWay was launched last year withan initial capital expenditure of $10 million. You expect to spend another $10 millionthis year. The company is expected to generate a pre-tax profit of $2 million nextyear, which is then going to grow a t 5 % every year afterwards. Googol Inc., anothercompany, is interested in buying MyWay. You need to figure out a baseline valuationfor MyWay. You also have the following information:• Capital expenditure can be depreciated linearly for 4 years (straight-line depreci-ation), starting next year.• Tax rate is 30%.• Googol is a mature company with a P/E ratio of 10.• Mature companies in the same business as MyWay have a P/E ratio o f 8.(Mature companies are assumed to have zero growth.)(a) Compute after-tax cash flows for MyWay.(b) Find the appropriate discount rate to value MyWay’s assets.(c) Compute the value of