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UB MGF 301 - MGF301 Spring 2009 Test 1 Version I (with answers)

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Name_________________________________ Student Number___________________________________TEST 1MGF 301 Corporation FinanceSpring 2009 VERSION I Please sign name in boxPlease tear off the answer sheet and answer all of the following questions on the answer sheet.(Note: Total Points = 100; Multiple Choice = 4 points each unless otherwise indicated)1. Jason has won the lottery and will receive $1,000 per year for 10 years. The payments are guaranteed by the state, so there is no risk of the payments not being made. Jason is trying to find someone to pay him $10,000 right now in exchange for his payments. Why can’t he find any takers for this guaranteed stream of payments? Explain. (6 points).Due to the time value of money, $10000 today is worth more than $10000 paid equally over 10 years. Hence, Jason is unable to find anyone to give him $10000 today for a stream of payments that is worth much less than $10000. (Note: to find out what this is worth, find the PV of an annuity that pays $1,000 per year for 10 years at an appropriate interest rate).2. Ben is selling his car to his friend for two payments: $1,000 which he received today (time 0), and $1,000 that he will receive in time 1. If Ben invests the payments as soon as he receives them and he earns 5% on his investment, how much will he have in time 2? (a) (1000+1000/1.05)x1.052(b) 1000+1000/1.05(c) 1000+1000x1.05(d) 1000[(1/.05 - (1/(.05x1.05))]3. If the expected inflation rate is 5%, what nominal return must an investor earn to achieve a real return of 3%?(a) approximately 7%(b) approximately 2%(c) approximately 8%(d) approximately 5%4. An investment project has the cash flow stream of C0 = $-250, C1 = $75, C2 = $125, C3 = $100, and C4 = $50. The discount rate is 12%. What is the formula for calculating the present value? Setup the problem and be as specific as you can (Note: you do not have to solve for the answer) (6 points)PV = -250 + 75/(1.12) + 125/(1.122) + 100/(1.123) + 50/(1.124)Name_________________________________ Student Number___________________________________5. Assume the lottery is currently offering the choice of (a) receiving $150,000 in cash today or (b) receiving $12,000 now and $12,000 every year forever. Calculate the discount rate that makes the two payment streams equal in present value? (6 points) Show your work.150,000 = 12,000 + 12,000/rRearranging: 138,000 = 12,000/rr = 12,000/138,000 = .08696 or 8.696%6-7. Exactly ten years ago, in 1996, WXZ corp. issued a 7% bond with face value of $1,000 and a 30 year maturity. The bond was issued with a price of $1,000 and was rated AA by Standard & Poors. Recently, WXZ has struggled financially and the rating on its bond has fallen to BB.6. What was the yield-to-maturity on the bond in 1996 when the bond was first issued? (a) a little above 7%(b) 7%(c) a little below 7%(d) cannot be determined7. What is the effect of the decrease in bond rating? (a) the YTM went down and the price went up (b) the YTM went down and the price went down (c) the YTM went up and the price went up (d) the YTM went up and the price went down8. Which of the following is true about bonds that are callable?(a) If the call price is reached, the call feature means the bondholder has the option to sellthe bond back to the company(b) Bonds are usually called after a large increase in interest rates drives up bond prices (c) Callable bonds are more desirable to potential investors because the call feature adds value (d) None of the above is true9. Which of the following best explains why a stock price can suddenly decrease by more than 50% in a year like GE has done over the past year?(a) Stock prices are typically very stable, making large changes unlikely (b) Stock prices are primarily based on the book value of equity which changes at least every quarter(c) Stock prices can change substantially when expectations of future growth rates change(d) None of the aboveName_________________________________ Student Number___________________________________10. A bank is paying interest at a 5% annual rate on deposits. If the bank compounds interesttwice a day (i.e., 2 times per day, 365 days a year), which of the following is the EAR?(a) EAR = [1+(.05/730)]730 - 1 (b) EAR = [1+(.05/2)]730 - 1 (c) EAR = [1+(.05/365)]2 - 1(d) none of the above11. Baby Products Inc. has been paying a $3/share dividend each year and is expected to pay a $3/share dividend next year. The discount rate for this company is 12%.(a) If Baby Products pays a constant dividend of $3/share forever, what is the price of its stock? Show your calculation. (6 points)P = D/r = 3/.12 = 25(b) If Baby Products is expected to pay a $3/share dividend in time 1, a $4/share dividend in time 2 and a dividend that increases by 4% each year thereafter, estimate the price of the stock. Show your calculation. (6 points) P = 3/1.12 + 4/(.12-.04)/1.12 = 2.6786 + 44.6429 = 47.32or P = 3/1.12 + 4/(1.122) + 4.16/(.12-.04)/1.122 = 47.32(c) Calculate the present value of growth options (PVGO). Show your calculation. (6 points)The answer to (b) is with growth options, the answer to (a) is without growth options, so PVGO = 47.32 - 25 = 22.3212. If a firm has a return on equity of 16% and it has a plowback ratio of 40%, what is the firm’sgrowth rate?(a) 16%(b) 9.6%(c) 40% (d) 6.4% 13. An 8% bond has a par value of $1,000 and pays interest quarterly. It has a maturity date 20 years from today and a yield to maturity of 7%. Mark each of the following as True or False: (2 points each)__F___(a) The bond will pay interest of $70 per year__T___(b) The bond will be selling at a premium__T___(c) If the yield to maturity increases, the bond price will fallName_________________________________ Student Number___________________________________14. If ABC does not pay a dividend and ABC is expected to lose money (i.e., negative earnings) for the next two years before returning to profitability, how would you estimate the value of the ABC stock price using a present value model based on a growing perpetuity? Explain. (6 points)If the company does not pay dividends, then another measure of value is required to estimate the stock. Cash flows work well in cases like this. But there is also a concern that the company will do poorly for the next two years before regaining profitability. This suggests a model with non-constant growth will be appropriate. So the best fit is the


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UB MGF 301 - MGF301 Spring 2009 Test 1 Version I (with answers)

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