The University of Winnipeg

Department of Economics
Practice Exam #1

IMPORTANT INSTRUCTIONS:

This exam has two sections and a formula sheet on the last three pages. You may remove the formula
sheet pages in order to use them. Students may use both a financial calculator and a scientific
calculator. Other programmable calculators are not permitted. No outside formula sheets or other
reference materials are permitted.

Long answer questions must be answered in the exam booklet. Multiple choice questions must be
answered on the exam question pages.

Students must hand in both the exam question pages and the exam booklet.

SECTION I: LONG ANSWER

Answer each long answer question in the exam booklets provided. Show all relevant work: write out
the formula used and substitute the appropriate numerical values into the formula. If you need to use
the same formula multiple times for the same question, there is no need to rewrite the original
formula, simply show the substituted values into the formula. After this point you may use your
financial calculator functions to solve the problem, where applicable. Round all calculations to two
decimal places.

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Question 1

Cash Flow in One Year

Security Market Price Today Weak Economy Strong Economy
A 231 0 600
B 346 600 0

Assume both states of the economy are equally likely.

a) What is the market price of a portfolio consisting of one share of security A and one share of security B?
What expected return will you earn from holding this portfolio? (2 marks)
Portfolio = A + B, P(Portfolio) = P(A) + P(B) = 231 + 346 = 577.
[0.5(600)+0.5(600)]−577
E (R)= =0.0399
577

b) Now Suppose security C has a payoff of $600 when the economy is weak and $1800 when the economy
is strong. What is the no-arbitrage price of security C? (2 marks)
Since C = 3A + B, P(C) = 3P(A) + P(B) = 3(231) + 346 = 1,039

c) What is the risk-free rate of return in this economy? Explain why this is the risk-free return. (2 marks)
The risk-free return is on any risk-free investment, that is, an investment that pays the same amount
no matter the state of the economy. Here, the portfolio from part a), A + B, pays 600 in both states,
and is thus risk-free. So the risk-free return is 3.99%.

d) What is the expected return of security C? What is its risk premium? (2 marks)
[0.5(600)+0.5(1800)]−1039
E (R)= =0.1550
1039
Risk Premium = E(R) – risk-free return = 15.5% - 3.99% = 11.51%

Question 2
You wish to build an independent fund for your retirement planned for your 50 th birthday. On your 25th
birthday, you will make the first contribution of $2,400 into the fund that will earn 10%/year compounded
semi-annually. Each subsequent annual payment into the fund will be 1% larger than the previous one. You
will make your last payment into the fund on your 50 th birthday. At age 50, when you retire, you have
decided to opt for 40 years of equal monthly payments from the fund with the payments to start one month
after your 51st birthday. How large will each payment be, assuming the fund will still be earning 10%/year
compounded semi-annually?

Solution
10%/yr comp. s.a., convert to semi-annual effective: 10/2 = 5% per 6 months effective.
d
( )
g 2
Need annual effective rate: r d =(1+r g ) −1=(1.05) −1=0.1025 or 10.25%

First part is a growing annuity with C = 2400, N = 50 – 25 + 1 = 26, r = 10.25%, g = 1%

2
 [ ( )] [ ( ) ]=23,287.78
n 26
C 1+g 2400 1.01
PV 24= 1− = 1−
r −g 1+r .1025−0.01 1.1025

This is the PV at time 24, since your first payment is at time 25. For the second part, we'll need the
PV at time 51, since the first retirement payment starts one month after your 51st birthday.
So N = 51 – 24 = 27.

Find the FV at time 51: FV = PV (1+r )n=23,287.78 (1.1025)27=324,601.32

Next need effective monthly rate: r =(1+r eff )t −1=1.051/ 6−1=0.00816 or 0.816%
Second part is a regular annuity with N = 40 x 12 = 480, r = 0.816% and PV = 324,601.32

PV =
C
r [
1−
1
(1+r )n ] C
or 324,601.32= 0.00816 1− [ 1
(1.00816)
480 ] and C = $2,703.42

Question 3

A company is considering investing in 2 mutually exclusive projects. The projected cash flows follow in the
table below. Assume that the appropriate discount rate is an effective annual rate of 11%.

Project 0 1 2 3 4

A -5,000 2,500 2,000 1,500 1,000

B -20,000 9,000 9,000 5,000 4,000

Calculate the NPV and the IRR, and PI of each project. Explain which project should be taken according to
each of these three decision rules. Which decision rule should you follow?

Project 0 1 2 3 4 NPV IRR PI

A -5,000 2,500 2,000 1,500 1,000 631.02 17.804746 0.13

B -20,000 9,000 9,000 5,000 4,000 1,703.59 15.590898 0.09

Using NPV, the company should select Project B

Using IRR, the company should select Project A

Using PI, the company should select Project A

Use NPV!!

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Question 4

Jack Sparrow, owner of Black Pearl Shipping, is considering undertaking a mystical quest to the Isle of
Tortuga, which will require the construction of a new ship. In deciding whether to proceed with the project,
Captain Jack has accumulated the following information.

The decision to undertake the quest is to some extent based on favourable marketing research, indicating
that the company's shipping sales will likely increase as a result of the quest. The research project was
completed at a cost of $1 million last year.

The estimated immediate, up-front cost of constructing the new ship is $10 million. For tax purposes this
ship will be part of a CCA class that depreciates assets at a rate of 15% per year. Although short of cash, the
company plans to raise money for the new ship by issuing $5 million in debt at a cost of 6%, and $5 million
of equity at a cost of 18%.

The company estimates the length of the quest to be 5 years, after which the ship will be sold. It estimates
today that the ship's salvage value in 5 years will be $3 million.

If the ship is constructed, Black Pearl Shipping will have to increase its inventory immediately by $2
million and by an additional $1 million at the end of each of the first two years. In addition, its accounts
payable will increase immediately by $1 million and by another $1.5 million in one year's time. No further
changes of the company's net operating working capital requirements are expected until the end of the
quest, at which time all net operating working capital increases will be recovered.

If the ship is constructed, the company's sales will increase by $7 million in the first year. However, due to
high competition, these incremental sales are expected to decline by 2% each year for the remainder of the
quest. It is assumed that all cash flows will occur at the end of the year.

The operating costs (excluding CCA) of the new ship are expected to be $3 million in the first year. Due to
rising input costs in this sector of the economy, costs are expected to increase by 3% per year over the
length of the quest. It is also assumed that these cash flows will occur at the end of each year.

The company's tax rate is 40 percent. Black Pearl's estimated cost of capital for projects of this risk is 12
percent.

Black Pearl is profitable enough to fully benefit from all CCA deductions.

Required:
Using net present value (NPV) analysis, provide a clear recommendation as to the acceptance or rejection
of the proposed quest. Be careful to include only relevant costs in your analysis. Show all of your work,
including formulae used with substitutions.

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Solution

PV (initial investment) = -$10,000,000

FV 3,000,000
PV (salvage value) = =
1 r  10.12 5
n

= $1,702,280.567

PV (Revenues)

[ ( )]
N
C (1−T c ) 1+g
PV = 1−
r− g 1+r

[ ( )]
5
7,000,000(1−0.4) 0.98
PV = 1−
0.12+0.02 1.12

= $14,612,731.93

PV (Expenses)

[ ( )]
N
C (1−T c ) 1+ g
PV = 1 1−
r −g 1+r

[ ( )]
5
−3,000,000(1−0.4) 1.03
PV = 1−
0.12−0.03 1.12

= -$6,843,935.14

PV (changes in NWC)

500,000 1,000,000 1,500,000

PV =−1,000,000  − 
1.12 1.12 2 1.12 5

= -$499,625.023

0.5 x C x d x T c S x d xT c
PV [Tax Shield ]=
d +r [x 1+
1
1+r]−
d +r
x
1
(1+r )t

PV [Tax Shield ]=
0.5 x 10,000,000 x 0.15 x 0.4
0.15+0.12 [
x 1+
1
1.12]−
3,000,000 x 0.15 x 0.40
0.15+0.12
x
1
(1.12)5

5
= 1,724,890.03

Initial Outlay -10,000,000

PV salvage 1,702,280.57
PV revenues 14,612,731.93
PV expenses -6,843,935.14
PV change in NWC -499,625.02
PV CCA 1,724,890.03

NPV 696,342.37

Accept since NPV > 0

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SECTION II: MULTIPLE CHOICE

Each of the following questions is followed by several suggested answers or completions. Select the
best alternative and circle the corresponding letter.

1. Who has unlimited liability?

a) A general partner.
b) A shareholder.
c) A limited partner.
d) A sole proprietor
e) a and d

2. According to finance theory, the goal of the financial manager should be to …

a) work toward maximizing the company’s profits in the current year.
b) work toward maximizing the long-term profits of the company.
c) work toward satisfying all the stakeholders of the company.
d) work toward manipulating events to temporarily push up the company’s stock price.
e) work toward maximizing the current true value of the company’s stock.

3. The most common measure of firm value is given by the:

a) Quick Ratio
b) Current Ratio
c) Debt/Equity Ratio
d) P/E Ratio
e) Market-to-Book Ratio

4. You have just won a lottery and have been offered several options to receive your winnings. Assume the
equilibrium market rate of interest is 8%. To maximize your return you would select

a) a single payment of $400,000, paid immediately.

b) 5 annual payments of $100,000, starting 1 year from today. (N = 5, I/Y = 8%; PMT = 100,000,
Compute PV = $399,271.00)
c) 5 annual payments of $92,000, starting immediately. (N = 5, I/Y = 8%; PMT = 92,000, Compute
PV = 367,329.32, then multiply by 1.08 (since 1st payment is today) to get PV = $396,715.67)
d) 60 monthly payments of $8,000, starting one month from now. (Convert to monthly effective
rate: r = 1.08^(1/12) – 1 = 0.6434% N = 60, I/Y = 0.6434%, PMT = 8,000, Compute PV =
$397,159.23)
e) 60 monthly payments of $7,900, starting immediately. ((N = 60, I/Y = 0.6434%, PMT = 7,900,
Compute PV = $392,194.74, then multiply by 1.006434 to get PV = $394,718.13)

5. You invested $120 at an interest rate of 11% per year compounded annually. How much will his
investment grow to by the beginning of the 10th year?
a) $230
b) $255.80
c) $283.94
d) $306.96

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 e) $340.73
Beginning of year 10 = end of year 9.
PV =120; I/Y =11; N = 9; CPT FV = 306.96

6. AA is a growing perpetuity with the first payment of $1 in one year and a growth rate of 9%. BB is the
same as AA, except the first payment is now. The discount rate is 10%. Today, how much more is BB
worth than AA?
a) -$1
b) $1
c) $10
d) -$10
e) $100
C 1
PV of AA = = =100
r−g 0.10−0.09
Since BB has its first payment today, the formula calculates the PV at time -1. We can move this to
time zero as follows: PV of BB = 100 x (1+r) = 100 x 1.10 = 110. 110 – 100 = 10.

7. A bank quotes interest rates as the rate per year compounded quarterly. Its most recent quotation is 8%. If
you convert this rate into the rate per year compounded semi-annually, it will become
a) 8.08%
b) 8.2432%
c) 8.16%
d) 7.8461%
e) 4.04%
First find the effective quarterly rate: 8% / 4 = 2% per quarter compounded quarterly.
d
( )
g 2
Now convert to semi-annual effective rate: r d =(1+r g ) −1=(1+0.02) =4.04
To get an APR compounded semi-annually: 4.04 x 2 = 8.08%

8. A growing annuity will provide you with 6 annual payments with the first payment of $8,000 occurring 4
years from now. The equilibrium market rate of interest is 10%/year compounded annually and the growth
rate of payments is 10%/year. The present value today (rounded to cents) of this annuity is

a) $48,000
b) $43,636.36
c) $39,669.42
d) $36,063.11
e) $32,784.65
Since the growth rate is equal to the interest rate, the payments grow at the same rate they are
discounted, and the PV of each payment does not change. So with 6 payments, we have a PV of 6 x
8000 = 48,000 in 4 years' time.
48000
PV at time 0 = =32,784.65
(1.10)4

9. The future value of a lump sum at the end of five years is $1,000. The nominal annual interest rate is 10
percent and interest is compounded semiannually. Which of the following statements is most correct?

8
 a) The present value of the $1,000 is greater if interest is compounded monthly rather than
semiannually.
b) The effective annual rate is greater than 10 percent.
c) The effective rate per compounding period is 5 percent.
d) Statements b and c are correct.
e) All of the statements above are correct.
Semi-annual effective rate = 10/2 = 5% so C is true.
d
( )
g 2
Annual effective rate = r d =(1+r g ) −1=(1.05) −1=.1025 so B is true.
A is false, since monthly compounding will reduce the PV.

10. In shopping for a 5-year GIC that provides the best return on investment, you see that trust companies
and banks have provided several options. The investment that would provide the best return to you is one
that pays

a) 7% per year compounded monthly.

b) 7.125% per year compounded quarterly.
c) 7.25% per year compounded semi-annually.
d) 7.375% per year compounded annually.
e) 8.25% per year compounded every 5 years.
Convert all interest rates to monthly effective rates:
a) 7/12 = 0.5833%
1
( )
3
b) 7.125 /4 = 1.78125 and r d =(1.0178125) −1 = 0.5903%
d 1
( ) ( )
g 6
c) 7.25 /2 = 3.625 and r d =(1+r g ) −1=(1.03625) −1 = 0.5952%
1
( )
12
d) r d =(1.07375) −1 = 0.5947%
1
( )
60
e) 8.25 x 5 = 41.25% r d =(1.4125) −1 = 0.5773%

11. An investment of $6000 at the start of the year will pay $1000 at the end of the year for a set number of
years. What is the minimum number of years (rounded up to the nearest whole number) for which these
payments must be made if the investment is to be worthwhile, given that the interest rate is 6%?

a) 5
b) 6
c) 7
d) 8
e) 9
Need NPV > 0 . We can solve for the N in an annuity with the PV =6000:
PV = -6000; PMT = 1000; I/Y = 6; CPT N = 7.65
Round up to 8.

12. Bond A has a coupon rate of 12% and 10 years until maturity. Bond B has a coupon rate of 10% and 14
years until maturity. Bond C has a coupon rate of 15% and 18 years until maturity. If the yield to maturity
for all the bonds is 12%, then the bonds will sell respectively at

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 a) a discount; a discount; a discount
b) a discount; par; a premium
c) a premium; a discount; par
d) a discount; a premium; par
e) par; a discount; a premium
When coupon rate = YTM, the bond sells at par.
When coupon rate < YTM, the bond sells at a discount.
When coupon rate > YTM, the bond sells at a premium.

13. Davy Jones is considering the purchase of stock in Giant Squid Inc. knowing that stocks of similar risk
have an effective annual rate of return of 14%. Giant Squid Inc. intends to pay quarterly dividends, with the
first dividend of $1 occurring in two months. Each subsequent dividend will be 2% greater than the
previous one. The current price of a share of Giant Squid Inc. is

a) $75.19
b) $66.67
c) $67.44
d) $16.67
e) $76.02
Use the dividend-discount model to find the PV of the growing perpetuity.
First step is to find the quarterly effective interest rate:
1
( )
r d =(1.14) 4 −1 = 3.33%
1
PV 0=
Now use the growing perpetuity formula: ( .0333−0.02) and PV = 75.19
This is the PV at time -1, since the first payment occurs in two months but we are discounting it over a 3-
month time period (one quarter).
We need to move this amount one month into the future (or just look at the answers and see that only
one of them is larger than 75.19, so that must be the right one).
1
( )
12
r d =(1.14) −1 = 1.0979%
75.19 x (1 + 0.010979) = 76.02

14. An investment costs $10,000 and is expected to generate cashflows of $3,000 for each of the next 5 years.
The discount rate is 15.235%. The NPV is ___ and the IRR is ___ for that project.

a) 0.76; 15.238%.
b) 3.33; 27.22%.
c) 5,000; 0%.
d) -7397; -70%
e) none of the above.
Use the cash flow menu:
CF0 = -10,000
CF1 = 3,000
F01 = 5
I = 15.235

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CPT NPV = 0.76
CPT IRR = 15.238%

15. The QT Company is generating a net cash flow of $333,000 per year. If they invest in a new press machine
they expect to increase their net cash flow to $400,000 per year. The cost of the new press machine is
$250,000. To accept or reject the investment they have to consider
a) the press machine cost of $250,000 and total net cash flow of $400,000.
b) the change in net cash flow of $67,000 versus the press machine cost of $250,000.
c) the current net cash flow of $333,000 and the cost of $250,000.
d) the opportunity cost of the facility of $333,000.
e) none of the above.

11
 Market-to-book ratio = Market Value of Equity / Book Value of Equity

Debt-equity ratio = total debt / total equity

Current ratio = current assets / current liabilities

Quick ratio = (cash + marketable securities + accounts receivable) / current liabilities

Earnings per share (EPS) = Net income / number of shares outstanding

Gross Margin = Gross Profit / Sales

Operating Margin = Operating Income / Sales

Net Profit Margin = Net Income / Sales

Return on Equity = Net Income / Book Value of Equity

Return on Assets = Net Income / Total Assets

Price-earnings (P/E) ratio = Share Price / Earnings per Share

NPV = PV(Benefits) – PV(Costs)

Cn
PV 0= n
( 1+r )

n
FV =C 0 (1+r)

n
C1 C2 Cn Ct
PV 0=C 0+ +
(1+r ) ( 1+r )2
+...+ = ∑
( 1+r ) t =0 (1+r )t
n

C
PV 0=
r

C1
PV 0=
( r −g )

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 PV 0=
C
r (
1−
1
(1+r )n )
C n
FV n = ((1+r ) −1)
r

[ ( )]
n
C1 1+g
PV 0= 1−
( r −g ) 1+r

[ ( )]
n
C1 1+ g n
FV n = 1− x (1+r )
(r −g ) 1+r

APR
r=
k compounding periods per year

EAR = [1 + (APR ÷ k)]k – 1

d
( )
r d =(1+r g ) g −1

r−i
Real interest rate= ≈r −i
1+i

After tax interest rate = r(1-T)

1
YTM n= ( )FV
P
n
−1

CPN CPN CPN +FV

P= + +...+
1+r 1 (1+r 2)2 (1+r n)n

D i v 1+P 1
P 0=
1+r E

D i v 1+P 1 D i v 1 P1 −P 0
rE= −1= +
P0 P0 P0

Di v 1
P 0=
r E −g

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 D i v t= EPS x Dividend Payout Ratet

g= Retention rate x Return on new investment

PV ( Future total dividends+repurchases)

P 0=
Shares outstanding 0

0.5 x C x d x T c S x d xT c
PV [Tax Shield ]=
d +r [x 1+
1
1+r]−
d +r
x
1
(1+r )t

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