Name ________________________ Student Number ____________ Section ______
COMMERCE 2FA3
DR. RICHARD DEAVES
DURATION OF EXAMINATION: 3 hours
MCMASTER UNIVERSITY FINAL EXAMINATION
April 21, 2009
THIS EXAMINATION PAPER INCLUDES 17 PAGES AND 60 QUESTIONS (CORRESPONDING TO 100 MARKS). YOU ARE RESPONSIBLE FOR ENSURING THAT YOUR COPY OF THE PAPER IS COMPLETE. BRING ANY DISCREPANCY TO THE ATTENTION OF YOUR INVIGILATOR.
Special Instructions:
1. There are 20 TRUE/FALSE questions each worth 1 mark and 40 MULTIPLE CHOICE questions each worth two marks. For all questions, there is only one best answer.
2. Use of Casio FX-991 calculator only is allowed.
3. Two double-sided (8 1/2 by 11 inches) formula sheets prepared by the student, and which must be signed and handed in with the test, may be used. If you do not have formula sheet(s), please point this out to an invigilator.
4. All answers must be written on a scan sheet (see below).
OMR EXAMINATION – STUDENT INSTRUCTIONS
NOTE: IT IS YOUR RESPONSIBILITY TO ENSURE THAT THE ANSWER SHEET IS PROPERLY COMPLETED: YOUR EXAMINATION RESULT
DEPENDS UPON PROPER ATTENTION TO THESE
INSTRUCTIONS.
The scanner, which reads the sheets, senses the shaded areas by their non-reflection of light. A heavy mark must be made, completely filling the circular bubble, with an HB pencil. Marks made with a pen or felt-tip marker will NOT be sensed. Erasures must be thorough or the scanner may still sense a mark. Do NOT use correction fluid on the sheets. Do NOT put any unnecessary marks or writing on the sheet.
i. Print your name, student number, course name, section number and the date in the space provided at the top of Side 1 (red side) of the form. Then the sheet MUST be signed in the space marked SIGNATURE.
ii. Mark your student number in the space provided on the sheet on Side 1 and fill in the corresponding bubbles underneath.
iii. Mark only ONE choice from the alternatives (1,2,3,4,5 or A,B,C,D,E) provided for each question. If there is a True/False question, enter response 1 (or A) as True, and 2 (or B) as False. The question number is to the left of the bubbles. Make sure that the number of the question on the scan sheet is the same as the question number on the test paper.
iv. Pay particular attention to the Marking Directions on the form.
True/False (20 questions - 1 mark each):
1. Using the dividend discount model as opposed to a free cashflow valuation methodology should result in two different valuations for a stock.
A) True B) False
2. Multiple solutions can arise when using the internal rate of return method to evaluate projects.
A) True B) False
3. ETFs are an expensive way to provide indexation: A) True
B) False
4. It has been shown that retail investors who actively trade outperform those who take a more buy-and-hold approach.
A) True B) False
5. The internal rate of return of a project is that discount rate which equates the discounted present value of the cash inflows with the discounted present value of the cash outflows.
A) True B) False
6. If mutually exclusive project choices all have negative NPVs, a firm subject to capital rationing should choose that project which has the least negative NPV.
A) True B) False
7. When two projects are mutually exclusive, the acceptance of one project precludes acceptance of the other.
A) True B) False
8. The net present value of an investment project normally decreases as the required rate of return increases.
9. A change in the discount rate for a project will have a smaller impact on the early cashflows than on the more distant cashflows.
A) True B) False
10.The net present value approach is preferred to the profitability index approach for mutually exclusive projects because it measures project value in absolute terms while the profitability index measures value in relative terms.
A) True B) False
11.The profitability index provides the same accept/reject decision result as the net present value method.
A) True B) False
12.A company should proceed with disinvestment if the NPV of continuation is negative.
A) True B) False
13.Project A and Project B have identical costs and identical lives. At a 5% discount rate, Project A has a higher net present value than Project B. Based on this, Project A must also have a higher net present value than Project B at a 15% discount rate.
A) True B) False
14.A total return index ignores dividends paid on stocks in the index. A) True
B) False
15.Debentures are secured by mortgages or liens on specific assets. A) True
B) False
16.If the Liquidity Premium Theory is true, one should never expect to observe a downward sloping yield curve.
17.If the coupon rate of a bond is greater than its yield to maturity, the bond must have a price greater than its par value.
A) True B) False
18.During a period of consistently declining interest rates, it would be unwise for a bond manager to have a portfolio consisting of longer term bonds as opposed to shorter term bonds.
A) True B) False
19.The PVIFA is less than the PVIFAdue. A) True
B) False
20.Put options unlike call options are more valuable when there is high volatility. A) True
Multiple Choice (20 questions - 2 marks each):
21. In a semi-strong-form efficient market,
A) Investors who analyze financial statements may have an advantage over other investors.
B) Security prices reflect historical information about security prices.
C) All investors (including those with inside information) can expect to earn the same risk-adjusted rate of return.
D) A security’s price reflects all possible information.
E) All investors can expect to earn the risk-free rate of interest.
22. At 65 Emily has just retired and has decided to purchase an annuity with some of her retirement savings. She has $500,000 in her retirement account which is providing annual interest of 3%. She wishes to have $100,000 left at age 90. What income replacement ratio can she obtain from this annuity if her final salary was $50,000?
A) 49% B) 52% C) 55% D) 58%
E) None of the other answers.
23. Which of the following is NOT true regarding the payback method?
A) The payback method is based on the number of periods required to recover a project’s required investment.
B) The payback method ignores cashflows that occur after the payback period. C) The payback method considers the time value of money to the extent that
cashflows within the payback period are not weighted equally.
D) The payback method does not incorporate risk as financing costs are ignored. E) The payback method does not address the question of whether a project will
increase the value of the firm.
24. With regards to capital budgeting, which of the following statements is correct? A) Results obtained using the profitability index method and internal rate of
return method are relative measures and don’t take into account the scale of a project.
B) The internal rate of return method may provide multiple solutions.
C) The net present value method assumes that all cashflows can be reinvested at the company’s cost of capital.
25. With regards to capital budgeting, which of the following statements is NOT correct?
A) When a company already owns a piece of land, the original cost of the land should be excluded from the analysis.
B) When evaluating a potential use of a piece of land, it should only be
compared to the land’s market value if the company is considering selling it. C) All costs of financing should be excluded from cashflow calculations because
they are accounted for in the discount rate.
D) Taxation needs to be considered in calculating cashflows.
E) The capital budgeting process is central to the success of the company.
26. Which of the following relationships between a bond’s price, coupon rate, yield to maturity and rate of return is NOT correct?
A) A bond’s price is equal to its face value when the coupon rate equals its yield to maturity.
B) The rate of return on a bond should be fairly close to its yield to maturity if the bond is purchased and held to maturity.
C) The price of a bond and its yield to maturity move inversely with one another.
D) Prior to maturity, a bond paying no coupons (pure discount bond) will always trade for a price below its face value.
E) Current yield is another name for yield to maturity.
27. There are three stocks in a market index. A sells for $20/share. B sells for $50/share and C sells for $100/share. All stocks go up by $5/share. If A is half the index in market value and B and C are 25% each, what is the change in the index?
A) 15.25% B) 16.25% C) 17.25% D) 18.25%
E) None of the other answers.
28. Risk pooling works best when: A) Claims are independent.
B) The company has at least 100 customers buying a particular insurance contract.
C) The probability of a loss is low.
29. A stock is expected to pay a dividend of $1 every two years, starting in two years. Given a required annual return of 12%, what is the stock worth? A) $3.93
B) $4.17 C) $8.33 D) $9.52
E) None of the other answers.
30. Assume the anticipated growth rate in dividends is constant for Fly-By-Nite Airlines. The expected value of the firm’s stock at the end of four years (P4) is:
I. D5 / (k – g) II. P0 x (1 + g)4
III. D0 x (1 + g) / (k – g) A) I only
B) II only C) I and II only D) I and III only E) I, II and III
31. A lack of trust in financial markets is particularly negative because it: A) Leads to outrage at excessive bonuses.
B) Tilts the maturity of debt to the short term. C) Leads to costly litigation.
D) Makes people nervous to participate in markets. E) None of the other answers.
32. Brewer Brewery has a bond outstanding that has a 14% yield to maturity (based on semi-annual compounding) and a price of $684 (based on a face value of $1,000). If the bond matures in five years and coupons are paid semi-annually, what is the coupon rate of the bond?
A) 4.50% B) 5.00% C) 5.50% D) 6.00%
33. What is the expected return of a portfolio 40% invested in Canadian stocks, 30%
invested in U.S. stocks and 30% invested in EAFE stocks if all asset classes have an expected return of 10% and all correlations are 0.50?
A) 9.58% B) 10.00% C) 10.49% D) 11.23%
E) None of the other answers.
34. Preferred shares typically pay a constant dividend every year. The current dividend yield on a series of preferred shares is 6%. If you purchase these preferred shares and then sell them after two years, how much should you expect to make per year on a total return basis (assume the required return does not change)?
A) 6%
B) More than 6% C) Less than 6%
D) It depends on the current price of the shares E) None of the other answers.
35. Your sister recently purchased a year coupon-paying bond (Bond A) and a 5-year pure discount bond (Bond B), both with YTMs of 9%. One week after she purchased the bonds, interest rates increased and are now expected to remain constant for the remainder of the life of the bonds. Interest payments can be reinvested at the new higher YTMs. Based on this situation, which of the following statement(s) is/are correct?
I. The prices of both bonds are lower than what she originally paid for them.
II. Her realized return on Bond A will be slightly higher than 9% if she holds the bond to maturity.
III. Her realized return on Bond B will be slightly higher than 9% if she holds the bond to maturity.
IV. The prices of both bonds are higher than what she originally paid for them.
36. You have exclusive rights to an investment opportunity whose NPV is $75,000 (based on a 10% discount rate) and whose IRR is 15%. Very shortly afterwards, wanting to get out of the business and not keen to wait for a better offer, you agree to sell the project to another company for $50,000. What IRR will the purchasing company make on the project if they expect the project to generate the same cashflows as you did? (Note that you need to factor in for this
company the cost of the exclusive rights.) A) Less than 10%
B) 10%
C) Between 10 and 15% D) 15%
E) The purchasing company will make a negative return on the project.
37. Your firm is considering two mutually exclusive projects. The net cash inflows of the two projects are as follows:
Year Project A Project B
0 -2,500 -2,500
1 1,000 400
2 40 650
3 1,250 900
4 1,000 1,150
5 1,000 1,400
Due to conflicting results from NPV and IRR, you decide to calculate the MIRR. The appropriate discount rate for your company is 11.5%. The MIRR for Project A is ______ and the MIRR for Project B is ______.
A) 16.1%; 16.3% B) 19.5%; 18.8% C) 16.1%; 18.8% D) 19.5%; 16.3%
38. You are attempting to evaluate a mutual fund manager and notice that the fund they manage has had returns over the last few years that exceed those of the overall market. Which of the following explanations is NOT consistent with market efficiency?
A) The fund has a higher risk portfolio than the overall market.
B) The returns are before accounting for transaction costs and costs of analysis. C) The fund’s outperformance is a random event.
D) The fund had a higher performance even after taking risk into account but the model used to calculate the risk-adjusted return is wrong.
E) The fund has exploited several anomalies.
39. A call option can be valued by considering a portfolio which is: A) Long stock and short call options.
B) Long put options and short call options. C) Long the risk-free security and short a bond. D) Long a bond and short the risk-free security. E) None of the other answers.
40. A project requires an initial investment of $5,000 and will produce cash inflows of $1,500 at the end of year 1, $2,000 at the end of year 2 and $3,000 at the end of year 3. The internal rate of return of the project falls between:
A) 12-14% B) 14-16% C) 16-18% D) 18-20% E) 20-24%
41. Deaves Enterprises just paid a $2 dividend. Dividend growth is expected to be 15% for 5 years (ending with the dividend at time 5). Afterwards the company will slow down and 5% growth is anticipated indefinitely. The cost of capital is 12%. What does Deaves stock go for?
A) It’s priceless. B) $71.11
C) $59.82 D) $45.07
42. Sterling Inc. recently reported earnings of $800,000 and has 500,000 shares of common stock outstanding. The company has growth opportunities whose total NPV is $4,000,000, and its discount rate is 15%. Calculate the price-earnings (P/E) ratio of the firm (using latest reported earnings as your denominator). A) 6.67
B) 9.33 C) 10.67 D) 11.67 E) 32.00
43. A given investment project will cost $184,000. Cashflows are expected to be $74,000 per year for the life of the investment, which is 5 years. There will be no salvage value to consider. The required rate of return is 18%. According to each of the following criteria, is the project acceptable based on the information given? Payback ______; net present value ______; profitability index ______.
A) Cannot say; Yes; Yes. B) Yes; Yes; Cannot say.
C) Cannot say; Yes; Cannot say. D) No; Yes; Yes.
E) Cannot say; No; Yes.
44. Karen Capital is currently evaluating two mutually exclusive projects for her employer High Value, Inc. The relevant cashflows and simple net present values for the two projects are shown below. The cost of capital for High Value is 10%. Assuming both projects are repeatable, which project should be selected?
Year Project X Project Y
0 -10,000 -10,000
1 6,500 4,800
2 6,500 4,800
3 - 4,800
NPV $1,281 $1,937
A) Project X. B) Project Y.
C) Either is equally good, but only one should be adopted. D) Both projects should be adopted.
45. Ironman-distance triathlons (4km swim, 180km bike and 42.2km run) have become so popular that many races are completely full up to a year in advance. In order to take advantage of this popularity, you are considering organizing an Ironman race in Hamilton. In order to hold the race, you would need to invest $200,000 one year in advance in order to clean up Hamilton Harbour for the swim and purchase a permit from the City of Hamilton that will enable you to hold the race once per year for five years. You have decided that the entry fee should be $500 per person and estimate that the total annual costs will be $300 per participant. You also expect to be able to draw either 250 or 500 participants (with equal probability) depending on whether or not a rumoured competing race is also organized. After a year, you will know with certainty whether or not the competing race has been organized or not. The appropriate discount rate for this project is 12%. The net present value of investing today so that the race could begin next year is $70,358. What is the value of the option to postpone the decision for one year?
A) $0 B) $1,284 C) $1,604 D) $71,642
E) None of the other answers.
46. Which of the following is NOT a capital budgeting decision-making technique? A) NPV
B) IRR C) PIV D) MIRR E) PI
47. Which of the following is a true statement?
I. All else being equal, the value of a perpetual bond will remain
unchanged from one year to the next, unless market interest rates change. II. All else being equal, bond prices and coupon rates move inversely. III. For two bonds identical except for maturity, the market price of the low-maturity bond will change more (in percentage terms) than that of the high-maturity bond for a given change in market interest rates.
A) I only
48. If portfolio weights are positive: 1) Can the return on a portfolio ever be less than the smallest return on an individual security in the portfolio? 2) Can the standard deviation of a portfolio ever be less than the smallest standard deviation of an individual security in the portfolio?
A) 1) yes; 2) yes B) 1) yes; 2) no C) 1) no; 2) yes D) 1) no; 2) no E) 1) maybe; 2) no
49. Which of the following statements is/are true about the variance of the possible future returns on a financial asset where you have multiple possible states of the economy along with associated probabilities of the states occurring?
I. The variance is a simple average of the squared deviations of the actual returns from the expected returns.
II. The greater the dispersion in the possible returns on the firm's stock, the lower the variance of the possible returns, all else being equal. III. The variance of the possible returns on a riskfree asset is zero. A) I only
B) II only C) III only
D) II and III only E) I, II, and III
50. Which of the following describes a security that plots below the security market line?
A) The security is undervalued. B) The security is overvalued. C) The security is fairly valued.
D) A security cannot be plotted in this way. E) The security is an airline.
51. You win the lottery and are given the option of receiving $250,000 now or an annuity of $25,000 at the end of each year for 30 years. Which of the following is correct?
A) None of the other statements is correct.
B) You will always choose the lump sum regardless of interest rates. C) You will choose the annuity payment if the interest rate is 10%. D) You will always choose the annuity.
52. What would your payment be on a 10-year, $150,000 loan at a 10% interest rate compounded semi-annually assuming payments are made annually?
A) $19,716.67 B) $20,743.77 C) $24,411.81 D) $24,674.60
E) None of the other answers.
53. You are going to invest $500 at the end of each year for 10 years. Given an interest rate, you can find the future value of this investment by:
I. Adding the cashflows together and finding the future value of the sum using the appropriate future value factor.
II. Applying the proper future value factor to each cashflow, then adding up these future values.
III. Finding the present value of each cashflow, adding all of the present values together, then finding the future value at the end of year 10 of this lump sum.
IV. Finding the present value of the entire payment stream. A) II only
B) III only
C) II and III only D) I, II, and IV only E) II, III, and IV only
54. Your parents agree to pay half of the purchase price of a new car when you graduate from college. You will graduate and buy the car two years from now. You have $6,000 to invest today and can earn 10% on invested funds. If your parents match the amount of money you have in two years, what is the maximum you can spend on the new car?
55. Suppose you are trying to find the present value of two different cashflows using the same (positive) interest rate for each. One cashflow is $1,000 ten years from now, the other $800 seven years from now. Which of the following is true about the PVIFs used in these valuations?
A) The PVIF for the cashflow ten years away is always less than the PVIF for the cashflow seven years from now.
B) Both discount factors are greater than one.
C) Regardless of the interest rate, the discount factors are such that the
present value of the $1,000 will always be greater than the present value of the $800.
D) Since the payments are different, no statement can be made regarding the PVIFs.
E) You should factor in the time differential and choose the payment that arrives the soonest.
56. Your company uses wheat in the production of a cereal product. Which of the following actions would allow you to lock in the acquisition cost of your wheat?
I. Sell a futures contract on wheat. II. Buy a futures contract on wheat. III. Buy a wheat put.
IV. Sell a crude oil call. A) I only
B) II only C) IV only D) I or IV only E) II or III only
57. You sold (wrote) a May American put option on Netscape stock with an exercise price of 165. Which of the following statements is true?
A) You have the right to buy Netscape shares for $165 at any time prior to the option expiration in May.
B) This was a poor investment.
C) You have the right to sell Netscape shares for $165 at any time prior to the option expiration in May.
D) You are obligated to sell Netscape shares for $165 if the owner of the option chooses to exercise prior to expiry.
58. The _______ of a futures contract is obligated to ______ delivery and pay for the contracted goods at the futures price; the _______ of a futures contract is
obligated to ______ delivery and accept payment for the goods at the futures price.
A) seller; make; buyer; take B) seller; take; buyer; make C) buyer; make; seller; take D) buyer; take; seller; take E) buyer; take; seller; make
59. An option that gives the owner the right, but not the obligation, to buy an asset is called a:
A) Parity option. B) Call option. C) Put option. D) Poor investment.
E) None of the other answers.
60. We observe the following exchange rate quotes for the Arcadian Peco (P), the Swiss Franc (F) and the U.S. Dollar ($): 3 P per $; 9 F per $. What should the P per F exchange rate be?
