Midterm Study Guide

Fin 5170
Fall 2009
The exam will consist on multiple choices, and problems and may be an essay question. I will ask a maximum of
two questions taken from the following material covered in class:
Chapter 1
Describe the concept of agency problems and different ways to ameliorate agency problems in a corporation
Chapter 3
Example 3.7 (pages 65-66)
Use the concept of arbitrage to explain the price of Security A in table 3.8, and Security B in table 3.9). Compute
the risk premium of both securities.
Example 3.10 in page 72
Example 3.11 in page 74
Problems 14, 17, 18 (pages 78-80)
You will also have the opportunity to answer several questions from the next pages:

Chapter 1 - The Corporation

1.1 The Four Types of Firms

2)
Which of the following organization forms for a business does not avoid double taxation?
A)

Limited Partnership
B)
"C" Corporation
C)

"S" Corporation
D)

Limited Liability Company

Answer:

B
3)
Which of the following organization forms has the most revenue?
A)

"S" Corporation
B)
Limited Partnership
C)

"C" Corporation
D)

Limited Liability Company

Answer:

C
4)
Which of the following organization forms accounts for the greatest number of firms?
A)

"S" Corporation
B)
Limited Partnership
C)

Sole Proprietorship
D)

"C" Corporation
Answer:

5)

Which of the following is NOT an advantage of a sole proprietorship?

A)

Single taxation
B)
Ease of setup
C)

Limited liability
D)

No separation of ownership and control

Answer:

6)
Which of the following statements regarding limited partnerships is true?
A)

There is no limit on a limited partner's liability.

B)
A limited partner's liability is limited by the amount of their investment.
C)

A limited partner is not liable until all the assets of the general partners have been exhausted.
D)

A general partner's liability is limited by the amount of their investment.

Answer:

B
7)
Which of the following is / are an advantage of incorporation?
A)

Access to capital markets

B)
Limited liability
C)

Unlimited life
D)

All of the above

Answer:

D
9)
A limited liability company is essentially
A)

a limited partnership without limited partners.

B)
a limited partnership without a general partner.
C)

just another name for a limited partnership.

D)

just another name for a corporation.

Answer:

B
10)
The distinguishing feature of a corporation is that
A)
their is no legal difference between the corporation and its owners.
B)
it is a legally defined, artificial being, separate from its owners.
C)

it spreads liability for its corporate obligations to all shareholders.

D)

provides limited liability only to small shareholders.

Answer:

B
12)
You own 100 shares of a "C" Corporation. The corporation earns $5.00 per share before taxes. Once the corporation has
paid any corporate taxes that are due, it will distribute the rest of its earnings to its shareholders in the form of a dividend.
If the corporate tax rate is 40% and your personal tax rate on (both dividend and non-dividend) income is 30%, then how
much money is left for you after all taxes have been paid?
A)

$210

$300

$350

$500

B)

C)

D)

Answer:

Explanation:

A)
EPS number of shares (1 - Corporate Tax Rate) (1 - Individual Tax Rate)
$5.00 per share 100 shares (1 - .40) x (1 - .30) = $210
B)

C)

D)

13)
You own 100 shares of a Sub Chapter "S" Corporation. The corporation earns $5.00 per share before taxes. Once the
corporation has paid any corporate taxes that are due, it will distribute the rest of its earnings to its shareholders in the
form of a dividend. If the corporate tax rate is 40% and your personal tax rate on (both dividend and non-dividend)
income is 30%, then how much money is left for you after all taxes have been paid?
A)

$210

B)

$300

C)

$350

D)

$500

Answer:

Explanation:

A)

B)

C)
EPS number of shares (1 - Individual Tax Rate)
$5.00 per share 100 shares (1 - .30) = $350
D)

14)
You are a shareholder in a "C" corporation. This corporation earns $4 per share before taxes. After it has paid taxes, it will
distribute the remainder of its earnings to you as a dividend. The dividend is income to you, so you will then pay taxes
on these earnings. The corporate tax rate is 35% and your tax rate on dividend income is 15%. The effective tax rate on
your share of the corporations earnings is closest to:
A)

15%

35%

45%

50%

B)

C)

D)

Answer:

Explanation:

A)

B)

C)
Fist the corporation pays taxes. It earned $4 per share, but must pay $4 .35 = $1.40 to the government in corporate
taxes. That leaves $4.00 - $1.40 = $2.60 to distribute to the shareholders. However, the shareholder must pay $2.60 .15
= $0.39 in income taxes on this amount, leaving only $2.21 to the shareholder after all taxes are paid. The total amount
paid in taxes is $1.40 + 0.39 = $1.79. The effective tax rate is then $1.79 $4 = .4475 or 44.75% which is closest to 45%.
D)

1.2 Ownership Versus Control of Corporations

1)
In a corporation, the ultimate decisions regarding business matters are made by
A)

the Board of Directors.

B)
debt holders.
C)

shareholders.

D)

investors.

Answer:

3)
The Principal-Agent Problem arises
A)

because managers have little incentive to work in the interest of shareholders when this means working against their own
self-interest.
B)
because of the separation of ownership and control in a corporation.
C)

Both A and B
D)

None of the above

Answer:

4)
If shareholders are unhappy with a CEO's performance, they are most likely to
A)

buy more shares in an effort to gain control of the firm.

B)
file a shareholder resolution.
C)

replace the CEO through a grassroots shareholder uprising.

D)

sell their shares.

Answer:
D
5)
A ________, is when a rich individual or organization purchases a large fraction of the stock of a poorly performing firm
and in doing so gets enough votes to replace the board of directors and the CEO.
A)

shareholder proposal
B)
leveraged buyout
C)

shareholder action
D)

hostile takeover
Answer:

D
6)
Which of the following statements is false?
A)

In bankruptcy, management is given the opportunity to reorganize the firm and renegotiate with debt holders.
B)
Because a corporation is a separate legal entity, when it fails to repay its debts, the people who lent to the firm, the debt
holders are entitled to seize the assets of the corporation in compensation for the default.
C)

As long as the corporation can satisfy the claims of the debt holders, ownership remains in the hands of the equity
holders.
D)

If the corporation fails to satisfy debt holders' claims, debt holders may lose control of the firm.
Answer:

Explanation:

A)

B)

C)

D)
If the corporation fails to satisfy debt holders' claims, debt holders may take control of the firm.

7)
What strategies are available to shareholders to help ensure that managers are motivated to act in the interest of the
shareholders rather than their own interest?
Answer:

1.
2.
3.

The threat of a hostile takeover

Shareholder initiatives
Performance based compensation

Chapter 2 - Introduction to Financial Statement Analysis

2.1 The Disclosure of Financial Information
1)
U.S. public companies are required to file their annual financial statements with the U.S. Securities and Exchange
Commission on which form?
A)

10-A

B)

10-K

C)

10-Q

D)

10-SEC

Answer:

3)
The third party who checks annual financial statements to ensure that they are prepared according to GAAP and verifies
that the information reported is reliable is the
A)

NYSE Enforcement Board.

B)
Accounting Standards Board.
C)

Securities and Exchange Commission (SEC).

D)

auditor.

Answer:

2.2 The Balance Sheet

1)
Which of the following balance sheet equations is incorrect?
A)

Assets - Liabilities = Shareholders' Equity

B)
Assets = Liabilities + Shareholders' Equity
C)

Assets - Current Liabilities = Long Term Liabilities

D)

Assets - Current Liabilities = Long Term Liabilities + Shareholders' Equity

Answer:

3)
Accounts payable is a
A)

Long-term liability.
B)
Current Asset.
C)

Long-term asset.
D)

Current Liability.
Answer:

Use the table for the question(s) below.

Consider the following balance sheet:
Luther Corporation
Consolidated Balance Sheet
December 31, 2006 and 2005 (in $ millions)

Assets
Current Assets
Cash

2006

2005

63.6

58.5

Accounts receivable

55.5

39.6

45.9
6.0
171.0

42.9
3.0
144.0

Inventories
Other current assets
Total current assets

Liabilities and
Stockholders' Equity
Current Liabilities
Accounts payable
Notes payable /
short-term debt
Current maturities of longterm debt
Other current liabilities
Total current liabilities
Long-Term Liabilities
Long-term debt
Capital lease obligationss
Total Debt

2006

2005

87.6

73.5

10.5

9.6

39.9
6.0
144.0

36.9
12.0
132.0

239.7
--239.7

168.9
--168.9

22.8

22.2

Long-Term Assets
Land
Buildings
Equipment
Less accumulated
depreciation
Net property, plant, and
equipment
Goodwill
Other long-term assets
Total long-term assets

66.6
109.5
119.1

62.1
91.5
99.6

(56.1)

(52.5)

Deferred taxes

239.1
60.0
63.0
362.1

200.7
-42.0
242.7

Other long-term liabilities

Total long-term liabilities
Total liabilities
Stockholders' Equity

--262.5
406.5
126.6

--191.1
323.1
63.6

Total Assets

533.1

386.7

Total liabilities and

Stockholders' Equity

533.1

386.7

6)
What is Luther's net working capital in 2005?
A)

$12 million

$27 million

$39 million

B)

C)

D)

$63.6 million
Answer:

Explanation:

A)
NWC = current assets - current liabilities = 144 - 132 = $12 million
B)

C)

D)

7)
If in 2006 Luther has 10.2 million shares outstanding and these shares are trading at $16 per share, then Luther's Marketto-book ratio would be closest to:
A)

0.39

0.76

1.29

2.57

B)

C)

D)

Answer:

Explanation:

A)

B)

C)
MTB = market cap / book value of equity = (10.2 million 16) / 126.6 = 163.2 / 126.6 = 1.289
D)

8)
When using the book value of equity, the debt to equity ratio for Luther in 2006 is closest to:
A)

2.21

2.29

2.98

3.03

B)

C)

D)

Answer:

Explanation:

A)

B)
D/E = Total Debt / Total Equity
Total Debt = (notes payable (10.5) + current maturities of long-term debt (39.9) + long-term debt (239.7) = 290.1 million
Total Equity = 126.6, so D/E = 290.1 / 126.6 = 2.29
C)

D)

9)
If in 2006 Luther has 10.2 million shares outstanding and these shares are trading at $16 per share, then using the market
value of equity, the debt to equity ratio for Luther in 2006 is closest to:
A)

1.71

B)

1.78

C)

2.31

D)

2.35

Answer:

Explanation:

A)

B)
D/E = Total Debt / Total Equity
Total Debt = (notes payable (10.5) + current maturities of long-term debt (39.9) + long-term debt (239.7) = 290.1 million
Total Equity = 10.2 $16 = 163.2, so D/E = 290.1 / 163.2 = 1.78
C)

D)

10)
If in 2006 Luther has 10.2 million shares outstanding and these shares are trading at $16 per share, then what is Luther's
Enterprise Value?
A)

-$63.3 million

B)
$353.1 million
C)

$389.7 million
D)

$516.9 million
Answer:

Explanation:

A)

B)

C)
Enterprise value = MVE + Debt - Cash = 10.2 $16 + 290.1 - 63.6 = 389.7
D)

11)
Luther's current ratio for 2006 is closest to:
A)

0.84

0.87

1.15

1.19

B)

C)

D)

Answer:

Explanation:

A)

B)

C)

D)
current ratio = current assets / current liabilities = 171 / 144 = 1.19
2.3 The Income Statement
1)
Which of the following statements regarding the income statement is incorrect?
A)

The income statement shows the earnings and expenses at a given point in time.
B)
The income statement shows the flow of earnings and expenses generated by the firm between two dates.
C)

The last or "bottom" line of the income statement shows the firm's net income.
D)

The first line of an income statement lists the revenues from the sales of products or services.
Answer:

Explanation:

A)

B)

C)

D)

Use the table for the question(s) below.

Consider the following income statement and other information:
Luther Corporation
Consolidated Income Statement
Year ended December 31 (in $ millions)
2006
2005
Total sales
610.1
578.3
Cost of sales
(500.2)
(481.9)
Gross profit
109.9
96.4
Selling, general, and
administrative expenses
(40.5)
(39.0)
Research and development
(24.6)
(22.8)
Depreciation and amortization
(3.6)
(3.3)
Operating income
41.2
31.3
Other income
----Earnings before interest and taxes (EBIT)
41.2
31.3
Interest income (expense)
(25.1)
(15.8)
Pretax income
16.1
15.5
Taxes
(5.5)
(5.3)
Net income
10.6
10.2
Price per share
Shares outstanding (millions)
Stock options outstanding (millions)

$16
10.2
0.3

$15
8.0
0.2

Stockholders' Equity
Total Liabilities and Stockholders' Equity

126.6
533.1

63.6
386.7

4)
For the year ending December 31, 2006 Luther's earnings per share are closest to:
A)

$1.01

B)

$1.04

C)

$1.58

D)

$4.04

Answer:

Explanation:

A)

B)
EPS = Net Income / Shares Outstanding = $10.6 / 10.2 = $1.04
C)

D)

6)
Luther's Operating Margin for the year ending December 31, 2005 is closest to:
A)

1.8%

B)

2.7%

C)

5.4%

D)

16.7%

Answer:

Explanation:

A)

B)

C)
Operating Margin = Operating Income / Sales
OM = 31.3 / 578.3 = .054 or 5.4%
D)

7)
Luther's Net Profit Margin for the year ending December 31, 2005 is closest to:
A)

1.8%

2.7%

5.4%

16.7%

B)

C)

D)

Answer:

Explanation:

A)
Net Profit Margin = Net Income / Total Sales = 10.2 / 578.3 = .018 or 1.8%
B)

C)

D)

8)
Luther's earnings before interest, taxes, depreciation, and amortization (EBITDA) for the year ending December 31, 2006 is
closest to:
A)

19.7 million

37.6 million

41.2 million

B)

C)

D)

44.8 million
Answer:

Explanation:

A)

B)

C)

D)
EBITDA = EBIT + Depreciation & Amortization = 41.2 + 3.6 = $ 44.8 million

9)
Luther's return on equity (ROE) for the year ending December 31, 2006 is closest to:
A)

2.0%

B)

6.5%

C)

8.4%

D)

12.7%

Answer:

Explanation:

A)

B)

C)
ROE = Net income / shareholders' equity = 10.6 / 126.6 = .084 or 8.4%
D)

10)
Luther's return on assets (ROA) for the year ending December 31, 2006 is closest to:
A)

2.0%

6.5%

8.4%

12.7%

B)

C)

D)

Answer:

Explanation:

A)
ROA = Net income / total assets.
This is a little tricky in that total assets aren't given in the problem. The student must remember the basic balance sheet
equation A = L + SE. Total Liabilities and Shareholders' Equity is given and this is the same as total assets. So ROA =
10.6 / 533.1 = .020 or 2.0%
B)

C)

D)

1
11. Luther's price - earnings ration (P/E) for the year ending December 31, 2006 is closest to:
A)

7.9

10.1

15.4

16.0

B)

C)

D)

Answer:

Explanation:

A)

B)

C)
P/E = Price / EPS or Market Cap / Earnings = (10.2 $16) / $10.6 = 15.4
D)

2.4 The Statement of Cash Flows

1)
Which of the following is not a section on the cash flow statement?
A)

Income generating activities

B)
Investing activities
C)

Operating activities
D)

Financing activities
Answer:

Explanation:

A)

B)

C)

D)

2.6 Accounting Manipulation

1)
In response to corporate scandals such as Enron and WorldCom, in 2002 congress passed a law that requires, among other
things, that CEOs and CFOs certify the accuracy and appropriateness of their firm's financial statements and increases he
penalties against them if the financial statements later prove to be fraudulent. The name of this act is?
A)

The Glass-Steagall Act

B)
The Sarbanes-Oxley Act
C)

The Accuracy in Accounting Act

D)

The McCain-Feingold Act

Answer:

Explanation:

A)

B)

C)

D)

Chapter 3 - Arbitrage and Financial Decision Making

7)
You have an investment opportunity in Germany that requires an investment of $250,000 today and will produce a cash
flow of 208,650 in one year with no risk. Suppose the risk-free rate of interest in Germany is 6% and the current
competitive exchange rate is 0.78 to $1.00. What is the NPV of this project? Would you take the project?
A)

NPV = 0; No
B)
NPV = 2,358; No
C)

NPV = 2,358; Yes

D)

NPV = 13,650; Yes

Answer:

Explanation:

A)

B)

C)
NPV = -250,000 + (208,650 / 1.06) $1.00 / 0.78 = 2358, so since NPV > 0, accept
D)

Use the table for the question(s) below.

Project
"eenie"

Cash flow
today
-10

Cash flow
in one year
15

"meenie"
"minie"
"moe"

10
-15
10

-8
20
-15

10)
If the risk-free interest rate is 10%, then of the four projects listed, if you could only invest in one project, which on e
would you select?
A)

Eenie

Meenie

Minie

Moe

B)

C)

D)

Answer:

Explanation:

A)
Eenie has highest NPV
NPV Eenie = -10 + 15 / 1.1 = 3.64
NPV Meenie = 10 - 8 / 1.1 = 2.73
NPV Minie = -15 + 20 / 1.1 = 3.18
NPV moe = 10 - 15 / 1.1 = -3.64
B)

C)

D)

11)
If the risk-free interest rate is 10%, then of the four projects listed, which project would you never want to invest in?
A)

Eenie

B)

Meenie

Minie

C)

D)

Moe

Answer:

Explanation:

A)

B)

C)

D)
Moe has negative NPV
NPV Eenie = -10 + 15 / 1.1 = 3.64
NPV Meenie = 10 - 8/1.1 = 2.73
NPV Minie = -15 + 20 / 1.1 = 3.18
NPV moe = 10 - 15 / 1.1 = -3.64
3.4 Arbitrage and the Law of One Price
2)
Which of the following statements regarding the Law of One Price is incorrect?
A)

At any point in time, the price of two equivalent goods trading in different competitive markets will be the same.
B)
One useful consequence of the Law of One Price is that when evaluating costs and benefits to compute a net present
value, we can use any competitive price to determine a cash value, without checking the price in all possible markets.
C)

If equivalent goods or securities trade simultaneously in different competitive markets, then they will trade for the same
price in both markets.
D)

An important property of the Law of One Price is that it holds even in markets where arbitrage is not possible.
Answer:

Explanation:

A)

B)

C)

D)

Use the table for the question(s) below.

Consider the following prices from a McDonald's Restaurant:
Big Mac Sandwich
$2.99
Large Coke
$1.39
Large Fry
$1.09

4)
A McDonald's Big Mac value meal consists of a Big Mac Sandwich, Large Coke, and a Large Fry. Assume that there is a
competitive market for McDonald's food items and that McDonalds sells the Big Mac value meal for $4.79. Does an
arbitrage opportunity exists and if so how would you exploit it and how much would you make on one extra value meal?
A)

Yes, buy extra value meal and then sell Big Mac, Coke, and Fries to make arbitrage profit of $0.68

B)
No, no arbitrage opportunity exists
C)

Yes, buy Big Mac, Coke, and Fries then sell value meal to make arbitrage profit of $1.09
D)

Yes, buy Big Mac, Coke, and Fries then sell value meal to make arbitrage profit of $0.68

Answer:

Explanation:

A)
Buy value meal and sell Big Mac, Coke and Fries
-4.79 + 2.99 + 1.39 + 1.09 = 0.68 (so arbitrage exists)
B)

C)

D)

5)
Walgreen Company (NYSE: WAG) is currently trading at $48.75 on the NYSE. Walgreen Company is also listed on
NASDAQ and assume it is currently trading on NASDAQ at $48.50. Does an arbitrage opportunity exists and if so how
would you exploit it and how much would you make on a block trade of 100 shares?
A)

No, no arbitrage opportunity exists

B)
Yes, buy on NASDAQ and sell on NYSE, make $25
C)

Yes, buy on NYSE and sell on NASDAQ, make $25

D)

Yes, buy on NASDAQ and sell on NYSE, make $250

Answer:

Explanation:

A)

B)

Yes, buy 100 shares 48.50 and sell 100 shares 48.75 = $25.00
C)

D)

7)
Advanced Micro Devices (NYSE: AMD) is currently trading at $20.75 on the NYSE. Advanced Micro Devices is also listed
on NASDAQ and assume it is currently trading on NASDAQ at $20.50. Does an arbitrage opportunity exists and if so how
would you exploit it and how much would you make on a block trade of 1000 shares?
Answer:

Yes, buy 1000 shares 20.50 and sell 1000 shares 20.75 = $250.00

3.5 No-Arbitrage and Security Prices

1)
Which of the following statements regarding arbitrage and security prices is incorrect?
A)

We call the price of a security in a normal market the no-arbitrage price for the security.
B)
In financial markets it is possible to sell a security you do not own by doing a short sale.
C)

When a bond is underpriced, the arbitrage strategy involves selling the bond and investing some of the proceeds.
D)

The general formula for the no-arbitrage price of a security is Price(security) = PV(All cash flows paid by the security).
Answer:

Explanation:

A)

B)

C)

D)

Use the information for the question(s) below.

An independent film maker is considering producing a new movie. The initial cost for making this movie will be $20
million today. Once the movie is completed, in one year, the movie will be sold to a major studio for $25 million. Rather
than paying for the $20 million investment entirely using its own cash, the film maker is considering raising additional
funds by issuing a security that will pay investors $11 million in one year. Suppose the risk-free rate of interest is 10%.
6)
Without issuing the new security, the npv for this project is closest to what amount? Should the film maker make the
investment?
A)

$1.7 million; Yes

B)
$1.7 million; No
C)

$2.7 million; Yes

D)

$2.7 million; No
Answer:

Explanation:

A)

B)

C)
NPV = -20 + 25 / 1.10 = $2.7 million, since NPV > 0 take the investment
D)

8)
What is the NPV of this project if the film maker does not issue the new security? What is the NPV if the film maker

issues the new security?

A)

$1.7 million; $1.7 million

B)
$1.7 million; $2.7 million
C)

$2.7 million; $1.7 million

D)

$2.7 million; $2.7 million

Answer:

Explanation:

A)

B)

C)

D)
NPV (no security) = -20 + 25 / 1.1 = $2.7
NPV(w/ security) = -10 + (25 - 11) / 1.10 = $2.7 million
Use the table for the question(s) below.

Security
A
B
C

Cash flow
today
0
100
100

Cash flow
in one year
100
0
100

9)
If the risk-free rate of interest is 7.5%, then the value of security "A" is closest to:
A)

$91.00

$92.50

$93.00

$100.00

B)

C)

D)

Answer:

Explanation:

A)

B)

C)
= 100 / 1.075 = 93.02 which is approximately $93.00
D)

11)
If the value of security "C" is $180, then what must be the value of security "A"?
A)

$80

$90

$100

B)

C)

D)

Unable to determine without the risk-free rate.

Answer:

Explanation:

A)
The cash flows from C are simply a combination of A & B, so price(C) = price(A) + price(B) Since B is already in todays
dollars, price(B) must = 100, so price A = 180 - 100 = $80.
B)

C)

D)

Use the information for the question(s) below.

An exchange traded fund (ETF) is a security that represents a portfolio of individual stocks. Consider an ETF for which
each share represents a portfolio of two shares of International Business Machines (IBM), three shares of Merck (MRK),
and three shares of Citigroup Inc. (C). Suppose the current market price of each individual stock are shown below:
Stock
IBM
MRK
C

Current Price
$79.50
$40.00
$48.50

13)
Suppose that the ETF is trading for $424.50; you should
A)

sell the EFT and buy 2 shares of IBM, 3 shares of MRK, and 3 shares of C.
B)
sell the EFT and buy 3 shares of IBM, 2 shares of MRK, and 3 shares of C.
C)

buy the EFT and sell 2 shares of IBM, 3 shares of MRK, and 3 shares of C.
D)

do nothing, no arbitrage opportunity exists.

Answer:

Explanation:

A)

B)

C)

D)
Value of ETF = 2 79.50 + 3 40.00 + 3 48.50 = $424.50, so no arbitrage opportunity exists

14)
Suppose a security with a risk-free cash flow of $1000 in one year trades for $909 today. If there are no arbitrage
opportunities, then the current risk-free interest rate is closest to:
A)

8%

10%

11%

12%

B)

C)

D)

Answer:

Explanation:

A)

B)
PV = FV / (1 + i) ==>>> (1 + i) = FV / PV = $1000 / $909 = 1.10 so i = 10%
C)

D)

Use the information for the question(s) below.

An exchange traded fund (ETF) is a security that represents a portfolio of individual stocks. Consider an ETF for which
each share represents a portfolio of two shares of International Business Machines (IBM), three shares of Merck (MRK),
and three shares of Citigroup Inc. (C). Suppose the current market price of each individual stock are shown below:
Stock
IBM
MRK
C

Current Price
$79.50
$40.00
$48.50
15)

Assume that the ETF is trading for $426.00, what (if any) arbitrage opportunity exists? What (if any) trades would you
make?
Answer:

Value of ETF = 2 79.50 + 3 40.00 + 3 48.50 = $424.50, so an arbitrage opportunity exists. You should sell the EFT
for $426.00 and buy 2 shares of IBM, 3 shares of MRK, and 3 shares of C.

3.6 The Price of Risk

1)
Which one of the following statements is false?
A)

When we compute the return of a security based on the average payoff we expect to receive, we call it the expected return.
B)
The notion that investors prefer to have a safe income rather than a risky one of the same average amount is call risk
aversion.
C)

Because investors are risk averse, the risk-free interest rate is not the right rate to use when converting risky cash flows
across time.
D)

The more risk averse investors are, the higher the current price of a risky asset will be compared to a risk-free bond.
Answer:

Explanation:

A)

B)

C)

D)

Use the table for the question(s) below.

Security
A
B
C

Market Price
Today
200
600
???

Cash Flow in One Year

Poor Economy Good Economy
840
0
0
840
840
4200

2)
Based upon the information provided about securities A, B, and C, the risk-free rate of interest is closest to:
A)

4%

5%

8%

10%

B)

C)

D)

Answer:

Explanation:

A)

B)
We can construct the risk-free asset by forming a portfolio of A and B. This portfolio has a certain payoff of $840. The
price for this portfolio is $800. We know that $800 = $840 / (1 + i) ==> (1 + i) = 840 / 800 = 1.05 ==> i = .05 or 5%.

C)

D)

4)
Suppose a risky security pays an average cash flow of $100 in one year. The risk-free rate is 5%, and the expected return
on the market index is 13%. If the returns on this security are high when the economy is strong and low when the
economy is weak, but the returns vary by only half as much as the market index, what risk premium is appropriate for
this security?
A)

4%

6.5%

9%

11%

B)

C)

D)

Answer:

Explanation:

A)
Since the security is half as risky as the market, then the risk-premium for the security should be half of the market risk
premium. The market risk premium is 13% - 5% = 8%, so the risk premium on this security should be half of this or 4%.
B)

C)

D)

Use the table for the question(s) below.

Security
A
B

Market Price
Today
200
600

Cash Flow in One Year

Poor Economy Good Economy
840
0
0
840

???

840

4200

3.7 Arbitrage with Transaction Costs

1)
Which of the following statements is false?
A)

No arbitrage opportunities will exist until the underlying prices diverge by more than the amount of the transaction costs.
B)
Because you will generally pay a slightly lower price when you buy a security (the ask price) than you receive when you
sell (the bid price) you will pay the bid-ask spread.
C)

The price of a security should equal the present value of its cash flows, up to the transaction costs of trading the security
and the cash flows.
D)

In most markets, you must pay transactions costs to trade securities.

Answer:

Explanation:

A)

B)

C)

D)

2)
Consider a bond that pays $1000 in one year. Suppose that the market interest rate for savings is 8%, but the interest rate
for borrowing is 10%. The price range that this bond must trade in a normal market if no arbitrage opportunities exist is
closest to:
A)

$909 to $917

$909 to $926

$917 to $926

B)

C)

D)

$909 to $1000
Answer:

Explanation:

A)

B)
VB @ 8% = 1000 / 1.08 = $926 VB @ 10% = 1000 / 1.10 = $909 so range is 909 to 926
C)

D)

Use the table for the question(s) below.

Security
IBM
MRK
C

Bid
79.45
39.95
48.50

Ask
79.50
40.05
48.55

6)
Consider an ETF that is made up of one share each of IBM, MRK, and C. The current quote for this ETF currently is
$167.75 (bid) $167.85 (ask). What should you do?

Answer:

There is an arbitrage opportunity. Buy the ETF at the ask of $167.85 and sell the underlying securities at the bid prices. So
we have +79.45 + 39.95 + 48.50 - 167.85 = .05 arbitrage profit per share

7)
Consider an ETF that is made up of one share each of IBM, MRK, and C. The current quote for this ETF currently is
$167.85 (bid) $167.95 (ask). What should you do?
Answer:

Nothing, there is no arbitrage opportunity here. The ask price must fall below $167.90 or the bid price must be above
$168.10 for there to be an arbitrage.

8)
Consider an ETF that is made up of one share each of IBM, MRK, and C. The current quote for this ETF currently is
$168.15 (bid) $168.20 (ask). What should you do?
Answer:

There is an arbitrage opportunity. Sell the ETF at the bid of $168.15 and buy the underlying securities at the ask prices. So
we have + 168.15 - 79.50 - 40.05 - 48.55 = .05 arbitrage profit per share

Chapter 4 - The Time Value of Money

3)
Which of the following statements is false?
A)

The process of moving a value or cash flow backward in time is known as discounting.
B)
FV =

C
(1 r )n
C)

The process of moving a value or cash flow forward in time is known as compounding.
D)

The value of a cash flow that is moved forward in time is known as its future value.
Answer:

Explanation:

A)

B)
FV = C(1 + r)n
C)

D)

8)
Consider the following timeline:

If the current market rate of interest is 9%, then the present value of this timeline as of year 0 is closest to:
A)

$492

$637

$600

$400

B)

C)

D)

Answer:

Explanation:

A)
PV = FV(1 + r)n
100 / (1.09)1 = 91.74
200 / (1.09)2 = 168.34
300 / (1.09)3 = 231.66
Sum = 491.74 which is approximately $492
B)

C)

D)

9)
Consider the following timeline:

If the current market rate of interest is 8%, then the value as of year 1 is closest to:
A)

$0

$1003

$540

$77

B)

C)

D)

Answer:

Explanation:

A)

B)

C)

D)
Two part problem:
FV = PV(1 + r)n = 500(1.08)1 = $540
PV = FV/(1 + r)n = -500 / (1.08)1 = -$463

So the answer is $540 + -$463 = $77

4.3 The Power of Compounding: An Application
2)
It has long been told that the Dutch purchased Manhattan island in 1626 for the value of 60 guilders ($24). Assuming that
the Dutch invested this money into an account earning 5%, approximately how much would their investment be worth
380 years later in 2006?
A)

$2.7 billion

$3.1 billion

$4.5 billion

B)

C)

D)

$1.9 trillion
Answer:

Explanation:

A)
FV = 24(1.05)380 = 2,704,860,602 or 2.7 billion
B)

C)

D)

2)
Which of the following statements is false?
A)

FV =

PV
(1 r )n
B)
N

PV =

n0

Cn
(1 r )n
C)

FV =

n0

Cn (1 + r)n
D)

Most investment opportunities have multiple cash flows that occur at different points in time.
Answer:

4)
Consider the following timeline detailing a stream of cash flows:

If the current market rate of interest is 10%, then the present value of this stream of cash flows is closest to:
A)

$674

$600

$460

B)

C)

D)

$287

Answer:

Explanation:

A)

B)

C)
PV = 100 / (1.10)1 + 100 / (1.10)2 + 200 / (1.10)3 + 200 / (1.10)4 = $460
D)

Use the information for the question(s) below.

Joe just inherited the family business, and having no desire to run the family business, he has decided to sell it to an
entrepreneur. In exchange for the family business, Joe has been offered an immediate payment of $100,000. Joe will also
receive payments of $50,000 in one year, $50,000 in two years, and $75,000 in three years. The current market rate of
interest for Joe is 6%.
6)
In terms of present value, how much will Joe receive for selling the family business?
Answer:

PV = $100,000 + $50,000 / (1.06)1 + $50,000 / (1.06)2 + $75,000 / (1.06)3 = $254,641

4.5 The Net Present Value of a Stream of Cash Flows

1)
You have been offered the following investment opportunity, if you pay $2500 today, you will receive $1000 at the end of
each of the next three years. Assuming that you could otherwise earn 10% per year on your money, the NPV for this
opportunity is closest to:
A)

$12

$18

B)

C)

-$13
D)

$500

Answer:

Explanation:

A)

B)

C)
NPV = -2500 + 1000 / (1.10)1 + 1000 / (1.10)2 + 1000 / (1.10)3 = -13.15 which is approximately -$13
D)

Use the information for the question(s) below.

Joe just inherited the family business, and having no desire to run the family business, he has decided to sell it to an
entrepreneur. In exchange for the family business, Joe has been offered an immediate payment of $100,000. Joe will also
receive payments of $50,000 in one year, $50,000 in two years, and $75,000 in three years. The current market rate of
interest for Joe is 6%.
4)
Suppose a second entrepreneur approaches Joe and offers him $250,000 today for the business. Should Joe accept the new
entrepreneur's offer or stick with the original offer of $100,000 and the series of payments over three years? Why?
Answer:

Joe should take the original offer of $100,000 + payments.

PV of the original offer = $100,000 + $50,000 / (1.06)1 + $50,000 / (1.06)2 + $75,000 / (1.06)3 = $254,641
So, the NPV of taking the second offer is $250,000 - $254,641 = -$4,641 Since the NPV is negative we would not take the
second offer.
Use the table for the question(s) below.
Year
0
1
2
3

A
-$150
40
80
100

B
-$225
175
125
-50

5)
If the interest rate is 10%, then which investment(s), if any, would you take and why?
Answer:

NPVA = -150 + 40 / (1.10)1 + 80 / (1.10)2 + 100 / (1.10)3 = $27.61

NPVB = -225 + 175 / (1.10)1 + 125 / (1.10)2 + -50 / (1.10)3 = -$0.17
Therefore, you should take A since NPVA > 0 and reject B since NPVB < 0.

1)

4.6 Perpetuities, Annuities, and Other Special Cases

Which of the following statements regarding perpetuities is false?

A)

To find the value of a perpetuity one cash flow at a time would take forever.
B)

A perpetuity is a stream of equal cash flows that occurs at regular intervals and lasts forever.
C)

PV of a perpetuity =

r
C

D)

One example of a perpetuity is the British government bond called a consol.

Answer:

Explanation:

A)

B)

C)
PV of a perpetuity =

C
r

D)

Use the information for the question(s) below.

Suppose that a young couple has just had their first baby and they wish to ensure that enough money will be available to
pay for their child's college education. Currently, college tuition, books, fees, and other costs, average $12,500 per year.
On average, tuition and other costs have historically increased at a rate of 4% per year.

8)
Assuming that college costs continue to increase an average of 4% per year and that all her college savings are invested in
an account paying 7% interest, then the amount of money she will need to have available at age 18 to pay for all four years
of her undergraduate education is closest to:
A)

$97,110

$107,532

$101,291

$50,000

B)

C)

D)

Answer:

Explanation:

A)
This is a two step problem.
Step #1 determine the cost of the first year of college.
FV = PV(1 + i)N = $12,500(1.04)18 = $25,322.71
Step #2 figure out the value for four years of college.
1

1 g

PV of a growing annuity due = C x r g 1 1 r (1 + r)

= $25,322.71

1
1 .04
1

.07 .04
1 .07

B)

(1 + .07) = $97,110.01

C)

D)

13)
Suppose that a young couple has just had their first baby and they wish to insure that enough money will be available to
pay for their child's college education. They decide to make deposits into an educational savings account on each of their
daughter's birthdays, starting with her first birthday. Assume that the educational savings account will return a constant
7%. The parents deposit $2000 on their daughter's first birthday and plan to increase the size of their deposits by 5% each
year. Assuming that the parents have already made the deposit for their daughter's 18th birthday, then the amount
available for the daughter's college expenses on her 18th birthday is closest to:
A)

$42,825

$97,331

$67,998

$103,063

B)

C)

D)

Answer:

Explanation:

A)

B)
FV of a growing annuity

1
1 .05
1
$2,000

.07 .05
1
.07

C)

18

(1.07)18= $97,331

D)

Use the information for the question(s) below.

Assume that you are 30 years old today, and that you are planning on retirement at age 65. Your current salary is $45,000
and you expect your salary to increase at a rate of 5% per year as long as you work. To save for your retirement, you plan
on making annual contributions to a retirement account. Your first contribution will be made on your 31st birthday and
will be 8% of this year's salary. Likewise, you expect to deposit 8% of your salary each year until you reach age 65.
Assume that the rate of interest is 7%.
17)
The present value (at age 30) of your retirement savings is closest to:
A)

$87,000

$108,000

$46,600

$75,230

B)

C)

D)

Answer:

Explanation:

A)
First deposit = .08 $45,000 = $3,600

1
1 .05
1
$3,600

.07 .05
1
.07

B)

C)

D)

35

= $87,003

26)
Assume that you are 30 years old today, and that you are planning on retiring at age 65. Your current salary is $45,000 and
you expect your salary to increase at a rate of 5% per year as long as you work. To save for your retirement, you plan on
making annual contributions to a retirement account. Your first contribution will be made on your 31 st birthday and will
be 8% of this year's salary. Likewise, you expect to deposit 8% of your salary each year until you reach age 65. At
retirement (age 65) you will begin withdrawing equal annual payments to pay for your living expenses during retirement
(on your 65th birthday). If you expect to die one day before your 101st birthday (Your last withdraw will be on your 100th
birthday) and if the annual rate of return is 7%, then how much money will you have to spend in each of your golden
years of retirement?
Answer:

$71,260
First deposit = .08 $45,000 = $3,600

1
1 .05
1
$3,600

.07 .05
1
.07

so,
N = 36
I=7
PV = 928,895
FV = 0
Compute PMT = 71260

35

(1.07)35= $928,895

4.8 Solving for Variables Other Than Present Value or Future Value
1)
You are interested in purchasing a new automobile that costs $35,000. The dealership offers you a special financing rate of
6% APR (0.5%) per month for 48 months. Assuming that you do not make a down payment on the auto and you take the
dealer's financing deal, then your monthly car payments would be closest to:
A)

$729

B)

$822

C)

$842

D)

$647

Answer:

Explanation:

A)

B)
PV = 35000
I = .5
N = 48
FV = 0
Compute Payment = $821.98
C)

D)

2)
You are considering purchasing a new home. You will need to borrow $250,000 to purchase the home. A mortgage
company offers you a 15 year fixed rate mortgage (180 months) at 9% APR (0.75% month). If you borrow the money from
this mortgage company, your monthly mortgage payment will be closest to:
A)

$2,585

$660

$2,535

$1,390

B)

C)

D)

Answer:

Explanation:

A)

B)

C)
PV = 250000
I = 0.75
N = 180
FV = 0
Compute PMT = $2535.67
4)
You are saving for retirement. To live comfortably, you decide that you will need $2.5 million dollars by the time you are
65. If today is your 30th birthday, and you decide, starting today, and on every birthday up to and including your 65th
birthday, that you will deposit the same amount into your savings account. Assuming the interest rate is 5%, the amount
that you must set aside each and every year on your birthday is closest to:
A)

$71,430

$27,680

$26,100

B)

C)

D)

$26,260

Answer:

Explanation:

A)

B)

C)
PV (age 29) = 2500000 / (1.05)36 = 431643.54
PV = 431,643.54
FV = 0
I=5
N = 36
Compute PMT = $26,086

5). You are looking for a new truck and see the following advertisement. "Own a new truck! No money down.
Just five easy annual payments of $8000." You know that you can get the same truck from the dealer across
town for only $31,120. The interest rate for the deal advertised is closest to:
A
)
9%

8%

8.5%

10%

B
)

C
)

D
)

An
sw
er:

Explanatio
n:
A)

PV =
31120
FV = 0
N=5
PMT =
-8000
Compute
I=
8.9965%