Name:________________________________

Student #:_____________________________

Financial Management

NTU

Midterm Exam

April 10, 2024

Please remember to write your name on the top of this page.

This exam is worth 30% of your final grade. The work on this exam must be entirely your own.
Calculators are allowed during the exam.

This exam consists of two sections:

SECTION I (40%): For each question, please choose one answer and write it down in the provided
table: “Answer to Table I”. Answers not written in this table will NOT be graded.

SECTION II (60%): For each question, please write clearly and show your work (including setting
up the correct formula before you use a calculator). In case you are constrained by time or cannot
solve the formula for the exact solution, partial credit will be given for setting up the correct
formula. NO credit will be given for a correct answer without any supporting work.
Section I: Multiple Choice Questions (40%)
1. Which of the following is false regarding the dividend discount model for stock valuation?
a. It considers both the potential of capital gains yield and dividend yield.
b. Stock price is the sum of the present values of all future expected dividends.
c. Under growing perpetuity, the model is sensitive to small changes in the assumption of
growth rate.
d. One cannot use the dividend discount model to value young firms that are not paying
out dividends.
e. None of the above.

2. Which of the following is false regarding using P/E ratios to value stocks? Consider your
answer under the constant dividend growth model (all else equal except the variable in
question):
a. P/E ratios are higher for stocks with higher risk.
b. P/E ratios are higher for stocks with higher expected growth rates.
c. P/E ratios are higher for stocks with lower investment needs.
d. P/E ratios are higher for stocks with higher dividend payout ratios.
e. None of the above.

3. Colgate-Palmolive Company has just paid an annual dividend of $0.96. Analysts are predicting
an 11% per year growth rate in earnings over the next 5 years. After then, Colgate’s earnings
are expected to grow at the current industry average of 5.2% per year. If Colgate’s equity cost
of capital is 8.5% per year and its dividend payout ratio remains constant, for what price does
the dividend discount model predict Colgate stock should sell? [Slides]
a. $36.75
b. $38.49
c. $39.44
d. $41.33

4. Which of the following is false regarding IRR?

a. IRR may not provide a unique number.
b. IRR is hard to interpret when dealing with non-conventional cash flows.
c. IRR is useful in comparing mutually exclusive projects.
d. IRR is useful in informing how much error we can make in estimating discount rates.
e. None of the above.

5. Which of the following is false regarding stock valuation? Consider your answer under the
dividend discount model:
a. The proper discount rate to use in this model represents the expected return investors
can get for other financial instruments with similar risk.
b. One disadvantage of the dividend discount model is it ignores capital gains yield.
c. If a firm invest retained earnings in projects with expected returns higher than the
equity cost of capital, the stock price is expected to increase when dividend payouts
decrease.
d. The proper discount rate is typically higher than the market risk-free rate.
e. None of the above.
6. Recently, Ohio Hospitals Inc. filed for bankruptcy. The firm was reorganized as American
Hospitals Inc., and the court permitted a new indenture on an outstanding bond issue to be put
into effect. The issue has 10 years to maturity and a coupon rate of 10%, paid annually. The
face value is $1,000. The new agreement allows the firm to pay no interest for 5 years. Then,
interest payments will be resumed for the next 5 years. Finally, at maturity (Year 10), the
principal plus the interest that was not paid during the first 5 years will be paid. However, no
interest will be paid on the deferred interest. If the required annual return is 20 percent, what
should the bonds sell for in the market today?
a. $242.26
b. $281.69
c. $578.31
d. $362.44
e. $813.69

7. You are running a hot Internet company. Analysts predict that its earnings will grow at 30%
per year for the next five years. After that, as competition increases, earnings growth is
expected to slow to 2% per year and continue at that level forever. Your company has just
announced earnings of $1,000,000. What is the present value of all future earnings if the
interest rate is 8%? (Choose the closest answer. Assume all cash flows occur at the end of the
year.) [HW]
a. 18.6 million
b. 24.7 million
c. 38.2 million
d. 46.9 million
e. 51.9 million

8. Suppose a security with a risk-free cash flow of $150 in one year trades for $140 today. If there
are no arbitrage opportunities, what is the current risk-free interest rate? [HW]
a. 5.28%
b. 6.30%
c. 7.14%
d. 8.68%
e. 9.91%

9. Which of the following if false regarding the term structure of interest rates:
a. If the market expects future spot yields to remain constant, we’ll typically see an
upward sloping yield curve today.
b. Interest rate risk is the sensitivity of bond prices to yield movements.
c. All else equal, if the market expects future spot yields to increase, we tend to observe
upward sloping yield curves today.
d. Forward rates can be viewed as the market’s expectation today of future spot rates.
e. None of the above.
10. You are thinking about investing in a mine that will produce $10,000 worth of ore in the first
year. As the ore closest to the surface is removed it will become more difficult to extract the
ore. Therefore, the value of the ore that you mine will decline at a rate of 8% per year forever.
If the appropriate interest rate is 6%, then the value of this mining operation is closest to:
a. $71,429
b. $500,000
c. $166,667
d. $231,211
e. This problem cannot be solved.

Answer to Part I:

1 2 3 4 5

6 7 8 9 10
Section II: Short Answer Questions
1. (10%) Mack Industries just paid a dividend of $1.00 per share (i.e., D0 = $1.00). Analysts
expect the company's dividend to grow 20 percent this year (i.e., D1 = $1.20), and 15 percent
next year. After two years the dividend is expected to grow at a constant rate of 5 percent.
The required rate of return on the company's stock is 12 percent. What should be the current
price of the company's stock?

1.2 1.2 ∗ 1.15 1.2 ∗ 1.15 ∗ 1.05 1

+ '
+ ∗ = 18.67347
1.12 1.12 0.12 − 0.05 1.12'

2. (10%) Elmdale Enterprises is deciding whether to expand its production facilities. Although
long-term cash flows are difficult to estimate, management has projected the following cash
flows for the first two years (in millions of dollars):

a. What are the incremental earnings for this project for years 1 and 2?
b. What are the free cash flows for this project for the first two years?
a.
Year 1 2
Incremental Earnings Forecast ($000s)
1 Sales 125.0 160.0
2 Costs of good sold and operating expenses other than depreciation (40.0) (60.0)
3 Depreciation (25.0) (36.0)
4 EBIT 60.0 64.0
5 Income tax at 35% (21.0) (22.4)
6 Unlevered Net Income 39.0 41.6
b.
Free Cash Flow ($000s) 1 2
7 Plus: Depreciation 25.0 36.0
8 Less: Capital Expenditures (30.0) (40.0)
9 Less: Increases in NWC (5.0) (8.0)
10 Free Cash Flow 29.0 29.6
3. (10%) What is the duration of a security with a 4-year maturity that pays $100 every year-end?
Assume currently the yield is 10%.

100 1
𝑃= 31 − 7 = 316.99
10% (1 + 10%)6
100 100 100 100
1 × B 1.1 C + 2 × B ' C + 3 × B D C + 4 × B 6 C
𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 1.1 1.1 1.1 = 2.38
316.99

4. (10%) Suppose you are an investment banker and a client wants to enter a forward contract
with the bank now to borrow $20M over a one year period that starts three years from now.
Assume both the client and the bank have good credit so that you could treat all cash flows as
risk free. Currently, the treasury yield curve is as follows:

Maturity 1 2 3 4

Yield 0.05 0.06 0.065 0.07

a. What is the rate you could quote on this forward contract? (assuming zero profit for the
bank)

(1 + 𝑟D )D (1 + 𝑓) = (1 + 𝑟6 )6
(1 + 0.065)D (1 + 𝑓) = (1 + 0.07)6
∴ 𝑓 = 8.51%

b. How would you use the exiting treasury bonds to design this forward contract?

Buy 20M of 3-year bond, cost 20M/(1+0.0065)^3 = 16.556M

Finance this by short-selling 4-year bond, get 16.556M today
5. (10%) What factors explain the shape of a yield curve? List a least two distinct factors and
discuss briefly the intuitive behind them. Your explanation needs to be clear enough that a
person without much finance training would understand.

(1) Expectation for future short-term interest rates

(2) Interest rate risk

6. (10%) Consider the following bonds (assuming face values are $1000 for all four bonds):

a. What is the percentage change in the price of each bond if its yield to maturity falls from 6% to 5%?

We can compute the price of each bond at each YTM using Eq. 8.5. For example, with a 6% YTM, the
price of bond A per $100 face value is
100
P(bond A, 6% YTM) = = $41.73.
1.0615
1 æ 1 ö 100
The price of bond D is P(bond D, 6% YTM) = 8 ´ ç1 - ÷+ = $114.72.
.06 è 1.0610 ø 1.0610
One can also use the Excel formula to compute the price: –PV(YTM, NPER, PMT, FV).
Once we compute the price of each bond for each YTM, we can compute the % price change as Percent
change =
( Price at 5% YTM ) - ( Price at 6% YTM )
.
( Price at 6% YTM )
The results are shown in the table below.
Bond Coupon Rate Maturity Price at 6% Price at 5% Percentage Change
YTM YTM
(annual payments) (years)
A 0% 15 $41.73 $48.10 15.3%
B 0% 10 $55.84 $61.39 9.9%
C 4% 15 $80.58 $89.62 11.2%
D 8% 10 $114.72 $123.17 7.4%

b. Which of the bonds A–D is most sensitive to a 1% drop in interest rates from 6% to 5% and why?
Which bond is least sensitive? Provide an intuitive explanation for your answer.
 Bond A is most sensitive, because it has the longest maturity and no coupons. Bond D is the least.
sensitive. Intuitively, higher coupon rates and a shorter maturity typically lower a bond’s interest rate
sensitivity.
[HW]