Busi 370 – Midterm Stuff

• The midterm exam is on Thursday, August 2 (6:30-8:45; 135

minutes) in HA 098.

Please arrive a few minutes early.

• We will have a “question and answer” session from 12-3 pm

(NOT 3-6 pm) on Sunday, July 29th in HA 098. Bring your class
notes, assignments, textbook and the practice midterm.

• We will “answer” any questions you have about Assignment #3,

go through any other questions that you have, and, go through
the practice midterm questions.

• I will be available for additional office hours on Thursday, August

2 from 2-6 (in my office HA 351). You can also e-mail me at
[email protected] or call me at 604-822-8533. If you e-
mail me, please include your phone number.

• Since no cell phones are permitted on the “table” during the

exam, ensure that you bring a watch to keep track of time (since
some rooms do not have clocks and there is no guarantee that
the computer in the room will be working).

• Please bring your student identification.

• You will get a “clean” formula sheet (same as the one included
here) with your exam.

• The format (not the questions) will be similar to the practice exam-
i.e., 10-15 multiple choice (one mark each); approximately 10
marks short answer and the rest, problems. If we haven’t
discussed it in class, it is not examinable.

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 BUSI 370 – PRACTICE MIDTERM EXAM
Time: 135 minutes Total Marks: 90
Name(Last,First): ___________________________ Student No. ________
Signature: _____________________________ Section No. __________
1. Please be careful to budget your time carefully so that you can attempt all the
questions.
2. Please do not ask any questions concerning the INTERPRETATION of the
questions. If you believe there is missing or incorrect information, state your
assumption and proceed.
3. Read the whole question before you start answering. Read carefully.
4. Unless indicated otherwise, take intermediate calculations to FOUR
decimal places- i.e., 0.0123 or 1.2345%. For capital budgeting, take
calculations of dollar amounts to the closest dollar (no cents needed).
You must show all keys punched in on your calculator (including −,
BEG, if applicable).
5. Multiple Choice questions and Formula Sheets are provided separately. Put
your name on BOTH of them and return them with your exam (ON TOP OF
THE EXAM).
6. You MUST show your work to get the marks.
7. If you write on the back of a page, please indicate so.
8. TURN YOUR CELL PHONES OFF AND PUT THEM AWAY (IN YOUR BAG
OR COAT). CELL PHONES ARE NOT PERMITTED ON THE TABLE.
9. Do NOT tear any pages out (unstaple and restaple, if you have to).
There are pages in this exam (including this cover page). Check to
ensure that you have all the pages before you start answering the questions.

Question 1 – Multiple Choice 11

Question 2 – Discuss/Written Answers 10
Question 3 – Foreign Exchange 7
Question 4 – Time Value of Money 25
Question 5 – Securities Valuation and CAPM 16
Question 6 – Securities Valuation (Bonds,
Preferred Shares, Common Shares) 16
Question 7 – Portfolio Risk/Return 5
TOTAL 90

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Question 1—11 Marks [suggested time 17 minutes]
The multiple choice questions are provided separately and WILL NOT BE RETURNED TO
YOU. Put your name on the multiple choice questions and turn it in with your exam.
NOTE: None of these multiple-choice questions requires the use of a calculator. CIRCLE (the
letter of) THE BEST ANSWER. DON’T LEAVE ANY QUESTIONS UNANSWERED; guess if
you have to. A strategy with multiple choice questions is to “eliminate the wrong
answer(s) and then choose the correct one. THERE IS NO PENALTY for incorrect answers.

The multiple choice questions have NOT been provided.

Question 2—10 Marks [suggested time 12 minutes]
The written questions have NOT been provided. Written questions are “short-answer”
(1 to 2 marks each).
Question 3— 7 Marks [suggested time 11 minutes]
Bob has $1,000,000 Canadian to invest for 6 months. His options include buying Canadian
government treasury bills with an interest rate of 3% and US government treasury bills offering
an effective interest rate of 2%.
Bob would have to pay $1.30 Canadian today to purchase $1 US.
Today Bob can sell $1 US forward for 6 months for $1.31.
Today Bob can sell $1 US forward 1 year for $1.32.
Required: [Please take all interim calculations to SIX decimal places. Your dollar
denominated answers should be rounded to the nearest dollar. You forward rate answer
should be rounded to four decimal places.]

(a) If Bob believes that both investment alternatives are risk free, which t-bill should he
purchase so as to maximize his return? [Be sure to indicate the dollar amount of the return
under both options]. [5 marks]
(b) What forward rate would we required to ensure that the Interest Rate Parity Theorem
holds? [2 marks]
Question 4—25 Marks [suggested time 40 minutes]
Part A: (11 marks)
In September of 1995 (the beginning of the 1995/96 academic year) the government of BC
froze tuition fees. The fees were “unfrozen” effective September 2002 and have increased
over the past few years. The Confederation of University Faculty Associations of BC made a
submission to the BC Government (October 15, 2004) highlighting the following information:
Actual BC Average If Fees Had Increased by
Academic Year Undergraduate Tuition the Rate of Inflation
(September – August) Fees
1995/96 $2,563 $2,563
1996/97 $2,577 $2,587
1997/98 $2,518 $2,606
1998/99 $2,525 $2,613
1999/00 $2,568 $2,641
2000/01 $2,592 $2,691
2001/02 $2,527 $2,736
2002/03 $3,176 $2,801
2003/04 $4,140 $2,860
2004/05 $4,735 $2,907
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Required:
(a) Calculate the average annual percentage increase in tuition fees over the entire period
highlighted above (academic year 1995/96 – 2004/05). (4 marks)

(b) What was the “real” annual percentage increase in tuition fees over the entire period
highlighted above. (4 marks)

(c) If tuition continues to rise at the annual rate calculated in (a) above, how long will it take for
tuition fees to double (from their current 2004/05 level)? (3 marks)

Part B: (4 marks)
A very well known furniture retailer frequently advertises “no money down and no interest until
2006!”

You want to buy some furniture now, and have a bit of spare cash available. You go to the
store on June 30, 2004 and purchase $20,000 of furniture. The credit terms that you agree to
are $2,000 down [paid June 30, 2004]; $1,000 per month for the next 18 months [commencing
July 31, 2004]; and no interest.

Your brother comes over for dinner. He likes your new furniture and wants to buy some just
like it. However, he would rather pay all cash when he buys it.

Required
If the current effective interest rate is 8%, what is the cash price that your brother should pay
for the furniture?

Part C: (5 marks)
Virgin Wireless (“VW”) has been in business for many years. VW sells its cell phones to its
customers for $150 (its cost is $75) and then charges them $20 per month for 1,000 minutes of
usage. VW would like to offer “free” cell phones if customers are willing to sign a 3-year
contract. If VW wants to earn an effective annual return of 10%, calculate its monthly fee
for the “free” cell phone (including 1,000 minutes of usage).

Part D: (5 marks)
You have decided to purchase a new car with a list price of $50,000 and now are trying to
decide how to finance the purchase. One option is to take a 60-month loan from a bank at 8%
and to pay cash for the car. If you pay cash, the dealer will give you a $1,500 discount (reduce
the list price by $1,500). Alternatively, the dealer is willing to sell you the car with the
agreement that you will make monthly payments of $950 for the next 5 years. Explain which
option of financing you should take. Show your calculations.

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Question 5—16 Marks [suggested time 24 minutes]
Part A: (9 marks)
Freddy Freeloader invested $1,000,000 one year ago. At that time, the risk free rate of return
was 6% and the “market price of risk” was 8%. The investments Freddy purchased and the
results he enjoyed are set out below:

Investment Beta at Cost Current market Income received at the end of the
purchase value year [dividends or interest]
1 1.25 $150,000 $140,000 $30,000
2 1.15 $200,000 $200,000 $26,000
3 .95 $250,000 $300,000 $3,000
4 .85 $400,000 $460,000 $0
Total $1,000,000 $1,100,000 $59,000

Required:
(a) What was the portfolio beta at the time of purchase? [4 marks]

(b) What was Freddy’s required return expressed both in dollars and as a percentage?
[2 marks]

(c) Has Freddy done better or worse than required? Be sure to support your answer
numerically. [3 marks]

Part B: (7 marks)
You are a stock analyst and much of your time is spent trying to identify shares that are either
underpriced or overpriced in order to better advise your clients. Two of the stocks that you
have recently concentrated your efforts on are those of the NHL and the CFL.

NHL’s annual dividend has grown at an average rate of 5% per year for the past 10 years and
you expect this growth rate to continue indefinitely. The most recent dividend paid by the NHL
was $1.20 per share, and its current share price is $22.00 (“correctly priced”).

CFL has paid a constant dividend of $0.70 per share during each of the past 10 years and you
believe it unlikely that the dividend will be increased any time soon. The beta of the common
shares of the CFL is 0.90.

The risk-free rate of return is 4% and the “market price of risk” is 6%.

Required (Space is provided on the next page for your answer)

a. What is the beta of the common shares of the NHL? (4 marks)

b. If the current price of a share of the CFL is $10, are the shares of the CFL overpriced or
underpriced? (3 marks)

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Question 6—16 Marks [suggested time 24 minutes]

PART A: (4 marks)
Preferred shares with a par value of $100 pay a 6% dividend. The dividend is paid annually.
The latest dividend was paid yesterday and investors are currently demanding a yield of 5% on
these preferred shares. Assume that you buy these shares today and sell them a year and
one day from now when the yield on these shares is 7%. What will have been your return
on these shares? (4 marks)

PART B: (6 marks)
Cartoon Corporation (“CC”) has recently witnessed a period of depressed earnings
performance. As a result, dividend payments have been suspended. Yearly dividend
payments will resume two years from now. At that time the dividend is expected to be $0.25.
A dividend of $X is expected to be paid in the year following that. Beyond the time when the
$X dividend is paid, investors expect CC’s dividends to grow at an annual rate of 5%
indefinitely. CC’s shares currently trade for $7.66 and investors require an 18% rate of return
on them. Calculate the value of the $X dividend expected to be paid. (6 marks)

PART C: (6 marks)
A perpetual bond promises to make the following payments:
$50 3 months from now
$100 6 months from now
$150 9 months from now
$200 12 months from now
$50 Every year thereafter indefinitely (beginning at the end of year 2)

You want to earn an effective annual yield of 8.24% on these bonds. What would you be
willing to pay for these bonds? (6 marks)

Question 7—5 Marks [suggested time 7 minutes]

Consider two stocks, A and B, with expected rates of return and standard deviations as
follows:
Security Expected Return Standard Deviation
A 9% 6%
B 15% 12%
REQUIRED:
(a) What is the expected rate of return if a two-security portfolio contains twice as much A as it
does B? (2 marks)

(b) What is the standard deviation of this two-security portfolio, assuming that the two
securities are perfectly negatively correlated. (2 marks)

(c) What are the “benefits of diversification” for the two-security portfolio in (a) above,
assuming that the two securities are perfectively positively correlated. (1 mark)

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 SOLUTIONS
Question 3
(a) Invest in Canada
Rate—3% x 6/12 = 1.5%
Invest—C$1,000,000[1.015] = C$1,015,0000
Invest in US
Rate—(1.02)1/2 – 1 = 0.9950%
Convert—C1,000,000÷C$1.30:1US = US$769,231

Invest.—US$769,231[1.009950] = US$776,885

Convert—US$776,885[C1.31:1US] = C$1,017,719
Decision—Invest in the US [1*] as the return is C$2,719 higher. [Expressing the
difference in USD is not acceptable—we are in Canada so the alternatives must be
evaluated in terms of our home currency.]
f 1 + rA
(b) AB
=
s AB 1 + rB

fAB ÷1.30 = 1.015÷1.009950ÎfAB = [1.015÷1.009950]1.30 = 1.3065

Question 4
Part A:
(a) (4,735 – 2,563) ÷ 2,563 = 84.74% over 9 years
Thus, annual increase = (1.8474)1/9 – 1 = 7.06%
OR (4,735 ÷ 2,563) 1/9 –1 = 7.06%
OR –2,563 PV
4,735 FV
9 N
I/YR = 7.06%

(b) Average inflation rate over the 9 year period:

(2,907 – 2,563) ÷ 2,563 = 13.42%
Thus, (1.1342) 1/9 – 1 = 1.41%
OR (2,907 ÷ 2,563) 1/9 –1 = 1.41%
OR –2,563 PV
2,907 FV
9 N
I/YR = 1.41%

Thus, real rate = (1.0706) ÷ (1.0141) – 1 = 5.57%

OR (4,735 ÷ 2,907) − 1 = 62.88%

(1.6288) 1/9 – 1 = 5.57%

(c) In order for fees to double, they must increase 100%.

–4,735 PV
9,470 FV
7.06% I/YR
N = 10.16 years

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Part B:
I/YR = (1.08)1/12 –1 = 0.6434% 18 N 1,000 PMT PV = $16,945

Cash equivalent price $16,945 + $2,000 = $18,945

Part C:
Effective monthly rate = (1.10)1/12 – 1 = .007974
150 PV
.7974 I/YR
36 N
PMT= 4.81
Thus, monthly fee = 20 + 4.81 = 24.81

Part D:
If pay cash, need to borrow $48,500 [50,000–1,500] at a monthly interest rate of 0.6667%
[8%÷12].
Approach 1 Approach 2 Approach 3
48,500 PV – 48,500 PV 950 PMT
.6667 I/YR 950 PMT 60 N
60 N 60 N .6667 I/YR
PMT = 983.41 I/YR = .5455 PV = 46,852
Bank has higher PMT .5455 x 12 = 6.546% APR Dealer has lower PV
Dealer is better Bank’s rate is higher (8% APR) Dealer is better
Dealer is better

Question 5
Part A:
(a)
1.25 $150,000 ÷ $1,000,000 0.1875
1.15 $200,000 ÷ $1,000,000 0.2300
.95 $250,000 ÷ $1,000,000 0.2375
.85 $400,000 ÷ $1,000,000 0.3400
0.9950
(b) rp = rf + (rm – rf)B = 6% + (8%)(.995) = 13.96%; $1,000,000 x 13.96% = $139,600

(c) Actual return = $1,100,000 − $1,000,000 + $59,000 = $159,000. Expected return [from
above] $139,600. Freddy has done better than required!

OR r = 59,000 + (1,100,000 – 1,000,000) = 15.9% which is better than CAPM’s 13.96%.

1,000,000

Part B:
NHL
r = D1/P0 + g = (1.2)(1.05)/22 + .05 = .1073
.1073 = .04 + Beta(.06)
Beta = (.1073 - .04)/.06 = 1.1217
CFL
r = .04 + (.9)(.06) = .094
P0 = (.70)/.094 = 7.45
Thus, the shares (at $10) are overpriced.
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Question 6
Part A:
Price today = (100 x .06) ÷ .05 = 120
Price one year from now = (100 x .06) ÷ .07 = 85.71

Return = [6 + (85.71 – 120)] ÷ 120 = –23.58%

Part B:
The price is the present value of all future dividends.
DIV1 = 0 and DIV2 = .25 and DIV3 = X
The price three years from now, P3 = (1.05X) ÷ (.18 – .05) = 8.0769X
7.66 = (0.25) ÷ (1.18)2 + (X + 8.0769X) ÷ 1.183
7.66 = 0.1795 + 5.5245X
X = $1.35

Part C:
Effective quarterly rate = (1.0824)1/4 – 1 = 2%

Thus, the present value of the first four payments is:

0 CF0
50 CF1
100 CF2
150 CF3
200 CF4
2 I/YR
2ndF NPV = 471.25

The present value of the perpetuity at the end of year 1 = 50 ÷ .0824 = 606.80
Thus, present value today = 606.80 ÷ 1.0824 = 560.61

Thus, you would be willing to pay 471.25 + 560.61 = $1031.86

Question 7

(a) A:B = 2:1 Thus, A = 2÷(2 + 1) = 2/3 and B = 1÷(2+1)= 1/3

(2/3)(9%) + (1/3)(15%) = 11%

(b) Standard deviation = [(2/3)2(6)2 + (1/3)2(12)2 + 2(2/3)(1/3)( –1)(6)(12)]1/2 = 0

(c) There will be no benefits to diversification since the stocks are perfectly positively
correlated.

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Name (Last, First) _____________________
FORMULA SHEET ─ BUSI 370 MIDTERM
Future value of a cash flow
FV = PV(1 + i)n

Present value of a cash flow

PV = FV/(1 + i)n

Future value of an annuity (USE YOUR CALCULATOR)

FV = A {[(1 + i)n –1]/i}

FVANNUITY DUE = FVREG ANNUITY × (1 + r)

Present value of an annuity (USE YOUR CALCULATOR)

PV = A {[1- 1/(1 + i)n]/i}

Present value of a perpetuity

PV = A1/i

PVANNUITY DUE = PVREG ANNUITY × (1 + i)

Effective annual rate of return

rannual = (1 + QR/m)m -1

Effective period rate of return

r = (1 + QR/m)m/f -1

Nominal Interest Rate [Fisher Formula]

(1 + nominal) = (1 + real) (1 + expected inflation)

Interest Rate Parity Relationship

fab/sab = (1 + ra) ÷ (1 + rb)

Dividend Discount Model

P0 = Σ Dt ÷ (1 + kc)t

DDM – No Growth-Rate [k or r]
P0 = D0 ÷ k

DDM – Constant-Growth-Rate [k or r]
P0 = D1 ÷ (kc − g) kc = (D1 ÷ P0) + g Pn = Dn+1 ÷ (kc − g)

Dividend Payout
Dividend Payout = Dividend/Common Share = Dividends
Earnings/Common Share (EPS) Net Income
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Sustainable Growth Rate
g = ROE x (1 – Payout ratio)

Total Return
TR = [CF1 + (P1 − P0)] ÷ P0 = [D1 + (P1 − P0)] ÷ P0

Expected Return
E(R) = ΣRipri

Variance of Returns
m
Variance of returns = σ 2 = ∑ [Ri − E ( R)] pri
2

i =1

Standard Deviation of Returns

Standard deviation of returns = σ = σ 2

Coefficient of Variation
Standard deviation ÷ Expected return

Portfolio Expected Return

E(Rp) = ΣwiE(Ri)

Portfolio Risk
σ P = w A2 σ A2 + wB2 σ B2 + 2w A wB ρ ABσ Aσ B

Required Rate of Return [CAPM]

RCAPM = rf + Beta (rm – rf)

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