Answer to FIN 401 Exam 2 Fall 2015

Group A (3 Points 10 = 30 Points)

1. The interest rate charged per period multiplied by the number of periods per year is called the
__________ rate.
a. periodic interest
b. compound interest
c. effective annual
d. annual percentage
2.

You are comparing two annuities which offer monthly payments for ten years. Both annuities are
identical with the exception of the payment dates. Annuity A pays on the last day of each month
while annuity B pays on the first day of each month. Which one of the following statements is
CORRECT concerning these two annuities?
a.
Annuity A has a higher future value than annuity B in ten years.
b.
Annuity B has a higher future value than annuity A in ten years.
c.
Annuity A and annuity B have the same present value.
d.
Annuity A has a higher present value than annuity B.

3. You are considering borrowing money from a bank. The Citizen bank offers a loan with APR
5.25% and monthly compounding. The Chase Bank offers a loan with APR 5.3% and semiannual
compounding. Which bank should you borrow your money?
a. You should borrow from the Chase bank because it offers higher APR.
b. You should borrow from the Citizen bank because it offers lower ARR.
c. You should borrow from the Chase bank because it offers lower EAR.
d. You should borrow from the Citizen bank because it offers lower EAR.

4. Live Forever Life Insurance Co. is selling a perpetuity contract that pays $300 semiannually. If
the required rate of return on this investment is 12% per year, how much are you willing to pay
for this contract today?
a. $300
b. $600
c. $2,500
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d. $5,000
5. Which one of the following bonds has the lowest price risk?
a. 3-year; 2 percent coupon
b. 3-year; 10 percent coupon
c. 10-year; 2 percent coupon
d. 10-year; 10 percent coupon
6. Your broker offers you the opportunity to purchase a bond with coupon payments of
$60 per year and a face value of $1000. If the yield to maturity on similar bonds is
7% per year, this bond should:
a. Sell at a discount.
b. Sell at a premium.
c. Sell for either a premium or a discount but its impossible to tell which.
d. Sell for par value.
7. All else constant, as the market price of bond decreases the current yield _______ and the yield to
maturity ________
a. increases; increases.
b. increases; decreases.
c. decreases; decreases.
d. decreases; increases.

8. The Good Life offers a common stock that pays a quarterly dividend of $2 a share.
The company has promised to maintain a constant dividend forever. How much are
you willing to pay for one share of this stock if you want to earn a 8% return per year?
a. $2
b. $25
c. $80
d. $100

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9. Apocalyptica Corp. pays a constant $10 dividend per year on its stock. The company
will maintain this dividend for the next 10 years and will then stop paying
dividends forever. If the required return on this stock is 10% per year, what is the
current share price?
a.
b.
c.
d.

$20
$28.80
$61.45
$100

10. All else constant, as the growth rate of dividends increases, the stock value will _____; as the
stockholders required rate of return increases, the stock value will _______.
a. increases; increases
b. increases; decreases
c. decreases; increases
d. decreases; decreases

Group B (70 Points)

1. [14 Points] Seaborn Co. has identified an investment project with the following cash flows:
$950 one year from now, $1,050 two years from now, $1,200 three years from now, and $1,350
four years from now. If the discount rate is 10%, what is the present value of these cash flows?
Answer:
1) Use formula:
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$950
$1,050
$1,200
$1,350

$3,555.05
2
3
(1 10%) (1 10%)
(1 10%)
(1 10%) 4
2) Use financial calculator:
1 N, 10 I/Y, 950 FV, CPT PV = -863.64
2 N, 10 I/Y, 1,050 FV, CPT PV = -867.77
3 N, 10 I/Y, 1,200 FV, CPT PV = -901.58
4 N, 10 I/Y, 1,350 FV, CPT PV = -922.07
$863.64 + $867.77 + $901.58 + $922.07 = $3,555.06
CF, CF0=0, C01=950, F01=1, C02=1,050, F02=1, C03=1,200, F03=1, C04=1,350, F04=1,
NPV, I = 10, CPT NPV = 3,555.05
2. [14 Points] You want to borrow $20,000 from your local bank to buy a new car. Suppose the
APR for the car loan that you can borrow is 6%. The term of the loan is 5 years. The local bank
requires you to make your payment at the end of each month for five years, how much should
you pay each month? Also, please fill in the following amortization table of the loan for the
first month and show your calculations in detail.

Month

Beginning of

Monthly

Month loan
Balance
$20,000

Interest

Scheduled

End of Month

Payment

Principal

Loan Balance

$386.66

Repayment
$286.66

$19,713.34

$100

1) Use formula:

1 (1 6% / 12) 512
$20,000 C
; C $386.66
6% / 12

2) Use financial calculator:

512=60 N; 6/12=0.5 I/Y; 20,000 PV; CPT PMT=-386.66
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Interest = $20,000 0.5% = $100

Scheduled principal repayment = $386.66 - $100 = $286.66
End of month loan balance = $20,000 - $286.66 = $19,713.34
3. [14 Points] You are planning to save for retirement over the next 35 years. To do this, you will
invest $500 a month in a stock account and $300 a month in a bond account. The return of the
stock account is expected to be 9% per year, and the bond account will pay 6% per year. When
you retire 35 years later, you will combine your money into an account with a 3% return per
year. How much can you withdraw each month from your account assuming a 20-year
withdrawal period?
Answer:
1) Use formula:

Stock account:

Bond account:

(1 9% / 12)3512 1
$1,470,892.24
9
%
/
12

FVA $500

(1 6% / 12)3512 1
$427,413.09
6% / 12

FVA $300

So, the total amount saved at retirement is:

$1,470,892.24 + 427,413.09 = $1,898,305.33
Solving for the withdrawal amount in retirement using the PVA equation gives us:

1 (1 3% / 12) 2012
$1,898,305.33 C
; C $10,527.96
3% / 12

2) Use financial calculator:

Stock account: 420 N, 9/12 = 0.75 I/Y, -500 PMT, CPT FV = 1,470,892.24
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Bond account: 420 N, 6/12 = 0.5 I/Y, -300 PMT, CPT FV = 427,413.09
So, the total amount saved at retirement is:
$1,470,892.24 + 427,413.09 = $1,898,305.33
Solving for the withdrawal amount in retirement using the PVA equation:
240 N, 3/12 = 0.25 I/Y, 1,898,305.33 PV, CPT PMT = - 10,527.96
You can withdraw $ 10,527.96 each month.
4. [14 Points] Five Star Co. wants to issue new 15-year bonds for an expansion project. The
company currently has 8% (annual coupon rate) coupon bonds on the market that sell at par,
make semiannual payments, and mature in 15 years. The par value of bonds is $1,000. If the
company wants to sell its new bonds for 110, what should the coupon rate be for new bonds?
Suppose that the par value of new bonds is also $1,000.
Answer:
1) Use formula:
Since the current bond is selling at par, the yield to maturity is equal to the coupon rate, 8%.
Also, both bonds are issued by the same company and therefore they have the similar risk
level. Moreover, both bonds have the same years to maturity. Based on the bond pricing
theorem, both bonds should have the same yield to maturity. Hence, the yield to maturity for
the newly issued bond should be 8%.
Bond price = 110%$1,000 = $1,100

$1,100 $C

1
(1 8% / 2) 30
(8% / 2)

$1,000
(1 8% / 2) 30

$C $45.78
c

$45.78 2
9.16%
$1,000

2) Use financial calculator:

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30 N, 4 I/Y, -1,100 PV, 1000 FV, CPT PMT = 45.78

Coupon rate = ($45.78 2) / $1,000 = 9.16%
The coupon rate for the new bond should be 9.16%.
5. [14 Points] Bread, Inc. just paid dividend of $2 per share and is expected to maintain a
constant 5% growth rate per year in its dividends indefinitely. Suppose the required rate of
return on the companys stock is 15% per year, how much will you pay for the companys
stock today? How much will the stock price be in 2 years based on your prediction?
Answer:
P0

D1
$2 (1 5%)

$21
rg
15% 5%

P2

D3
$2 (1 5%) 3

$23.15
rg
15% 5%

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