UNIVERSITY OF TORONTO

Joseph L. Rotman School of Management

Oct. 27, 2015 Burke/Daroga/Jeon

RSM332 MID-TERM EXAMINATION Kan/Liang

DURATION - 2 hours
Aid Allowed: Silent electronic calculator and one 1-sided 8 12 11 crib sheet

Name: Student Number:

Circle the section that you are registered in:
Burke Daroga (Thu. 46p.m.) Daroga (Thu. 68p.m.)
Jeon Kan (Mon. 11a.m.1p.m.) Kan (Mon. 2p.m.4p.m.)
Kan (Tue.) Liang (Wed. 10a.m.12p.m.) Liang (Wed. 3p.m.5p.m.)

Instructions
1. Write all your answers on the examination paper.
2. Answer five out of six questions. Each question is worth 20 marks. Do not answer all
six questions! In the table below, cross out the question that you choose not to answer.

Question Marks

1
2
3
4
5
6

Total

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1. Consider the following excerpt for parts (a)(b):

Tony Robbins: Pizza is Key to Retirement for Millennials, Nicole

Goodkind (Yahoo! Finance, October 19, 2015)
... And despite economic constraints, millennials should be able to set them-
selves up for a healthy retirement, says Robbins. All you have to do is eat
pizza once a week instead of at a restaurant which should save about $50.
$50 a week over the course of the year times 10% compounded over 30 years
is $500,000. Millennials have time on their side and shouldnt underesti-
mate the power of compounding saving a tiny bit of money here and there
and investing it wisely in a 401(k) or IRA could make a huge difference 30
or 40 years down the line.

(a) Assume that the interest rate of 10%/year is an effective annual rate. For simplicity,
we assume that there are exactly 52 weeks in each year. Suppose that you save $50
a week, starting a week from today, how much money will you have in 30 years?
(5 marks)
(b) Repeat the same exercise in part (a) but instead assume the interest rate of
10%/year is continuously compounded. (5 marks)
(c) You obtain a $300,000 mortgage loan from TD Canada Trust to buy a house. The
mortgage has a 10-year fixed rate of 5%/year (using Canadian mortgage convention),
and the amortization period of the mortgage is 20 years. What is the monthly mortgage
payment? (5 marks)
(d) Consider the 12th monthly payment for the mortgage in part (c), how much of it
is for interest, and how much of it is for principal repayment? (5 marks)

2. Suppose you have the following utility function

1 2
U (C0 , C1 ) = C03 C13 ,

where C0 is todays consumption and C1 is tomorrows consumption. You are endowed

with Y0 = 0 units of goods today and Y1 = 10 units of goods tomorrow. There is a
production opportunity
that if I0 is invested today, then the output tomorrow would
be f (I0 ) = 10 I0 . In addition, you have access to a capital market where you can
borrow or lend at an interest rate of r = 10%.
(a) What is the optimal amount of investment that you should make? (3 marks)
(b) What is your optimal consumption plan? (7 marks)
(c) Suppose that the government introduces a tax of 30% on the total output of the in-
vestment. That is, instead of receiving 10 I0 , you will only receive (1 0.3) 10 I0 .
Does Fishers separation still hold? What is the optimal amount of investment now?
(5 marks)

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 (d) Now assume that the government also provides a capital investment tax credit of
10% to business, i.e., the tax collected by the government at t = 1 will be 0.310 I0
0.1I0 . What is the optimal amount of investment? (5 marks)
3. The current spot rates for 1-year to 3-year maturity are given by r1 = 3%, r2 = 4%,
and r3 = 5%.
(a) What are the forward rates for second year and third year (i.e., f2 and f3 )?
(4 marks)
(b) Suppose your friend offers you a forward contract that allows you to borrow (or
lend) $100 at t = 1 and pay back (or receive the proceeds) at t = 3, with the interest
rate being fixed today. What is the fair interest rate (on an annualized basis) for this
forward contract? (6 marks)
(c) Suppose your friend allows you to enter into the forward contract in part (b)
with an interest rate of 5%/year. Suppose you can trade zero-coupon bonds for any
dollar amount. Construct a trading strategy so that you can earn an arbitrage profit.
(10 marks)
4. You just turned 24 years old and would like to start saving for your dream car which you
plan to buy on your 30th birthday. You have placed $15,000 in a locked-in investment
account.
(a) If you expect the car to cost $90,000 in 6 years, what annual rate of return are you
required to earn in your locked-in investment account? (2 marks)
(b) Suppose that starting on the day of your 25th birthday you begin making deposits
of $975 into a separate savings account. The first deposit occurs on your 25th birthday
and you will continue to make deposits every 2 months up to and including your 30th
birthday. The savings account offers a guaranteed rate of return of 6% per annum
compounded monthly. What is the new required annual rate of return you need to earn
in your locked-in investment account to be able to afford your dream car? (8 marks)
(c) You just turned 30 years old and it turns out that your savings and lock-in in-
vestment account only have a combined value of $70,000, so you need to take out an
auto-loan of $20,000 so you can still purchase your dream car. The car dealer offers
you 2 choices of financing:
Choice 1: 4 year loan that charges 10% per annum compounded monthly with monthly
payments
Choice 2: 4 year loan that charges 9.9681% per annum compounded weekly with weekly
payments (assume that there are 52 weeks in a year).
Show that both choices have the same effective annual rate. (3 marks)
(d) What is the total interest payments under each one of the two choices? (7 marks)
5. A riskless pure discount (i.e., zero-coupon) Government of Canada bond that matures
on 27 October 2017, i.e., a 2-year bond, trades today at $90 (for a face value of $100).

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 A similar Government of Canada pure discount bond that matures on 27 October 2018
trades today at $86 (for a face value of $100). In dealing with the following questions,
you may assume that the Expectations Hypothesis holds.
(a) What is the yield-to-maturity (expressed in annual terms) on the 2-year bond?
(3 marks)
(b) What is the expected 1-year spot rate at the end of year 2? (4 marks)
(c) If the expected one-year spot rate at the end of year 3 (i.e., 27 October 2018) is 4
percent, what is the price today of a pure discount bond that matures on 27 October
2019, i.e., a 4-year bond, with a face value of $100? (4 marks)
(d) Assume the Government announces a scheme to pay one dollar per 100 dollars
of face value on its heretofore pure discount bonds. These additional one dollar per
hundred payments would be made every year that the bond is outstanding with the
final payment of one dollar per hundred paid at the time of maturity of the bond.
The first payments under this scheme would be made on 27 October 2017 (2 years
from today). What would be the price of the 3-year bond? (4 marks)
(e) In view of the term structure of the interest rates that you have calculated in (a)
(c) and subsequent to the announcement of the additional one dollar per hundred
payments, would you expect the 3-year pure discount bond or the 4-year pure discount
bond to have a higher yield-to-maturity? Explain your answer without calculating
the yields-to-maturity of the 3-year and 4-year bonds. Note that these bonds are no
longer pure discount bonds subsequent to the one dollar per hundred announcement.
(5 marks)

6. (a) Microsoft paid a dividend of $0.36 a month ago. Suppose you believe Microsoft
will continue to pay a dividend of $0.36/quarter indefinitely, with the next dividend
arriving in 2 months. What is the theoretical price of Microsoft if the effective annual
discount rate is 6%/year? (5 marks)
(b) The current annual earnings of Netflix is $0.38/share. Its stock price is $98/share.
Assuming a discount rate of 10%/year, what is the net present value per share of the
growth opportunity (NPVGO) of Netflix? (5 marks)
(c) PEG Ratio: A companys price-earnings-growth (PEG) ratio is calculated by
dividing the P/E ratio by the percentage growth rate in earnings. For example, a
company with a P/E ratio of 100 and an earnings growth rate of 25% has a PEG ratio
of 4.
Trent Enterprises just reported earnings of $2/share and paid its annual dividends. It
plans to retain 40% of its earnings for investments and pays out 60% of the earnings
as dividends. The historical return on equity (ROE) was 15%/year, a figure that is
expected to continue into the future. The appropriate discount rate for its stock is
12%. Suppose the stock price is obtained by using the Gordon model (i.e., dividend
growth model), what is the PEG ratio of Trent Enterprises? (6 marks)

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(d) Suppose Microsoft has a PEG ratio of 3.9 and Netflix has a PEG ratio of 2.5. Does
that mean Netflix is a better buy than Microsoft? Explain your answer. (4 marks)