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AP/ADMS 3530 3.00 Finance

Midterm Sample Exam – Solutions

This exam consists of 40 multiple choice questions and carries a total of 40 marks.
Choose the response that best answers each question. Circle your answers below, and
fill in your answers on the bubble sheet. Only the bubble sheet is used to determine your
exam score. Please do not forget to write your name and ID # both at the top of this cover
page and on the bubble sheet. Also please write the type of your exam (X or Y) on the
bubble sheet.

Please note the following points:

1) Read the questions carefully and use your time efficiently.
2) Choose the answers that are closest to yours, because of possible rounding.
3) Keep at least 4 decimal places in your calculations and at least 2 in your final
answers and at least 6 for the interest rates.
4) Unless otherwise stated, interest rates are annual, and bonds pay semi-annual
coupons and have a face value (or par value) of $1,000.
5) You may use the back of the exam paper as your scrap paper.
6) Instructors and invigilators will not answer questions during the exam.

NUMERICAL QUESTIONS

1. Jeff plans to retire with $1,000,000 dollars at the age of 65. He is 25 years old and
currently has $10,000 already saved. How much more does he need to save at the end of
each year to reach his goal if the interest rate is 5%.
A) $9,265.14
B) $7,695.37
C) $8,278.16
D) $7,328.93
E) $7,883.96

Solution: B

FV = $1,000,000; PV = $10,000; N = 40; I/Y = 5%; CPT PMT = $7,695.37

Please use the following information for the next 2 Questions

The knowledge from your Finance course has made you aware about the power of
compounding. Considering that most employers no longer offer defined benefit
pensions, interest rates are at an all-time low, and increased life expectancy, you plan to
save for your retirement beginning from age 25 to age 65. Since your great-grandparents
lived to be 100, you would like to finance a retirement income of $60,000 per year (at the
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beginning of the year), from age 65 to 100. You believe you can earn 3% each year on
your savings.

2. How much should you have accumulated in your retirement account at the start of the
year when you turn 65.
A) $1,758,389
B) $1,707,174
C) $1,327,910
D) $1,289,233
E) $1,044,789

Solution: C

Retirement Years
N=35; I/Y = 3% ; FV = 0, PMT = $60,000 ; PV = ?
PV = $1,289,233.20
PV of Annuity Due = PV of Regular Annuity * (1+r)
PV of Annuity Due = $1,289,233.20 * (1.03) = $1,327,910

3. How much should you have accumulated in your retirement account at the start of the
year you turn 65, if you want the retirement income to increase at a rate of 2% per year to
keep up with inflation.
A) $1,829,653
B) $2,000,000
C) $1,735,635
D) $1,787,704
E) $1,352,475

Solution: D

, .
1
. . .

PV = $1,735,634.73
PV of Growing Annuity Due = PV of Regular Annuity * (1+r)
PV of Growing Annuity Due = $1,735,634.73 * (1.03) = $1,787,703.78

4. You intend to begin savings towards a home after graduation which is two years from
today. The plan is to make 3 deposits of $5000 at the end of the first 3 years after
graduation, followed by 2 annual deposits of $6000. The account offers a return of 6%.
What is the amount you will have saved when you make the last deposit?
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A) $27,000
B) $33,823
C) $28,185
D) $28,278
E) $30,245

Solution: E

First Annuity Stream

N = 3 ; I/Y = 6%; PV = 0; PMT = $5000 ; FV = ?
FV4 = $15,918.00
FV6 = FV4 8 (1*r)^2 = $15,918 * (1.06)^2 = $17,885.46

Second Annuity Stream

N = 2; I/Y = 6%; PV = 0; PMT = $6000; FV = ?
FV6 = $12,360.00

Total Savings in Year 6 = $17,885.46 + $12,360.00 = $30,245.46

5. Your grandmother is setting up a Trust fund for you that will provide $10,000 at the end
of each year for 30 years, starting 5 years from today. She wants the payments to
increase at a rate of 3%, and the return of the trust fund is 5.5%. How much should she
invest today?
A) $175,354.48
B) $205,193.72
C) $157,000.76
D) $165,635.80
E) $182,467.21

Solution: D
1
1
r g 1

, .
1
. . .

PV of Growing Annuity (at end of year 4) = $205,193.72

PV of Growing Annuity (in year 0) = $205,193.72/1.055^4 = $165,635.81

6. Cheryl’s new job requires driving and she is financing the purchase of a new car costing
$35,000. She makes a down payment of $6000 and finances the remainder with a 7-year
loan at a 5% APR with monthly compounding. What is her monthly payment?
A) $494.68
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B) $631.23
C) $357.43
D) $345.23
E) $409.88

Solution: E

PV = $29,000;
N= 12 * 7 = 84;
I/Y = 5%/12 = 0.416667%;
FV = 0; CPT PMT = $409.88

7. Laura wants to save money to provide for her retirement. Beginning one month from
today, she will start depositing a fixed amount into a retirement savings account that will
earn 9% compounded monthly. She will make 360 such deposits. Then, one year after
making her final deposit, she will withdraw $80,000 annually for 25 years. The account
will continue to earn 9% compounded monthly. How much should Laura deposit monthly
into her retirement savings account?
A) $289.85
B) $349.67
C) $416.34
D) $434.98
E) $459.83

Solution: C

Step 1: PV of annual withdrawals, using EAR

EAR = (1 + 0.09/12)12 – 1 = 9.38%
FV 0
PMT -80,000
I/Y 9.38
N 25
CPT PV = 762,214

Step 2: Monthly deposit

FV 762,214
PV 0
I/Y 0.75
N 360
CPT PMT = 416.34
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8. Robert and Eunice are arranging a $300,000 Canadian mortgage with a 25-year
amortization period and a 4.95 percent quoted interest rate. They agree to make monthly
mortgage payments, starting one month from today. Suppose the bank offers them the
opportunity to pay their monthly payments in four equal instalments (pay one-quarter of
the monthly payment every week). How long will it take them to pay off their mortgage if
they make weekly payments? Assume that there are fifty-two weeks in one year.
A) 16.50 years
B) 17.95 years
C) 19.80 years
D) 21.49 years
E) 25.00 years

Solution: D

Step 1: Monthly payment

EAR = (1 + 0.0495/2)2 – 1 = 5.0113%
rmonthly = (1 + 0.050113)1/12 – 1 = 0.4083%
FV 0
PV -300,000
I/Y 0.4083
N 300
CPT PMT = 1,736.27

Step 2: Weekly payment

Weekly payment = $1,736.27/4 = $434.07
r_weekly = (1 + 0.050113)1/52 – 1 = 0.0941%
FV 0
PV -300,000
I/Y 0.0941
PMT 434.07
CPT N = 1,117.25 weeks
N = 1,117.25/52 = 21.49 years

9. Gina bought a 2010 Ford Explorer for $8,000 with no money down. She agreed to make
weekly payments of $75 for three years, beginning one week after she bought the vehicle.
What is the EAR of this loan? Assume that there are fifty-two weeks in one year.
A) 21.73%
B) 23.55%
C) 27.43%
D) 30.97%
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E) 34.65%

Solution: D

FV 0
PMT 75
PV -8,000
N 156
CPT I/Y = 0.5202
EAR = (1 + 0.005202)52 - 1 = 30.97%

10. You have just won the lottery and would like to establish a trust fund that will provide
$125,000 in scholarships each year forever for York University students. The trust fund is
expected to earn a 6.65 percent rate of return. How much money must you set aside
today to fund the scholarships, if the first payment of $125,000 will be made three years
from today?
A) $1,333,125
B) $1,525,000
C) $1,652,596
D) $1,879,699
E) $2,004,699

Solution: C

PV = 125,000/0.0665 = $1,879,699
Today = 1,879,699/(1.0665)2 = $1,652,596

11. You are considering two savings options. Both options offer a 4 percent rate of return.
The first option is to save $1,200, $1,500, and $2,000 at the end of each year over the
next three years, respectively. The other option is to save one lump sum amount today. If
you want to have the same balance in your savings at the end of the three years,
regardless of the savings option you select, how much do you need to save today if you
select the lump sum option?
A) $4,318.67
B) $4,491.42
C) $4,551.78
D) $4,607.23
E) $4,857.92

Solution: A
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PV = 1,200/ (1.04) + 1,500/ (1.042) + 2,000/ (1.043)

= 1,153.85 + 1,386.83 + 1,777.99
= $4,318.67

12. In order to help you through your studies at York University, your parents just
deposited $25,000 into a bank account paying 8% interest. Starting tomorrow, you plan to
withdraw equal amounts from the account at the beginning of each of the next four years.
What is the most you can withdraw annually?
A) $6,125.43
B) $6,988.91
C) $7,133.84
D) $7,548.02
E) $8,154.71

Solution: B

Set BGN
FV 0
I/Y 8
PV -25,000
N 4
CPT PMT = 6,988.91

13. Your brother is short of cash and makes you the following offer. He will pay you back
the money he borrows today over the next 10 years. He will make yearly payments with
the first payment being for $1,000 at the end of this year. The payments will grow by 10%
every year thereafter. If the appropriate interest rate is 12%, how much would you be
willing to lend your brother today?
A) $5,650.22
B) $6,144.57
C) $8,244.22
D) $10,000.00
E) $50,000.00

Solution: C

PV = 1,000/ (0.12 – 0.10){1-[1.10/1.12]10} = $8,244.22

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14. How much should you pay for a $1,000 bond with a 6 percent coupon, semi-annual
payments, and five years to maturity if the interest rate is 4.5 percent?
A) $927.90
B) $981.40
C) $1,000.00
D) $1,066.50
E) $1,089.83

Solution: D

Using your calculator: FV=1,000; PMT=30; n=10; I/Y=2.25; COMP PV = 1,066.50

15. What is the coupon rate for a bond that has six years until maturity, sells for $1,096.63,
and has a yield to maturity of 7%? The bond's coupons are paid semi-annually.
A) 4.5%
B) 9.0%
C) 5.5%
D) 7.5%
E) 11%

Solution: B

Using your calculator (watch signs!): FV=1000; n=12; PV=-1096.63; I/Y=3.5;

COMP PMT = 45.0; Coupon rate = (45 x 2)/1000 = 9%

16. What happens to the price of a four-year bond with a 6 percent coupon (paying semi-
annually) when market interest rates change from 6 percent to 5 percent? The bond's
coupons are paid semi-annually.
A) A price increase of $35.85
B) A price decrease of $35.85
C) A price increase of $41.31
D) A price decrease of 41.31
E) No change in price

Solution: A

Using your calculator

When market interest rates = 6% bond trades at par or $1000
When market interest rates drop to 5%:
FV=1000; n=8; PMT=30; I/Y=2.5; COMP PV = 1035.85 (an increase of $35.85)
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17. What is the yield to maturity of a bond with the following characteristics? Coupon rate
is 8 percent with semi-annual payments; current price is $961.63, three years until
maturity.
A) 4.75%
B) 5.5%
C) 9.5%
D) 11.0%
E) 12.4%

Solution: C

Using your calculator (watch signs):

FV=1000; n=6; PV=-961.63; PMT= 40; COMP I/Y = 4.75%
YTM = (4.75 x 2)/1000 = 9.5%

18. You buy a bond with a 4% coupon (pays semi-annually), a seven-year maturity for
$970.26. If interest rates do not change and you sell the bond in one year, what will be
your annual rate of return (assume coupons are not reinvested).
A) 2.06%
B) 2.25%
C) 4.12%
D) 4.5%
E) 8.0%

Solution: D

If interest rates do not change, your annual rate of return will be the bond’s YTM:

Using your calculator: Step1: Find YTM today

FV=1000; n=14; PV=-970.26; PMT= 20; COMP I/Y = 2.25 x2 = 4.5%

To prove this you can do the following steps Step 2: Find the price in 1 year:
FV=1000; n=12; PMT= 20; I/Y = 2.25; COMP PV $973.96

Step 3: Find rate of return

= [(20 x2) + (973.96 – 970.26)]/970.26 = 43.70/970.26 = 4.5%

19. A bond that pays annual coupons is issued with a coupon rate of 4%, a maturity of 10
years and a yield to maturity of 6%. What rate of return will be earned by an investor who
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purchases the bond today and sells it after one year when market interest rates have
decreased to 5%?
A) 8.6%
B) 9.2%
C) 12.9%
D) 13.6%
E) 14.3%

Solution: D

Step 1: Find the price today FV=1000; n=10; PMT= 40; I/Y = 6; COMP PV $852.80

Step 2: Find the price in one year FV=1000; n=9; PMT= 40; I/Y = 5; COMP PV $928.92

Step 3: Find rate of return = [40 + (928.92 – 852.80)]/852.80 =116.12 /852.80= 13.62%

20. If you purchase a six-year, zero-coupon bond ($1,000 maturity value) for $666.34, how
much could it be sold for two years later if interest rates have remained stable? (assume
annual compounding)
A) $680.58
B) $762.89
C) $873.44
D) $925.63
E) $1000

Solution: B

Using your calculator, first calculate the original YTM

FV=1000; n=6; PMT=0; PV=-666.34; COMP I/Y = 7%
Now using the I/Y calculated above and change n to 4 (4 years left)
FV=1000; n=4; PMT=0; I/Y=8; COMP PV = $762.89

21. Lambada Corp. has just paid a $5 annual dividend. The dividend is projected to grow
at 5% per year indefinitely. If the stock sells today for $65.625, what is the required rate of
return on the stock?
A) 6.25%
B) 6.75%
C) 12.62%
D) 13.00%
E) 14.54%
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Solution: D

r = D1/P0 + g; where D1 = D0 x (1+g) = $5 x (1+ 0.05) = $5.25; P0 = $65.625;

g = 5%; therefore r = $5.25/$65.625 + 0.05; r = 13%

22. Sritana Corp. has just paid a $2 per share dividend. The dividend is projected to grow
at 3% per year forever. If the required rate of return on the stock is 9%, then by what
percentage does the price of the stock in year 1 exceed its price today?
A) 2.0%
B) 3.0%
C) 5.25%
D) 9.0%
E) 9.25%

Solution: B

Note that (P1 – P0) / P0 = (D2 - D1) / D1= g = 3%.

Or you can calculate P0 & P1 and calculate the difference

P0 = D1/(r - g) = $2 × 1.03 / (0.09 - 0.03) = $2.06 / 0.06 = $34.33
P1 = D2/(r - g) = ($2.06 × 1.03) / (0.09 - 0.03) = $35.36
% increase = (P1 – P0) / P0 = ($35.36 - $34.33) / $34.33 = 3%

23. Monago Corp. expects to have an EPS (earnings per share) of $5 next year; with a
dividend payout ratio of 30%. If the stock’s required return is 16%, and its ROE (return on
equity) is 20% then what is the current stock price of Monago?
A) $60
B) $65
C) $70
D) $75
E) $80

Solution: D

The next dividend will be $5 × 0.30 = $1.50 per share. The plowback ratio is 0.70
implying a growth rate g = Plowback Ratio × ROE = 0.70 × 20% = 14%

From the dividend growth model, the price of a share is:

P0 = D1 / (r – g) = $1.50 / (16% - 14%) = $75
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24. The dividends of Zirabi Corp. are forecasted to grow at 20% per year for the next three
years and thereafter at 6% forever. If the discount rate is 15% and a dividend of $2.50 was
just paid, what should be the current share price of Zirabi stock?
A) $11.52
B) $14.78
C) $17.90
D) $32.71
E) $41.63

Solution: E

g1, g2, g3 = 20%; g4 = 6%; DIV0 = 2.50

DIV1 = 2.50 x 1.20 = 3.00; DIV2 = 3.00 x 1.20 = 3.60; DIV3 = 3.60 x 1.20 = 4.32
DIV4 = 4.32 X 1.06 = 4.5792
P3 = DIV4/(r-g) = $4.5792/(.15-.06) = $50.88
P0 = 3.00/1.15 + 3.60/(1.15)2 +(4.32 + 50.88)/(1.15)3 = $41.63

25. What is the required rate of return on a stock if the dividend yield for Year 4 is 4%, the
constant dividend growth rate is 4%, and a $2 dividend per share was just paid?
A) 4%
B) 6%
C) 8%
D) 10%
E) 12%

Solution: C

Required Return = Dividend Yield + Growth Rate = Div + g = 4% + 4% = 8%

Po

26. What proportion of earnings is being paid out by the firm if the sustainable
growth rate is 6% and the firm's ROE is 18%?
A) 6%
B) 18%
C) 33%
D) 40%
E) 67%

Solution: E
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Growth rate (g) = ROE * plowback ratio; 6% = 18% × plowback ratio

plowback ratio = 6%/ 18% = 0.33 or 33.33%
therefore payback = 1 – plowback ratio = 66.67% or 67%

27. Assume the anticipated growth rate in dividends is constant for the stock of Julia Inc.
The expected value of the firm's stock four years from today is

I. D5 / (r – g)
II. P0 * (1 + g)4
III. D0 * (1 + g) / (r – g)

A) I only
B) II only
C) I and II only
D) I and III only
E) I, II, and III

Solution: C

The price of a stock at any point in time is the present value of all future cash flows
which in this case is the present value of all future dividends.

Using the dividend discount model the stock price in year P4 = D5 / (r – g) therefore
option I is correct.

The price of the stock is year 4 can also be calculated as the future value of the
stocks current price growing at g percent per year. Therefore P4 = P0 * (1 + g)4
therefore option II is also correct.

Option III is wrong because it calculates the price of the stock today P0.

CONCEPTUAL QUESTIONS

28.The Present Value of an Annuity rises when

A) The interest rate decreases
B) The number of payments increases
C) The amount of each payment increases
D) All the answers are correct
E) None of the answers are correct

Solution: D
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29. Kyristia Corp. pays a constant $2.50 a share annual dividend. The market price of this stock
will:
A) Be greater five years from now than it is today provided that the market rate of
return remains constant.
B) Remain constant even as the market rate of return varies.
C) Increase when the market rate of return increases.
D) Decrease if the required return increases.
E) Remain constant as long as the dividend remains constant irrespective of the
rates of return.

Solution: D

30. The discount rate that makes the present value of a bond's payments equal to its market price
is termed the:
A) Effective rate of return
B) Yield to maturity
C) Current yield
D) Coupon rate
E) Real rate of return

Solution: B

31. Which of the following is considered an appropriate corporate goal?

A) Maximization of profits
B) Minimization of costs
C) Maximization of sales
D) Minimization of agency costs
E) None of the above

Solution: E

32. Which of the following is false?

A) Effective Annual Rate is based on compounding
B) Annual Percentage Rate is based on simple interest
C) Present Values of Annuity Dues are larger than Regular Annuities
D) Real Interest Rate is usually larger than the Nominal Interest Rate
E) The larger the discount rate the smaller the Present Value.

Solution: D
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33. Which of the following statements concerning residential mortgages is false?

A) All else being the same, the monthly payment of an American mortgage is greater than that of
a Canadian mortgage.
B) If interest rate increases at the time of renewal, the monthly payment will increase.
C) The term of the mortgage is always shorter than the amortization period.
D) A Canadian bank’s quoted mortgage rate is APR with semi-annual compounding.
E) The total interest paid in the first year of the mortgage is greater than that of the second year.

Solution: C (Reason: it is possible to have a shorter amortization period than the term)

34. If the rate of interest increases, which the following statement is false?
A) The present value of an annuity due will decrease.
B) The future value of a constant growth annuity will increase.
C) The monthly payment of an existing car lease will increase.
D) The present value of a stream of uneven cash flow will decrease.
E) The present value of perpetuity will decrease.

Solution: C

35. Given a period rate, which of the following will contribute to a higher EAR?
A) More compounding
B) Less compounding
C) Longer time horizon
D) Shorter amortization
E) Longer term

Solution: A

36. Which of the following statements is true?

A) All else being the same, the present value of an annuity due is greater than that of an ordinary
annuity.
B) The EAR of monthly compounding bank account is always greater than the EAR of semi-
annual compounding account.
C) It is always cheaper to borrow at a lower APR with monthly compounding than a higher APR
with quarterly compounding.
D) The real rate of interest can never be zero.
E) Simple interest essentially means earning interest on interest.

Solution: A
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37. The AMX Company is a publicly traded company in Toronto. This morning the company’s
bond price suddenly dropped by more than 10%. Which of the following is a possible reason for
the drop in bond price?
A) The rate of interest has increased.
B) The bond rating of the bond has dropped.
C) The company announced this morning that it has suffered a huge loss in revenues.
D) All of the above can be a possible reason.
E) None of the above can be a possible reason.

Solution: D

38. A convertible bond is a bond that:

A) Can be converted at the bondholder’s option into the company’s shares before the maturity
date.
B) Can be converted at the company’s option into the company’s shares before the maturity
date.
C) Can be converted at the bondholder’s option into the company’s shares after the maturity
date.
D) Can be converted at the company’s option into another bond with shorter maturity date.
E) Can be converted at the company’s option into another bond with longer maturity date.

Solution: A

39. Which of the following statements concerning stocks is true?

A) The rate and length of the expected growth rate in cash dividends has a major impact on the
market price of the stock.
B) The price of the stock is zero if the company has never paid dividends.
C) The stock’s dividend will not grow if the payout ratio is 80% every year.
D) As discount rate increases, the stock price also increases.
E) All profitable companies are required to pay cash dividends.

Solution: A

40. What happens to a firm that reinvests 100% of its earnings every year?
A) Its dividend will grow at a constant rate per year.
B) Its dividend will not grow at a constant rate.
C) It will not pay dividends.
D) Its earnings will not grow.
E) Its plowback ratio is zero.

Solution: C