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University of Toronto
Rotman School of Management
RSM230H1S – Financial Markets
Midterm Examination – February 17, 2017

Midterm Details

Duration: 110 minutes (1 hour 50 minutes)
Total number of pages: 11 (double-sided; including this cover page)
Total number of marks: 87


 Please write clearly. Illegible responses may result in a mark of zero.
 When giving a quantitative answer, please show your supporting calculations. For non-
quantitative questions, you may answer in point form, if appropriate.
 Aids allowed: one double-sided letter-sized (8.5"x11") page of notes and use of non-
programmable calculators will be permitted.
 You may use a pen and/or pencil. However, any contents written in pencil or over white-out will
NOT be remarked.
 You may not leave during the first 30 minutes, or the last 15 minutes of this midterm.

Total marks allocated as follows:
Question Marks Achieved Question Marks Achieved
MCQ: Prob 1:
SA 1: Prob 2:
SA 2: Prob 3:
SA 3: Prob 4:
SA 4: Prob 5:
SA 5: Prob 6:
SA 6:
Total Marks /87

Please clearly fill out all of the following information according to your T-card:
LAST name (print)
FIRST name (print)
STUDENT #
Lecture Section – DAY and TIME

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Multiple Choice: Clearly fill-in the SCANTRON the best choice for each (1.5 marks each; 24 marks total)
1. Which of the following items is NOT a real asset?
a) land
b) television
c) bond
d) gold mine


2. In the following list, which item is a financial asset?
a) land
b) bond
c) building
d) inventory


3. Which of the following is NOT one of the main functions performed by mutual funds?
a) pooling sums of money to make investments
b) paying out premiums to their clients
c) providing professional management expertise
d) acting as a “pass-through” for individuals to invest in the equity and debt markets


4. Which of the following is NOT a component of debt securities?
a) maturity
b) repayment
c) dividends
d) interest payments


5. Which one of the following is/are an example(s) of opportunity cost?
a) quitting your job to go to university
b) using a piece of land that you owned to build a house
c) spending time caring for an elder in your family instead of working
d) All of the above are examples of opportunity costs.


6. You invested $2,000 at 5 percent compounded annually. Determine the value of the investment in
five years. (Round your answer to two decimals.)
a) $500.00
b) $552.56
c) $2,500.00
d) $2,552.56




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7. Franklin needs to have $1,000 in 8 years. If his investment earns 5 percent compounded annually,
how much must he invest today? (Round your answer to two decimals.)
a) $676.84
b) $680.58
c) $1,477.46
d) $1,469.33


8. Eduardo bought a house for $120,000 five years ago. He has just sold it for $180,000. What annual
rate of return did he earn on this investment?
a) 10%
b) 8.45%
c) 1.08%
d) 3.13%


9. You are the CFO of a major, publicly traded corporation. You must choose between two mutually
exclusive projects. You will accept a project based on which of the following?
a) The greatest increase in shareholder value.
b) The highest accounting profit.
c) The greatest tax benefit.
d) The highest internal rate of return.


10. Use the following two statements to answer this question:
I. DCF methodologies are techniques for making capital expenditure decisions that are consistent with
the overriding objective of maximizing shareholder wealth.
II. DCF valuation involves estimating future cash flows and comparing their present values with
investment outlays required today.

a) I and II are correct.
b) I and II are incorrect.
c) I is correct, II is incorrect.
d) I is incorrect, II is correct.


11. Which of the following should NOT be considered in the capital budgeting decision?
a) Working capital requirements.
b) Initial cash outlay.
c) Opportunity costs.
d) Sunk costs.


12. Which of the following is NOT an example of cannibalization?
a) Kellogg’s introduces a new type of cereal.
b) Ford rolls out a new model of car.
c) Molson brings out a new beer.
d) Canadian Tire allows Tim Horton’s to operate a concession stand in their retail outlets.
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13. Which of the following statements is TRUE?
a) Preferred shares will trade at a discount from par value when market interest rates are less than the
dividend rate.
b) Preferred shares will trade at a premium when the market interest rate exceeds the dividend rate.
c) Preferred shares will trade at par when the dividend rate does not equal the market interest rate.
d) The market prices of preferred shares increase when market interest rates decline, and vice versa.


14. The yield to maturity (YTM) is:
a) the discount rate used to evaluate bonds.
b) the bond’s internal rate of return.
c) the yield that an investor would expect to make if he or she bought the bond at the current price, held
it to maturity, received all the promised payments on their scheduled dates, and reinvested all the cash
flows received at YTM.
d) All of the above.


15. Which of the following statements is TRUE?
a) The quoted price of a bond is the actual price an investor pays for the bond whenever the bond is sold
at a date other than the date of a coupon payment.
b) The quoted price of a bond is the actual price an investor pays for the bond when the bond is sold on
the date of a coupon payment.
c) A bond purchaser must pay the bond seller the cash price plus the accrued interest on the bond.
d) The cash price plus the accrued interest on the bond is the quoted price of the bond.


16. Which one of the following statements is NOT correct?
a) AAA bonds are the safest bond investment.
b) Speculative grade bonds require high yields.
c) Large, well-established companies always have speculative grade ratings.
d) Speculative bonds are also called junk bonds.


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Short Answer Questions: Please answer in the space provided below (6 questions; 24 marks total)

1. (6 points) What are the main ways that common stocks and corporate bonds are similar? What are
the main differences?



















2. (3 points) It has been argued that making investment decisions based on maximizing shareholder
value excessively encourages a focus on short-term profits. Comment.











3. (4 points) What are the main benefits of a liquid secondary market for stocks?









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4. (4 points) After a year of healthy earnings, your company has excess cash. Instead of paying it out as
an increased dividend, you are advised to reinvest it to grow the company. The return on such an
investment is above the risk-free interest rate but below your company’s cost of capital (i.e. hurdle
rate/discount rate). Will such an investment cause the company to grow? Is it good advice to
reinvest this money? Explain.









5. (4 points) When considering the introduction of a new product, if the new product takes customers
away from your existing older products, how does this enter into your NPV calculation for the new
product? How might the competitiveness of your industry affect your answer?











6. (3 points) Why would anyone buy a bond that pays a coupon rate below the fair market interest
rate?











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Numerical Problems: Please answer in the space provided below (6 questions; 39 marks total)

1. (12 points) In order to take advantage of its popular and profitable brand name, Doodles is
considering starting a new children's breakfast cereal division to sell a new cereal called Yucky Muck.
Doodles forecasts that it can sell 1 million boxes of cereal each year for the next 4 years at a price of
$5 per box. Production costs are expected to be $2.20 per box. Because health regulations are
expected to be more strictly enforced in the future, Doodles will have to exit the cereal business
after 4 years. You may assume that the sales and production costs will occur at the end of each year.

Machinery will have to be purchased immediately at a cost of $4 million. The machinery will be
depreciated toward zero in a straight-line manner over its normal life of 4 years.

Assume that there is no inflation and all cash flow estimates are nominal. Doodles discount rate for
this type of project is 9% (nominal).

Profits are taxed at 20%.

Required:
a) What is the NPV? Should Doodles invest in this new cereal business?


















b) Suppose instead that depreciation can be accelerated so that it will fully depreciate over 2 years
(again, straight-line toward zero). How does this change your NPV? (You should answer this question
without redoing all the calculations, just the necessary calculations.)






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2. (3 points) Would you rather invest your money at 4% per annum compounded semi-annually or
3.9% per annum compounded monthly? Explain.









3. (7 points) Altria Group (makers of Marlboro cigarettes) has a current share price of $72.42, and a
market capitalization of $140.65 Billion. It is expected to pay a dividend next year of $2.44 per share.

Best Buy (a retailer of electronics and related products) has a current share price of $44.68, and a
market cap of $14.02 Billion. It is expected to pay a dividend next year of $1.12 per share.

Required:
a) How many shares of each company are outstanding?






b) What are the dividend yields of these two companies?







c) What do you infer about the comparison between these two companies based on your answer to
part (b)?






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4. (5 points) Consider a young growing company that expects to pay dividends next year of $1 per
share. That will grow to $2 per share the following year and $3 per share for the third year. After
this, dividends are expected to grow at 3% per year forever more. The discount rate for
shareholders in 10%. The company has no debt. What is a fair price for this company’s shares?

















5. (5 points) XYZ Corporation raised capital in both the equity and debt markets. It has 3 million shares
of common stock outstanding. It also has long-term bonds outstanding that are valued at $20
million. Suppose XYZ is expecting free cash flow next year of $5 million, and this free cash flow is
expected to remain $5 million per year forever more afterward. The appropriate discount rate is 8%.
What is XYZ’s share price?








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6. (7 points) Consider the following two bonds with annual coupons):
Face value Maturity Coupon rate Yield
A: $1000 10 years 6% 6%
B: $1000 10 years 5% 6%

Required:
a) What is the price of each bond?











b) Which bond will be more affected by changes in interest rates in dollar term? in percentage
terms? (Explain in words. No calculations are required for this.)