MIDTERM PRACTICE PAPER C SOLUTIONS

1. Which of the following cash flow streams below gives the smallest Present Value?

A. A 12-year annuity due of $120 per year at 6% APR.

B. A lump sum payment of $1,050 received today.
C. A lump sum payment of $1,500 received at the end of 10 years at 3.5% APR.
D. A perpetuity that pays $100 per year at 10% APR with the first payment received
immediately.
E. All of the cash flow streams have the same present values.

SOLUTION:
Choice A – (BGN) N: 12; I/Y: 6; PMT: $120; cpt PV = $1,066.42
Choice B – $1,050
Choice C – N: 10; I/Y: 3.5; FV: 1,500; cpt PV = $1,063.38
$",$$
Choice D – "$%
+ $1,00 = $1,100

2. NEO Company just bought a new machine for $3.5 million and new inventory for $500,000.
Depreciation expense for the year was recognized at $300,000. What is NEO Company’s
Net Capital Spending for the year?

A. $4.3 million
B. $4.0 million
C. $3.8 million
D. $3.5 million
E. $3.2 million

SOLUTION:
$3.5 million was spent on the new machine.
Alternatively,
Ending NFA = $3.5 million – $300,000 = $3.2 million
Beginning NFA = $0 million
Net Capital Spending = $3.2 million – $0 + $300,000 = $3.5 million

3. Mark is saving towards buying a car. He needs $35,000 in 2 years’ time. Which of the
following savings plans below would leave Mark with the least amount of shortfall at the
end of 2 years?

A. $25,000 immediately in an account that earns 12% EAR compounded monthly.

B. $25,000 immediately in an account that earns 12% APR compounded monthly.
C. $1,250 at the end of each month in an account that earns 6% EAR.
D. $1,250 at the beginning of each month in an account that earns 6% APR.
E. All of the above saving plans result in the same shortfall for Salim.
SOLUTION:
Choice A – N: 2; I/Y: 12; PV: –$25,000; cpt FV = $31,360.00
Choice B – N: 24; I/Y: 1; PV: –$25,000; cpt FV = $31,743.37
!
Choice C – Find monthly rate: (1 + 6%)!" − 1 = 0.48676%
N: 24; I/Y: 0.48676; PMT: –$1,250; cpt FV = $31,740.81
Choice D – (BGN) N: 24; I/Y: 0.5; PMT: –$1,250; cpt FV = $31,948.89

4. You have the following financial statements for Money No Enough Corp.

Money No Enough Corp.

2022 and 2021 Balance Sheets (in $million)
2022 2021 2022 2021
Cash 20 20 Accounts Payable 15 20
Accounts 25 15 Notes Payable 30 25
Receivable
Inventory 25 35
Total Current 70 70 Total Current Liabilities 45 45
Assets
Long-term Debt 25 30
Common Stock 20 20
Net Fixed Assets 65 65 Retained Earnings 45 40
Total Assets 135 135 Total Liabilities & 135 135
Owners’ Equity

Money No Enough Corp.

2022 Income Statement (in $million)
Net Sales 45
Cost of Goods Sold 20
Depreciation Expense 10
EBIT 15
Interest Expense 5
Taxable Income 10
Less: Taxes (20%) 2
Net Income 8

What is the Cash Flow From Assets (CFFA) ignoring financing effects for Money No Enough
Corp. in 2022?

A. $17 million
B. $12 million
C. $7 million
D. –$2 million
E. –$5 million
SOLUTION:

OCF = 𝐸𝐵𝐼𝑇 × (1 − 𝑡& ) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = $15 × (1 − 20%) + $10 = $22

NCS = 𝐸𝑛𝑑𝑖𝑛𝑔 𝑁𝐹𝐴 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑁𝐹𝐴 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = $65 − $65 + $10 = $10
∆𝑁𝑂𝑊𝐶 = ($70 − $15) − ($70 − $20) = $5

CFFA = 𝑂𝐶𝐹 − 𝑁𝐶𝑆 − ∆𝑁𝑂𝑊𝐶 = $22 − $10 − $5 = $7

Check:
Cashflow to Creditors = $5 − [($30 + $25) − ($25 + $30)] = $5
Dividends = $8 − ($45 − $40) = $3
Cashflow to Shareholders = $3 − ($20 − $20) = $3
Interest Tax Shield = $5 × 20% = $1

CFFA = $5 + $3 − $1 = $𝟕 million

5. Ms. Liang deposited the following amount of money into her savings account:

End of Month Savings

January $1,500
April $2,000
August $1,000
November $2,500

Her account earned 6% APR. How much would Ms. Liang have at the end of December?

A. $7,200
B. $9,900
C. $8,500
D. $10,400
E. $6,800

SOLUTION:
'%
Monthly rate = "( = 0.5%

End of Savings No. of months Future Value

Month of
compounding
January $1,500 11 FV = $1,500 × (1 + 0.5%)""
= $1,584.59
April $2,000 8 FV = $2,000 × (1 + 0.5%)) = $2,081.41
August $1,000 4 FV = $1,000 × (1 + 0.5%)* = $1,020.15
November $2,500 1 FV = $2,500 × (1 + 0.5%)" = $2,512.50
TOTAL $7,198.66 ≈ $7,200
6. Moses was saving towards his daughter’s education. He deposited $3,640 today into his
savings account. In three months’ time, he will deposit $1,000. Thereafter, he would like
to make deposits every three months with the deposits growing by 3% each time. In other
words, his next deposit in six months’ time will be $1,030, and then in nine months’ time,
he will deposit $1,060.90, and so on. Moses’ account earns 8% APR. How much money
will Moses have at the end of 15 years?

A. $281,000
B. $261,000
C. $253,000
D. $273,000
E. Cannot be determined.

SOLUTION:
)%
Quarterly rate = * = 2%
(1 + 2%)'$ − (1 + 3%)'$
FV of growing annuity = $1,000 × _ ` = $261,057.23
2% − 3%

FV of lumpsum = $3,640 × (1 + 2%)'$ = $11,942.95

Total = $261,057.23 + $11,942.95 = $273,000.18 ≈ $273,000

7. Jack wanted to save $5 million for his retirement in 30 years’ time. He would deposit
$2,000 at the end of each month into his savings account. Additionally, he would invest
$15,000 at the end of each year into a separate investment account. His investment
account returned 10% EAR. What minimum APR must his savings account earn for Jack
to reach his goal?

A. 5.6%
B. 6.3%
C. 6.9%
D. 8.4%
E. 7.2%

SOLUTION:

Find FV of Investment Account:

N: 30; I/Y: 10; PMT: –$15,000; cpt FV = $2,467,410.34

FV of Savings Account:
$5,000,000 – $2,467,410.34 = $2,532,589.66

Find monthly rate:

N: 360; PMT: –$2,000; FV: $2,532,589.66; cpt I/Y = 0.5990%

APR = 0.599% × 12 = 7.1884% ≈ 𝟕. 𝟐%

8. Mr. Thia took out a $1.5 million 25-year equal monthly instalment mortgage with SBD
bank. The rate of the mortgage was 3.6%. How much would Mr. Thia have paid towards
the principal in his third instalment only?

A. $4,481.43
B. $3,108.61
C. $13,472.16
D. $9,297.96
E. $1.43

SOLUTION:

Find the monthly instalment:

+.'
N: 300; I/Y: "( = 0.3; PV: $1,500,000; cpt PMT = $7,590.04

Use AMORT function in calculator:

P1: 3; P2: 3; PRN = $3,108.61

9. Ximei took out a 5-year $120,000 car loan with monthly instalments from BOU bank. The
EAR of the loan was at 5.41%. What was the flat loan rate for this car loan that had been
offered to Ximei?

A. 3.2%
B. 3.0%
C. 2.8%
D. 2.6%
E. 2.4%

SOLUTION:
Given the EAR of 5.41%, find the monthly period rate:
"
Monthly rate = (1 + 5.41%)"( − 1 = 0.4400%

Find the monthly instalment of the car loan:

N: 60; I/Y: 0.44; PV: $120,000; cpt PMT = –$2,279.97

Find the flat rate, r:

𝑟 × $120,000 × 5 + $120,000
= $2,279.97
60

𝑟 × $600,000 = $16,798.20

𝑟 = 2.7997% ≈ 𝟐. 𝟖%
10. The enterprise value of Ah Boys Inc. is $41 million. Ah Boys Inc. has 1 million shares
outstanding, a market-to-book equity ratio of 5, a book debt-to-equity ratio of 2 and
excess cash of $8 million. What is the market price of Ah Boys Inc. stock?

A. $14
B. $4
C. $45
D. $23
E. $35

SOLUTION:
Enterprise Value = Market Value of Equity + Debt – Excess Cash

Market Value of Equity + Debt = $41m + $8m = $49m

Let market price of stock be $P.

Market Value of equity = $1,000,000P

$1,000,000P
Book Value of Equity = = $200,000P
5

Debt = $200,000P × 2 = $400,000P

$1,000,000P + $400,000P = $1,400,000P = $49m

$49,000,000
$𝑃 = = $𝟑𝟓
1,400,000

11. Which of the following statements is wrong?

A. Capital markets are where equity and long-term debt instruments are traded.
B. Capital markets are where debt securities of less than one year are traded.
C. Capital markets can either be a primary market or a secondary market.
D. Capital markets are where savings and investments are channelled between suppliers
and those in need.
E. Capital markets are where buyers and sellers trade assets.

SOLUTION:
Choice B. All the other choices are correct definitions of Capital Markets.
12. You have the following information about the probabilities of future states of the economy
and the respective returns for Asset C.

State of Probability Returns for Asset

Economy C
Poor 20% –30%
Below Average 40% 5%
Above Average 20% 15%
Boom 20% 40%

What is the standard deviation on returns for Asset C?

A. 22.5%
B. 8.4%
C. 5.1%
D. 25.1%
E. 29.0%

SOLUTION:
Find expected return:
E(r) = 20% × −30% + 40% × 5% + 20% × 15% + 20% × 40% = 7%

State of Probability Returns Deviation from Mean Squared

Economy for Asset Deviation from
C Mean
Poor 20% –30% −30% − 7% = −37% 0.1369
Below 40% 5% 5% − 7% = −2% 0.0004
Average
Above 20% 15% 15% − 7% = 8% 0.0064
Average
Boom 20% 40% 40% − 7% = 33% 0.1089

Find standard deviation on returns:

σ = √20% × 0.1369 + 40% × 0.0004 + 20% × 0.0064 + 20% × 0.1089 = 𝟐𝟐. 𝟓%

13. Which of the following statements below is most correct?

A. An increase in a firm’s financial leverage will likely lead to a fall in its Return on Equity
(ROE).
B. An increase in retail price for a firm’s products without any change to quantity sold will
likely lead to a fall in its Return on Equity (ROE).
C. An introduction of a Just-In-Time inventory management system to reduce excess
inventory in a firm’s warehouse will likely lead to a fall in its Return on Equity (ROE).
D. An increase in a firm’s cost of goods sold without any change in sales will likely
lead to a fall in its Return on Equity (ROE).
E. A decrease in the speed of collection on a firm’s receivables will likely lead to a rise in
its Return on Equity (ROE).
SOLUTION:
Choice A – wrong. An increase in financial leverage will result in a higher Equity Multiplier,
which in turn leads to a higher ROE (refer to Dupont Identity).
Choice B – wrong. An increase in retail price with no impact to quantity will result in higher
sales and higher net income, which in turn leads to a higher ROE.
Choice C – wrong. A reduction to inventory will result in a higher Total Asset Turnover, which
in turn leads to a higher ROE.
Choice D – correct. An increase in COGS with no change to sales will result in a lower
Net Income and Profit Margin, which in turn leads to a lower ROE.
Choice E – wrong. A decrease in speed of collection will result in the firm accumulating
Receivables and not collecting cash quickly. This means they will have less cash to use to
run their projects and invest, which in turn leads to a lower ROE.

14. Assuming only positive weights, the Coefficient of Variation (CV) of a portfolio formed
through the combination of two risky assets cannot be ________________________ the
coefficient of variation of both of the assets.

A. higher than
B. equal to
C. the weighted average of
D. lower than
E. None of the above.

SOLUTION:
Choice A.

The CV measures the risk per unit of return. When we combine risky assets into a portfolio,
assuming only positive weights, then the expected return of the portfolio will end up being the
weighted average return, while the standard deviation on returns of the portfolio will be less
than or equal to the weighted average standard deviation, depending on the correlation
between the risky assets.

Therefore, the CV of the portfolio will be lower than or equal to the CV of the risky assets. It
is equal (and also the weighted average in this case) if the expected returns and the
standard deviation of the two risky assets are the same and the two risky assets are perfectly
positively correlated with a correlation of +1.

The portfolio CV cannot be “higher than” that because that can only be achieved if we get a
standard deviation on returns of the portfolio that is higher than the weighted average
standard deviation. In other words, if this were true, not only would we not have any
diversification benefits from combining the assets, we would have ended up worse off from
diversification!
15. You have following expected return, standard deviation on returns information for Stocks
X and Y. Assume the market is in equilibrium.

Stock X Stock Y
Expected Return 18% 26%
Standard Deviation on Returns 35% 40%

Which of the following statements below is/are correct?

I. Stock X must have less total risk than Stock Y

II. Stock X must have less systematic risk than Stock Y
III. Stock X must have less unsystematic risk than Stock Y

A. I only.
B. I and II only.
C. I and III only.
D. II and III only.
E. All of the above.

SOLUTION:

Statement I – correct. Stock X has less total risk since it has a lower standard deviation.
Statement II – correct. Stock X has less systematic risk since it has the lower expected
return. Assuming market equilibrium, expected return is proportionate to beta.
Statement III – wrong. Since Stock X has the lower total risk and also the lower systematic
risk, we cannot conclude if it has less or more unsystematic risk.

16. You have the following historical returns for Stock T.

Return
Year 1 10%
Year 2 –35%
Year 3 5%
Year 4 15%

What is the geometric average return for Stock T?

A. 3.3%
B. 1.7%
C. –1.3%
D. –2.5%
E. –3.6%

SOLUTION:
"
Geometric Avg Return = [(1 + 10%)(1 − 35%)(1 + 5%)(1 + 15%)]* − 1 = −𝟑. 𝟔%
17. An asset’s risk premium is defined as:

A. The extra standard deviation over and above the standard deviation of the market.
B. The extra beta over and above the market beta of 1.
C. The extra price over and above the price of the Treasury bill.
D. The extra return over and above the return of the market.
E. The extra return over and above the risk-free rate.

SOLUTION:
Choice E.

18. You have the following information:

• The risk-free rate is 3%.
• The market risk premium is 9%.
• The beta of Stock P is 2.0.
• The expected return of Stock P is 18%.

Which of the following statements below is/are correct?

I. Stock P is overpriced.
II. The risk premium of Stock P is 12%.
III. Stock P has a required return of 15%.
IV. The reward-to-systematic risk ratio for Stock P is 0.09.

A. I only.
B. I and II only.
C. II and III only.
D. II, III and IV only.
E. All of the above.

SOLUTION:
Required return of Stock P = 3% + 2.0 × 9% = 21%

Risk Premium of Stock P = 18% − 3% = 15%

Since Expected Return of Stock P < Required Return of Stock P, the stock is overpriced.

18% − 3%
Reward to Systematic Risk ratio of Stock P = = 0.075
2.0

➔ Only Statement I is correct.

19. Which of the following statements below is wrong?

A. The market portfolio is the portfolio at the tangent line of the risk-free asset and the
efficient frontier of all risky assets.
B. The market portfolio does not have any unsystematic risk.
C. Assuming market equilibrium, a portfolio on the SML will also plot on the CML.
D. A portfolio that provides the greatest expected return for a given level of standard
deviation is called an efficient portfolio.
E. None of the above, i.e., all of the above statements are correct.

SOLUTION:
Choice C. All portfolios will plot on the SML. These would include portfolios that comprise
any combination of risky assets. Portfolios on the CML are simply combinations of the risk-
free asset and the Market portfolio. Hence, portfolios on the SML need not be on the CML.

20. You have the following information about Stock F and Stock G.

Stock F Stock G
Expected Return 16% 20%
Standard Deviation on Returns 40% 50%

You put together a portfolio consisting of 50% Stock F and 50% Stock G. The resultant
portfolio standard deviation on returns is 36.4%.
What is the correlation of returns between Stock F and Stock G?

A. –0.2
B. 0.0
C. 0.3
D. 0.5
E. 0.7

SOLUTION:

36.4% = ~0.5( 0.4( + 0.5( 0.5( + 2(0.5)(0.5)(0.4)(0.5)𝜌-,.

36.4%( − 0.5( 0.4( − 0.5( 0.5(

𝜌-,. = = 𝟎. 𝟑
2(0.5)(0.5)(0.4)(0.5)