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# ENG120

## You have 2 hours to complete this exam.

Any communication with other students during the exam (including showing,
viewing or sharing any writing) is strictly prohibited. Any violation will
result in a score of 0 points for the exam.

Clearly state all the mathematical expressions that are needed to solve the
problems. No credit will be given to numerical answers without the
proper setup.

Answer each of the following questions in the space provided. If you need more
space to show major computations you performed to obtain your answer for
a particular problem, use the back of the preceding page.

You can quote and use any result stated in class or in the main body of the
textbook as well as well-known general mathematical results but no
references to other sources (including textbook exercises) are allowed.

This exam is closed book; however you may use your 1 page cheat sheet as
described in class and on bcourses and a calculator without communications
capabilities.

Good luck!

## Midterm ENG120, Friedman Page 1 of 9

Multiple Choice circle the correct answer(s) more than one may be correct.
(3 points each)

1. In 2007 the corporate bond market was about \$6 trillion. Approximately how
much money was invested in CDSs on these bonds?

## a. \$50 billion b. \$2 trillion c. \$45 trillion

2. A retailer is contemplating building a new retail store across town from its
current retail outlet. The company already owns the (unused) land for this store.
Which of the following should be included as part of the incremental earnings for
the proposed new retail store?

a. The cost of the land where the store will be located.
b. The value of the land if sold
c. The loss of sales in the existing retail outlet, if customers who
previously drove across town to shop at the existing outlet become
customers of the new store instead.
d. Interest expense on the debt borrowed to pay the construction costs.

3. What are some typical investor mistakes for typical people?

a. True b. False

a. Nearly exact

## a. Revenues b. Interest on debt. c. Depreciation d. Costs

7. A company has spent \$2million developing a new product. How is that \$2million
used computing the NPV of the new product project?

## a. It is taken as an expense in year 1

b. It is not included in the calculation
c. It is depreciated over 5 years

8. Under what conditions would one exercise a call option early?

## a. The company is about to pay a dividend

b. It is in the money

## Midterm ENG120, Friedman Page 3 of 9

9. (12pts) Consider an investment project that requires an investment of
\$10million at the beginning of years 1 and 3 and has guaranteed profits of
\$2million per year starting in year 2 and then continuing forever.

## a. If the cost of capital is 5%, should you make this investment?

)* /
NPV = 10 + = 20.93 > 0 , so yes.
).*,- *.*,

b. Write down the formula for the IRR and check numerically that the IRR is
approximately 11%. (You dont need to analytically solve the IRR
equation.)
)* /
Equation: NPV = 10 + = 0
()56)- 8

)* /
Plug in 0.11, NPV = 10 + = 0.06 0
).))- *.))

c. According to the IRR rule, should you make this investment if the cost of
capital is 5%?

## 10. (12pts) Aco has a share price of \$50 today.

a. If Aco is expected to pay a dividend of \$3 this year, and its stock price is
expected to grow to \$70 at the end of the year, what is Acos dividend
yield and capital gain rate?

;<=) ?
Dividend yield = = = 0.06
>* ,*

>)@>* A*@,*
Capital gain rate = = = 0.4
>* ,*

b. If Aco is expected to pay a dividend of \$3 every year forever what is its
cost of capital?

;<= ;<= ?
P = r= = = 0.06
8 > ,*

c. If instead Acos yearly dividend is expected to grow 4%/year starting at
\$3 and continuing every year forever, what is its cost of capital?

;<= ;<= ?
P = r= + g = + 0.04 = 10%
8@C > ,*

## Midterm ENG120, Friedman Page 5 of 9

11. (12pts) Your company is planning to invest in a plant. Bco is an all-equity firm
that specializes in the same business. Suppose Bcos equity beta is 1.2, the risk-
free rate is 5%, and the market risk premium is 7%. Assume that your firm's
project is all-equity financed. In the following, use BCO as a comparable firm for
estimates.
a. Assuming Bco has no debt, estimate its cost of capital for your project.

r = H + beta market risk premium = 0.05 + 1.2 0.07 = 0.134

b. Instead assume that Bco has a stock price of \$25 per share, with 10
million shares outstanding and \$100 million in outstanding debt.
Assume Bco debt has a beta of zero. Estimate Bcos unlevered cost of
capital.

Use unlevered beta:
25 10
beta = 1.2 + 0 = 0.857
25 10 + 100
r = H + beta market risk premium = 0.05 + 0.857 0.07 = 0.11

c. Suppose that you do not know Bcos debt beta, but you do know that its
yield on debt is 5%. Using this information estimate Bcos unlevered cost
of capital.

25 10 100
W = 0.134 + 0.05 = 0.11
25 10 + 100 25 10 + 100

## Midterm ENG120, Friedman Page 6 of 9

12. (12pts) Consider an economy with two types of firms, S and I. S firms all move
together. Type I firms move independently of all other firms. Type S firms have
an expected return of 5% and type I firms have an expected return of 2%, while
both cost \$40/share and have a volatility of 20%. What is the expected return
and standard deviation of a portfolio that consists of an equal investment in:

a. 25 firms of type S?

E[R] = 5%

SD(S) = 20%

b. 25 firms of type I?

E[R] = 2%
/*%
SD(I) = = 4%
/,

c. 25 firms of type S and 25 firms of type I?

## E[R] = 0.5*5%+0.5*2% = 3.5%

Var(Rp)=Cov(Rp,Rp)=Cov(i25+s25,i25+s25)

= Cov(i25,i25)+2Cov(I25,s25)+Cov(s25,s25)

= Cov(i25,i25)+0+Cov(s25,s25)

= Var(i25)+ Var(s25)

= 0.5^2*20%^2+0.5^2*4%^2

=1.04%

SD = sqrt(1.04%) = 10.20%

## Midterm ENG120, Friedman Page 7 of 9

13. (12pts) Consider an industry in which all companies stocks have average
returns of 20%, volatilities of 10% and correlations of 0.50 with each other.

## a. Compute the volatility of a portfolio that consists of equal amounts of two

of these companies stocks.

Var(Rp) = 0.5^2*Var(A)+2*0.5*0.5*Cov(A,B)+0.5^2*Var(B)

= 2*0.25*0.10^2 +2*0.5*0.5*0.5*0.10^2

=0.0075

SD = sqrt(0.0075) = 8.66%

## b. What is the volatility of an equally weighted portfolio of n of these as n

becomes arbitrarily large?

## SD= sqrt of avg covariance = 0.5 0.10^2 = 7.07%

c. What is the beta of one of these companies stock with respect to a large
portfolio of n other of these stocks (not containing that specific
companys stock)?

## Cov(Ri, Rp) n Cov(Ri, Rj)/n 0.5 0.1/

beta = = = = 1.00
SD Rp / SD Rp / 0.0707/

## Midterm ENG120, Friedman Page 8 of 9

14. Suppose Yco stock is trading for \$50 per share, has volatility of \$20 and pays no
dividends. The risk free rate is 4% per year and the exercise date is 1 year away.
Assume a strike price of \$60 and that Yco does not pay any dividends.

a. Using simple arbitrage bounds, what is the maximum possible price of a
European call option on Yco and what is the maximum possible price of a
European put option on Yco?

call < stock price = \$50,

put < exercise price = \$60

b. What is the price of a European call option on Yco if the price of a
European put option on Yco is \$12?

Use put call parity, S+P = PV(K)+C,

60
C = 50 + 12 = 2.385
1.04