Michael G.

Foster School of Business

University of Washington

Finance – BA 500 – Autumn 2018

Prof. Thomas Gilbert

Midterm Exam

Name:

I have neither given nor received inappropriate aid on this work. Nor have I observed any academic
misconduct on the part of others pertaining to this work.

Signature

Please circle your final numerical answers!!!

This exam contains 11 numbered pages. The last question of this exam is question 5. The formula sheet
and scrap paper are at the back of the exam and may be detached from the rest.

Grading (points allocated by expected number of required minutes)

Question 1 _________ out of 30 points

Question 2 _________ out of 40 points

Question 3 _________ out of 20 points

Question 4 _________ out of 10 points

Question 5 _________ out of 10 points

Total out of 110 points

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Question 1: Short Problems (30 points)

The 6 parts of this question are independent. Brevity and precision in your answers will be rewarded!

a) (5 points) You are the CFO of a young start-up company that is losing money. How do you make
capital budgeting decisions?

b) (5 points) What is the present value of a stream of annual cash flows starting 5 years from now
at a value of $5,000 and growing at 2% per year forever? Assume that the appropriate discount
rate is an EAR of 5%.

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c) (5 points) Repeat question b. above assuming that the appropriate discount rate is an APR of 5%
with weekly compounding.

d) (5 points) Throughout the 1990s, risk-free interest rates in Japan were lower than risk-free
interest rates in the United States. As a result, many investors borrowed in Japan and invested
the proceeds in the United States. Was this an arbitrage opportunity? If so, why and what trades
would you have put in place to take advantage of the arbitrage? If not, why not?

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e) (5 points) According to problem 3 of homework 4, the correlation between Alaska Airlines’ stock
return and the return of the S&P500 is 0.25, the market’s standard deviation is 15% per year,
the market’s expected equity risk premium is 5% per year, the current yield on 10-year Treasury
bonds is 3.08%, and the volatility of Alaska Airlines’ stock is 35% per year. What is the
appropriate discount rate that the CFO of Alaska Airlines, Brandon Pedersen, should use when
evaluating a new project of equivalent systematic risk as the firm as a whole?

f) (5 points) A firm’s current EPS is $2 and it currently plows 50% of it back into the firm. The CEO
announces that it will increase the plowback ratio to 60% and invest in new internal projects
that have an expected return of 12%. Will the firm’s stock price go up or down immediately
after the announcement? Why?

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Question 2: Free Cash Flows (40 points)

The 3 parts of this question are related.

Using some incredible presentation skills and a bulletproof marketing strategy, you have just won a case
competition with UW engineers, pitching a new biodegradable bicycle tire. Congratulations!

The under-diversified Seattle-based shoe company Brooks has heard about your idea and is thinking
about acquiring your start-up. Together with their finance team, you are now seriously digging into the
financials…

To get the project off the ground, the company would need to immediately buy a new set of machines
for $10,500,000. This comes on top of the $250,000 that was spent over the past two years on
laboratory tests, prototypes, patents, and legal fees.

You have estimated that this tire will be on the market for 5 years, after which it will become obsolete.
After extensive customer surveys, you have estimated an expected selling price per tire of $40 in year 1.
By selling only via an online platform, the expected number of units sold in year 1 is 500,000. Beyond
year 1, you expect revenue to grow by 10% per year.

Throughout the life of the project, it is expected that COGS will be 40% of revenue and SG&A will be 15%
of revenue.

The manufacturing of the tire will require an immediate investment in net working capital equal to 10%
of next year’s expected revenue, and the level of net working capital each year will remain at 10% of the
subsequent year’s expected revenue. When the project shuts down, i.e., at the end of year 5, all net
working capital is immediately recovered.

The manufacturing of the tire will take place in a warehouse that Brooks currently uses for extreme-
temperature shoe testing. If the tire project does not get off the ground, Brooks’ plan is to continue
operating this shoe testing facility for one more year, at a cost of $250,000 in year 1.

You have estimated that, at the end of year 5, there is a 60% chance that the machines used for the tire
production will be worth $2,000,000 in the second-hand market and there is a 40% chance that the
metal will be worth only $500,000.

Under the new tax law passed by Congress last December, the corporate income tax rate is now 21%
and capital expenditures can be fully depreciated over one year.

a) (30 points) Using the table on the next page, calculate the expected free cash flows of the new
project.

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0 1 2 3 4 5

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b) (5 points) If the appropriate risk-adjusted discount rate for this project is 30%, what is the maximum amount
that Brooks should pay your team for the complete acquisition of the start-up?

c) (5 points) If Brooks does pay the maximum amount from part b. above, what would be the NPV and the
internal rate of return on the acquisition?

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Question 3: Straight from Class 3!!! (20 points)

The 2 parts of this question are related.

You just turned 25. Beginning on your 26th birthday, you will start saving for retirement, putting a constant nominal
amount per year into your retirement account for 40 years, i.e., until your 65th birthday. To fund your retirement, you
will start withdrawing money from your retirement account starting on your 66th birthday. You expect to make 25
annual withdrawals, i.e., until your 90th birthday.

Your objective is to maintain a standard of living per year equivalent to $50,000 today throughout your retirement.

By following your finance professor’s advice and investing in the S&P500, you expect to earn 8% per year on average
in your retirement account throughout your life. Economists expect inflation to be 3% per year on average forever.

a) (12 points) To achieve this standard of living, how much money needs to be in your retirement savings
account on your 65th birthday, i.e., immediately after you make your last deposit?

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b) (8 points) To reach this nest egg, how much do you need to save each year?

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Question 4: Efficient Portfolios (10 points)

The risk-free rate is 4%. The market portfolio has an expected return of 18% and a standard deviation of 25%. You
currently own a portfolio with an expected return of 10% and a standard deviation of 20%.

Is your portfolio efficient? If so, why? If not, why not, what is the expected return that you can earn on an efficient
portfolio with the same standard deviation as your current portfolio, and what is the composition of your new
efficient portfolio?

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Question 5: Bonds (10 points)

Suppose the current yield on a one-year zero-coupon bond is 3% while the current yield on a five-year zero-coupon
bond is 5%. Both bonds have $1,000 face value and neither bond has any risk of default. You can assume that the
yields are given as effective annual rates and all compounding is annual.

You plan to invest for only one year. You will earn more over the year by investing in the five-year bond as long as its
yield does not rise above what level?

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