Last name of TA

Your name and Perm # ________________________________________________________________

Day and time of your section

Econ 134A John Hartman

Test 3, Version A June 8, 2011

Instructions:

You have 140 minutes to complete this test, unless you arrive late. Late arrival will lower the time
available to you, and you must finish at the same time as all other students.

Each question shows how many points it is worth. Show all work in order to receive credit. You will
receive partial credit for incorrect solutions in some instances in the PROBLEMS section. Clearly circle
your answer(s) or else you may not receive full credit for a complete and correct solution.

Cheating will not be tolerated during any test. Any suspected cheating will be reported to the relevant
authorities on this issue.

You are allowed to use a nonprogrammable four-function or scientific calculator that is NOT a
communication device. You are NOT allowed to have a calculator that stores formulas, buttons that
automatically calculate IRR, NPV, or any other concept covered in this class. You are NOT allowed to
have a calculator that has the ability to produce graphs. If you use a calculator that does not meet these
requirements, you will be assumed to be cheating.

Unless otherwise specified, you can assume the following:

 Negative internal rates of return are not possible.

You are allowed to turn in your test early if there are at least 10 minutes remaining. As a courtesy to
your classmates, you will not be allowed to leave during the final 10 minutes of the test.

Your test should have 21 multiple-choice questions and 2 problems. The maximum possible point total is
95 points. If your test is incomplete, it is your responsibility to notify a proctor to get a new test.

Grading:
For your reference, an example of a well-labeled graph is below:
Filling in scantron & front page of
test correctly and completely 3/3
(automatic unless something is incorrect)

Multiple choice portion _____/63

Other portions of test _____/29

Total score _____

MULTIPLE CHOICE: Answer the following questions on your scantron. Each correct answer is worth 3
points. All incorrect or blank answers are worth 0 points. If there is an answer that does not exactly
match the correct answer, choose the closest answer.

For the next two problems, assume that there are two stocks, A and B. Stock A has an expected return of
5% and a standard deviation of 6%. Stock B has an expected return of 10% and a standard deviation of
8%. For each problem below, you will need to choose an answer that could be the lowest standard
deviation of a portfolio of the two stocks. (In other words, only one of the answers could be the
standard deviation of the minimum variance portfolio. Find that value.)

1. The two stocks are perfectly positively correlated.

A. 0% B. 2.5% C. 6% D. 14% E. 15%

2. The two stocks have a correlation strictly greater than –1 and strictly less than 1.
A. 0% B. 2.5% C. 6% D. 14% E. 15%

3. If the real interest rate is 15% and the inflation rate is 10%, then the nominal interest rate is
A. 1.5% B. 4.5% C. 5% D. 25% E. 26.5%

4. A stock pays $5 every three months, starting six months from today. If the stated annual interest rate is
10%, compounded every three months, what is the present value of the stock’s payments?
A. $50 B. $100 C. $190 D. $195 E. $200

5. Tricycle Cards has an opportunity to develop a new card game. In order to develop the card game,
Tricycle needs to spend $5,000 today. The company receives a positive cash flow of $8,000 two years
from now. No other cash flows occur with this project. If the annual discount rate is 14%, what is the
profitability index of this project?
A. 1.0 B. 1.1 C. 1.25 D. 1.4 E. 1.6
6. Bill Ivy receives an annuity of $1,000, payable once every two years. The annuity stretches out over
24 years. The first payment occurs two years from today. What is the present value of the annuity if the
effective annual interest rate is 9%?
A. $4,650 B. $4,800 C. $5,000 D. $5,450 E. $6,050

7. After conducting a Monte Carlo simulation, a new project is predicted to earn $500,000 with 30%
probability this year, earn $200,000 with probability 50%, and lose $100,000 with probability 20%.
What is the net present value of the project this year?
A. $200,000 B. $230,000 C. $270,000 D. $300,000 E. $330,000

For the next two problems, use the following information: A stock is currently priced at $50. The stock
will either increase or decrease by 10% over the next year. The risk-free rate and the expected return of
the stock are both 6%.

8. There is a call option on the stock with a strike price of $56. What is the risk-neutral value of the call
option?
A. $0 B. $2.25 C. $2.40 D. $5.65 E. $6

9. There is a call option on the stock with a strike price of $52. What is the risk-neutral value of the call
option?
A. $0 B. $2.25 C. $2.40 D. $5.65 E. $6
10. Jack’s Electronics is lobbying the New Hampshire legislature to issue $200,000 in three-year tax
exempt bonds. The coupon rate on these bonds is 4%, while the normal cost of debt for Jack’s is 6%.
What is the NPV of this potential financing transaction if the request is granted?
A. $0 B. $3,000 C. $7,000 D. $11,000 E. $15,000

11. Selma spent $200,000 today in the development of a new product, and will receive $250,000 five
years from now. Her annual discount rate is 4%. What is her annual internal rate of return for this
project?
A. 3% B. 3.5% C. 4% D. 4.5% E. 5%

12. You buy a stock today for $100. The next dividend payment will be made one year from now, and
you expect the growth rate (as a percentage) of the yearly dividend to be constant forever. Assume the
dividend paid earlier today was $3 and the effective annual discount rate is 6%. What is the annual
growth rate of the stock based on these assumptions?
A. 2.9% B. 3.9% C. 4.9% D. 5.9% E. 6.9%

13. Samantha takes out a mortgage for a $300,000 house. In order for the house’s mortgage to be paid
off after 30 years, she makes a down payment today and makes 360 monthly payments of $1,000,
starting one month from today. If the stated annual interest rate is 6%, and interest is compounded
monthly, how much will her down payment be?
A. $113,000 B. $133,000 C. $170,000 D. $402,000 E. $802,000
14. You make a deposit of $50,000 into an account that pays 18% annual interest compounded monthly.
How many months will you need to keep the money in the account in order for the account balance to
reach $100,000?
A. 35 B. 38 C. 41 D. 44 E. 47

15. Today is June 8, 2011. You invest $3,000 today. Find the future value on December 8, 2013, given
the stated nominal annual interest rates of 12% and interest compounded every three months.
A. $3,900 B. $3,930 C. $3,980 D. $4,030 E. $4,100

16. Suppose that taxable bonds are currently yielding 14%, while at the same time, non-taxable bonds of
comparable risk yield 10%. What is the break-even tax rate?
A. 4% B. 10% C. 14% D. 29% E. 40%

17. If you invest $500 today and receive $100,000 in 100 years, what is the geometric average of your
yearly return?
A. 3.4% B. 4.4% C. 5.4% D.6.4% E. 99.5%
18. If the price of a stock today is $31, the price one year from now is $35, and the dividend one year
from now is $1, then the capital gain is
A. $1 B. $4 C. $5 D. 3.2% E. 12.9%

19. If you buy Machine X, you have to pay $1,728 today (year 0), and disposal costs of $720 in year 2.
(Note: The disposal cost should be treated in the same way as a maintenance cost in determining
equivalent annual cost.) Machine X lasts two years. The effective annual discount rate is 20%. What is
the equivalent annual cost of Machine X?
A. $1,458 B. $1,524 C. $1,602 D. $2,040 E. $2,448

20. Which type of business involves liability that is limited to the amount invested in the ownership
shares for all owners of the business?
A. A sole proprietorship
B. A firm owned by two people that is neither a corporation nor a limited liability company
C. A general partnership owned by three people
D. A general partnership owned by 100 people
E. A corporation owned by two people

21. You deposit $1,000 in a bank today. Interest is compounded yearly at this bank. The annual interest
rate is 8%. Interest earned could be simple interest or compound interest. After 10 years, how much
extra interest is earned if interest is compounded?
A. $200 B. $250 C. $300 D. $350 E. $400
PROBLEMS: For the following problems, you will need to write out the solution. You must show all
work to receive credit. Each problem (or part of problem) shows the maximum point value. INCLUDE
AT LEAST FIVE SIGNIFICANT DIGITS FOR EACH ANSWER.

1. Joe Link Inc. distributes its dividends on a yearly basis. The most recent dividend of $3 per share was
paid earlier today. During the next three years, the dividend will increase by 10% per year. After that, the
growth rate will be 6% forever. The required return of the stock is 8%

(a) (3 points) What are the expected dividends one year and four years from today? (State the dividend
payment for each year.)

(b) (4 points) What are the present values of the expected dividends two and three years from today?
(State the present value for each year.)
(c) (8 points) Calculate the present value of the stock.
2. Chris buys one share of a stock at a price of $47 today, and a put option with an exercise price of $40
one month from now. (In other words, the expiration date of the put is one month from now.) The put
option is for purchasing one share. For simplicity in this problem, you can assume a discount rate of 0%.

(a) (3 points) What is the combined value of the share of stock and the put option if the price of the stock
one month from now is $38?

(b) (3 points) What is the combined value of the share of stock and the put option if the price of the
stock one month from now is $58?
(c) (8 points) Draw a well-labeled graph that shows the value of a combination of the stock and the put
as a function of the value of the stock at expiration. The vertical intercept should have the value of the
combination of the stock and the put. The horizontal intercept should have the value of the stock at the
expiration. Make sure to label your intercepts and other relevant numbers on each axis, where relevant.
(Hint: You may want to look at the front page of the test to see a well-labeled graph.)