Principles of Finance (FE 310)

Midterm Exam—Spring 2021

Directions
o This is an open book, open note, open computer exam. However, laptops can only be used to
work in Excel or to access course files you have saved to your computer or to access the course
Canvas page. You may not use the internet other than to access the course Canvas page. You
may not access e-mail, make or receive a phone call, text, or access any social networking site
(e.g. Facebook) or cloud storage account (e.g. Dropbox) during the exam.

o You must complete your exam in Excel. Include your name in the name of your Excel file. Only
your Excel file will be graded.

o Upload your completed exam on Canvas to the “Midterm” assignment link. If, for some reason,
you are unable to upload the file to the course Canvas page, email the exam to
anthony.defusco@kellogg.northwestern.edu.

o Your Excel file must be uploaded within 80 minutes. If you fail to upload your exam to Canvas
before the deadline, then your midterm will not be graded.

o There are 4 questions worth a total of 154 points. Points for each question are shown and may
not necessarily correspond to the amount of time it should take you to complete a question.
Pace yourself and try to answer all questions.

o Explain your answers. I can read Excel formulas, but if the problem says “Explain” or “Why”
etc. then do so in words. Incorrect answers without an explanation will receive no credit.

o You are to answer all questions without consulting anyone. If you are unsure about what a
question is asking or feel that it has been phrased ambiguously, make an assumption, state your
assumption clearly, explain why you are making that assumption, and proceed to solve the
problem as best as you can.

o It is paramount that you abide by Kellogg’s honor code in completing this exam. I trust that no
one will receive assistance from any other person nor provide assistance to someone else.
Anyone caught in violation of these rules will receive a failing grade for both this exam and the
entire course.

o You are not to discuss any part of this exam with anyone until after the exam has been graded.
Question 1 (32 points total)

The release of the next Star Wars movie has been postponed. Originally, the movie was slated to
premiere in 1.5 years, but with the delay the movie’s release is now expected to occur in 2 years.
Your task as an analyst at New Republic Bank is to estimate the losses incurred by Disney using
your knowledge of term structure and the time value of money.

You check your Bloomberg terminal today to find the following information on the current term
structure:

Risk-free U.S. Treasury zero-coupon bonds

with face value of $1000
Maturity Bond Price
(in years) (as a % of face value)
1.0 97.0
1.5 95.0
2 92.5
2.5 89.0

In addition, you make the following assumptions:

• Production costs for the movie are $500 million and will be incurred one year from now
regardless of the release schedule.
• The film will earn $1 billion at release and $500 million six months later
• The film’s future cash flows are risk free

a) (5 points) Calculate the risk-free interest rate (i.e. spot rate) for each of the zero-coupon
bonds.

b) (12 points) Calculate the change in the internal rate of return to Disney associated with the
six-month delayed release.

c) (15 points) Calculate the change in the net present value to Disney associated with the six-
month delayed release.

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Question 2: (56 points total)

After completing your Northwestern education, you are considering developing and selling the
kDrone, a remote-controlled aerial camera capable of capturing HD quality video that when not in
flight, also serves as a fitness monitor, calendar, and voice-activated link to over 10 million websites
simply by saying, “Hey, Wildcat!”

Here are the details of the project:

• At time 0, you will purchase the manufacturing equipment needed for $7,500,000. The
equipment can be depreciated to zero using straight line depreciation over five years (time 1-5).
At the end of year 5, you will sell it for $1,000,000.

• You anticipate selling 25,000 kDrones in the first year (time 1) and the number of kDrones you
sell will increase by 10% per year through the fifth year of sales (time 5). After five years, the
product will be obsolete and sales will be zero beginning in the sixth year (time 6).

• Each kDrone sells for $425. The sales price is constant through time.

• The cost of making each kDrone is $210 in the first year (time 1), but the cost per unit will
increase by 5% each subsequent year.

• You offer your very best customers the opportunity to pay for their kDrone one year after
purchase. You anticipate that 10% of your customers will take advantage of this offer.

• 20% of next-year’s sales will be held as inventory.

• Your tax rate is 40%.

• The appropriate discount rate for this project is 15%.

Should you invest in the project?

Recall: Use the template to answer this question!

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Question 3 (30 points total)

You are considering purchasing your first home. The home is listed at a price of $900,000. Your
mortgage broker informs you that you can lock in a 30-year fully amortizing mortgage at an APR of
8%, with monthly payments and monthly compounding. The mortgage requires a 20% down
payment, meaning you must pay for 20% of the home purchase in cash and take out a loan for the
remaining 80%. There are no fees or closing costs associated with the mortgage. Also, assume that
today is t = 0 and that if you decide to buy the house you will make the first payment a month from
now (t = 1).

a) (5 points) Calculate the monthly payment on your mortgage.

b) (5 points) How much of your first payment would go toward paying down the principle on
the mortgage? How much would go toward paying down the interest?

c) (5 points) How much of your 33rd payment would go toward paying down the principle on
the mortgage? How much would go toward paying down the interest?

d) (5 points) What would the remaining principle balance be after you make your 60th payment
(at the end of month t = 60)

e) (5 points) Calculate the effective annual interest rate (EAR) of your mortgage

f) (5 points) What would your monthly payment and EAR be if:

a. Your interest compounded quarterly instead of monthly?

b. Your interest compounded daily instead of monthly?

(assume there are 30 days in a month and 360 days in a year)

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Question 4: (36 points total)

You are shopping for a car and have found your dream car. Unfortunately, you have no money for
the car, so you must borrow the entire cost of the vehicle. Fortunately, because of the state of the economy,
the auto dealer and manufacturer are willing to provide some incentives to assist you with your
purchase. You have the following information:

You have negotiated a purchase price of $27,000 for the car.

Several banks are willing to lend you the $27,000 through a 48-month auto loan at the annual
percentage rate (APR) of 3%. (Hint: This means that this 3% APR is the competitive market interest
rate for 48-month auto loans.)

The manufacturer will allow you to choose from one of two incentives

• Zero percent financing (for 48 months), meaning a 48-month auto loan with a zero APR.

• A $1,000 rebate. Selecting this choice means that the purchase price of the car would be only
$26,000, but you would be required to borrow this amount from the bank to buy the car.

Assume your only sources of financing are the manufacturer’s 0% loan and the banks’ 3% loans.

All loans require monthly payments to begin one month after purchase.

a. (15 points) What is the value to you (in dollars today) of the 0% financing versus having no
incentives?

b. (15 points) What is the value to you (in dollars today) of the rebate versus having no incentives?

c. (6 points) What loan offer should you choose? Why?