Name_______________________________________ Perm #_______________________________

Econ 134A John Hartman

Instructions:

YOU WILL TURN IN THE ENTIRE TEST, INCLUDING THE MULTIPLE-CHOICE

You have 160 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.

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:

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 10 multiple choice questions (20 points) and 8 problems (49 points). The maximum
possible point total is 70 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 correctly, putting name and perm #
on this page, & having photo ID ___/1
(automatic unless something is incorrect)

Multiple choice portion _____/20

Problems _____/49

Total score _____/70

1. Stock X has a beta of 2 and a rate of return of 20%. Stock Y has a beta of 1.5 and a rate of return of 16%.
What is the market rate of return?
A. 24% B. 22% C. 18% D. 14% E. 12%

2. A stated annual interest rate of 24%, compounded continuously, is equivalent to a stated annual interest
rate of _____%, compounded every three months.
A. 24.7 B. 24.4 C. 24.0 D. 23.7 E. 23.3

3. A bond has a face value of $500 and will pay out a 12% coupon six months and 18 months from today.
The bond will also mature 18 months from today. If the effective annual interest rate of this bond is 15%,
what is the present value of this bond?
A. $495 B. $500 C. $505 D. $510 E. $515
Use the following information to answer the next three questions: No Sins Trucks stock exhibits price
changes that are a random walk. In any given day, the value of the stock goes up by $2 with probability 0.6
and down by $3 with probability 0.4. The stock’s current value is $90.

4. What is the probability that the value of the stock will be the same three days from today?
A. 0% B. 6% C. 22% D. 29% E. 43%

5. What is the probability that the value of the stock will exceed $95 three days from today?
A. 0% B. 6% C. 22% D. 29% E. 43%

6. What is the expected value of the stock three days from today?
A. $96 B. $91 C. $90 D. $86 E. $81
7. In your first job, suppose that your boss tells you to use the discounted payback period method, with the
cutoff date 5 years, 6 months from now. In other words, the payback period is 5 years, 6 months. The
effective annual discount rate is 10%. If your firm is selling something, which of the following offers should
you accept if you use this method?
A. $400 per year forever, with the first payment made one year from today
B. $700 per year forever, with the first payment made four years from today
C. A one-time payment of $2,000 six months from today
D. $10,000 per year forever, with the first payment made 7 years from today
E. $1,000 every two years forever, with the first payment made three years from today

8. A sample of stocks has rates of return of 20%, 30%, and 28%. The standard deviation of this sample is
X%. What is X?
A. 4 B. 5 C. 6 D. 7 E. 8

9. Which of the following would be information incorporated into the value of a stock if we believed in the
strong form of efficiency? (If more than one of the first four answers is correct, pick E.)
A. A public release showing last quarter’s earnings
B. Private information that an employee knows about the company
C. The stock’s previous prices
D. Published accounting statements
E. More than one of the above answers are correct

10. Heidi wants to borrow $30,000 from a local bank to buy a new car. She can afford to make monthly
payments up to $800 per month. Assuming that interest is compounded monthly, what is the largest annual
interest rate she can afford on a 48 month loan? (Hint: You may not be able to easily solve this problem
exactly.)
A. 5% B. 6% C. 7.5% D. 10% E. 12.5%
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. Provide at least four
significant digits to each answer or you may not receive full credit for a correct solution. Show all
work in order to receive credit. You will receive partial credit for incorrect solutions in some
instances. Clearly circle your answer(s) or else you may not receive full credit for a complete and
correct solution.

11. (5 points) Pinch an Inchworm, Inc. currently has $80,000 of stock issued, with no bonds. The current cost
of equity is 20%. If the company sells $20,000 of bonds and uses this money to purchase $20,000 worth of
stock, what is the new cost of equity? Assume that the cost of debt is 10% and that there are no other
securities issues by Pinch an Inchworm. You can also assume that the weighted average cost of capital is
constant.
12. Lucy Bongo Drinks, Inc. always acts as a cash cow unless indicated otherwise. Without any re-
investment of their earnings they will earn $5 per share every year forever. The effective annual interest rate
for owning this stock is 20%. Assume that the next dividend payment will be made later today. Suppose that
Lucy Bongo Drinks, Inc. could retain all of its earnings 4 years from today, and earn 25% on these earnings
over the following year. (In other words, no dividend would be paid 4 years from today if Lucy Bongo
Drinks retains all of its earnings, and would continue to act as a cash cow in later years.)

(a) (1 point) What is the present value of this stock if it continues to act as a cash cow?

(b) (2 points) Should Lucy Bongo Drinks retain its earnings 4 years from today? Why/why not?

(c) (3 points) How much does the present value of Lucy Bongo Drinks change if the company retains its
earnings 4 years from today?
13. Two families, the Greens and the Browns, are buying a house today. The Greens will completely pay
back a loan on their house monthly over the next 10 years, starting in one month. The Browns will do so
monthly over the next 30 years, also starting in one month. Each family will take out a mortgage of $100,000
and will make equal monthly payments to pay back the loan. The stated annual interest rate for both families
is 12%, compounded monthly.

(a) (3 points) During the next 10 years, how much more will the Greens pay each month (relative to the
Browns)?

(b) (3 points) How much more interest will the Browns pay (relative the Greens) over the life of each
family’s respective loans?
14. (7 points) There are 3 states of the world, X, Y, and Z. In state X, Stock A has a rate of return of 6% and
Stock B has a rate of return of 20%. In state Y, Stock A has a rate of return of 10% and Stock B has a rate of
return of 2%. In State Z, Stock A has a rate of return of 14% and Stock B has a rate of return of 11%. All
three states have one-third probability of occurring. What is the standard deviation of a portfolio that has
50% of money invested in each of Stocks A and B?
15. Find the present value of each of the following restaurants’ future dividend payments. Assume the
effective annual interest rate for each restaurant is 20%. Assume each company is infinitely lived unless
mentioned otherwise.

(a) (3 points) Check Your Mailboat, Inc. will pay out a dividend of $5 every 3 months, starting in 18 months.

(b) (4 points) Mr. Buss’s Buses, Inc. will pay out a dividend of $9 every 2 years, starting in 5 years. The
company will go out of business 50 years from today, and pay its shareholders $1,000 per share. No dividend
payments will be made after the company goes out of business.
16. (6 points) Isaias buys one share of stock at a price of $80 today, and two put options with an exercise
price of $40 two years from now. (In other words, the expiration date of the option is two years from now.)
The put option is for selling one share. For simplicity in this problem, you can assume that the discount rate
is 0%. Draw a well-labeled graph that shows the value of a combination of the two shares of stock and the
put option as a function of the value of stock at expiration. The vertical intercept should have the value of the
combination of the stock and the put options. 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.) Explain your answer in
words, math, and/or using additional graphs.
17. (6 points) Mary Ann has just won the Super Wacky Lottery jackpot. She is given two choices: (1)
Receive a monthly payment of $10,000 (starting today) or (2) Receive a one-time lump sum payment today
of $1,000,000. If Mary Ann’s stated annual discount rate is 6%, compounded monthly, what is the minimum
number of monthly payments she must receive in order to do better with the first option?
18. (6 points) Pump With Pride and Love, Inc. stock currently sells for $60 per share. Each of the next 4
years, the value of the stock will go up or down by $5, each with 50% probability. Ron buys a European call
option with expiration date 4 years from today. The exercise price on this option is $69. What is the present
value of this option if the effective annual interest rate is 25%?
NOTE: YOU CAN TEAR THIS SHEET OFF
AND USE AS EXTRA SCRATCH PAPER.
PLEASE NOTE THAT ANYTHING ON THIS Logarithmic rule
SHEET WILL NOT BE GRADED UNLESS ab = c  b = log c / log a
EXPLICITLY SPECIFIED ON THE TEST.

Variance of a sample
Perpetuity 1 T
Var  
T  1 i 1
( Ri  R ) 2
C
PV 
r Variance of a distribution, with each outcome
having the same probability of occurring
1 T
Annuity Var   ( Ri  R ) 2
T i 1
C 1 
PV  1 
r  (1  r )T 
Covariance formula
N
( xi  x )( yi  y )
Growing perpetuity  X ,Y  Cov( X .Y )  
i 1 N
C
PV 
rg
Correlation of A and B
Cov( A, B)
Growing annuity Corr ( A, B)  , where SD stands
SD( A)  SD( B)
 1 1 1  g  
T
for standard deviation
PV  C     
 r  g r  g  1  r  
Variance of a portfolio
Quadratic formula X A2 A2  2 X A X B A,B  X B2 B2
ax2 + bx + c = 0 

 b  b 2  4ac
x
2a