Question: Wally’s Warehouses just went public with an initial public offering of stock. Wally’s stock is not expected to pay any dividends for the next four years. One year after that time (i.e five years from now), Wally’s will pay a $1.00 per share dividend which will grow the next year to $2.00 per share.

Part I: Multiple Choice Questions – MUST Circle the correct answer.
Each multiple choice question is worth 2 points each.

1. Preferred stock is:
A) an example of an annuity.
B) issued by corporations and usually pays a fixed dividend.
C) an example of a perpetuity.
D) both A & B.
E) both B & C.

2. The coupon of a bond is:
A) its time period to maturity.
B) its current price.
C) its face value.
D) its yield to maturity.
E) the amount of the interest payment.

3. One common reason that firms issue two different classes of common stock is to:
a) spread the business risk of the firm
b) allow one stock to increase in price while the other declines
c) restrict voting privileges from some shareholders
d) none of the above – it is not possible for any firm to have two classes of common stock

4. Which of the following are advantages of debt from the perspective of the company issuing the debt (that is, not the investor buying the debt)?
I. Cost of debt is independent of earnings; debtholders do not share in profits.
II. Cost of debt is lower than cost of equity (also tax deductions for amount of interest paid).
III. The owners of the firm do not have to share control (no voting rights).
a) I and II only
b) I only
c) II only
d) I, II, and III only
e) II and III only

5. Investors will be willing to pay more for a corporation’s callable bonds than they will for a corporation’s non-callable bonds.
a. True
b. False

6. Unpaid debt is a liability, which if not paid can cause bankruptcy.
a. True
b. False

7. For a typical coupon paying bond, the discount rate that makes the present value of a bond’s payments equal to its price is termed the:
a) coupon rate
b) yield to maturity
c) yield to call
d) face value
e) maturity value

8. What is the percentage return on a stock that was purchased for $60.00, paid a dividend of $6.00 after one year, and then was sold for $58.00?
a. negative 3.33%
b. 3.33%
c. 6.67%
d. 10.00%
9. Zero-coupon bonds:
a. actually have a non-zero coupon
b. have zero value just prior to maturity.
c. have no maturity.
d. always sell at a discount before maturity.
e. always sell at a premium before maturity

10. For an existing bond that has already been issued, which of the following factors will change when interest rates change?
a) the expected cash flows from a bond
b) the present value of a bond’s payments
c) the coupon payment on a bond
d) the maturity value of a bond

11. Why does depreciation provide a tax shield for the company?
a) Taxes are reduced by the amount of the depreciation
b) Taxes are reduced by the amount of the interest on the company’s debt
c) Taxable income is reduced by the amount of the depreciation
d) Taxable income is reduced by the amount of the interest on the company’s debt

11. Which of the following projects “A” through “D” would you feel the best about accepting? Assume the opportunity cost of capital is 12% for each project.
a) “A” has a small, but negative, NPV
b) “B” has a positive NPV when discounted at 10%
c) The cost of capital for project “C” exceeds its rate of return
d) “D” has a zero NPV when discounted at 14%

12. By issuing a floating rate note instead of a fixed rate note, a firm allows both its debt investors and the firm itself to greatly reduce interest rate risk.
a. True
b. False

FILL-IN BLANK QUESTION (4 points, simply fill in the blank, no additional discussion is needed)
In recent decades, all US recession periods have been preceded by a/an ____________________________________curve

Part II Problems: You must show your work

1. Suppose the following two bonds exist:
Annual Coupon Maturity Face Value YTM
Bond J 7% 9 years $1000 9%
Bond K 7% 20 years $1000 9%
a. Compute today’s price of Bond J only (5 points)
b. If market interest rates increase by 2% tonight, which bond will have a larger percentage price change? (4 pts)
(NOTE: If you can clearly describe, in words, the reason that one bond changes more it is not necessary to do the calculation)

2. Wally’s Warehouses just went public with an initial public offering of stock. Wally’s stock is not expected to pay any dividends for the next four years. One year after that time (i.e five years from now), Wally’s will pay a $1.00 per share dividend which will grow the next year to $2.00 per share. After this, the dividend will increase by 1% per year forever from that point in time. We observe that the expected return on the S&P 500 is 8%/year, the risk-free rate of interest is 3%/year, and the Beta of companies of similar risk to Wally’s Warehouses is 1.2 Calculate the price that you should pay for a share of Wally’s Warehouses stock. (14 points)

3. The Spicoli Company makes surfboards. Spicoli just spent $1 million to bring its plant into compliance with earthquake codes. It hired a surfing consultant to help it develop more stimulating surfboards. The consultant needs to be paid $200,000. She presented her plans to the Spicoli Company in which they can now spend an additional $4 million for equipment that will allow it to make a new range of surfboards which should be a big seller for the next 4 years. Spicoli Company evaluates all potential new projects using a discount rate of 10%. The Spicoli Company has an annual interest expense of $100,000 and pays a $50,000 annual dividend to its founder, Jeff Spicoli. The Spicoli Company’s tax rate is 40 percent.
The $4 million in equipment will be straight line depreciated to a salvage value of zero over 4 years. The Spicoli Company actually expects the equipment to be worth $1 million at the end of 4 years. If Spicoli goes ahead with the project, it will immediately need an additional $1 million for an increase in the net working capital that it needs to make these surfboards.
Spicoli expects to sell 2,000 surfboards each year for 4 years at which point the project will come to an end. Each surfboard costs $400 to make and will be sold for $1200. Should they go ahead with the surfboard project? (16 points)

4. Suppose that a daytime resident MBA student will have to pay $30,000 per year in tuition and fees while in a state university MBA program. In addition, he/she will give up an average annual income of $60,000 per year for the two years spent in the program. Then suppose that this MBA will receive a starting salary of $80,000.
Assume some things. All costs of the first year of the MBA program, including opportunity costs, are incurred at the beginning of the program, the second year's costs are incurred twelve months later, the first year's salary is received at the beginning of the first year of employment, that is, at graduation or 24 months after entering the program, the second year's salary 12 months later, and so on. Ignore living costs throughout the program ဩDQ0%$VWXGHQW must live in any event – and ignore taxes. Assume that salaries don’t grow if he/she keeps working without getting an MBA or gets the MBA and works afterward. Assume the student will work for 30 years after receiving the MBA and will work in his/her current job for a total of 32 years if the student does not choose to get an MBA. Assume all
future cash flows should be discounted at 10 percent per year for this analysis. Is the MBA worthwhile from a purely financial standpoint? (15 points total)