UNIVERSITY OF TORONTO

Joseph L. Rotman School of Management

Oct. 22, 2013 Brean/Kan/

RSM332 MID-TERM EXAMINATION Yang/Yung

DURATION - 2 hours
Aid Allowed: Silent electronic calculator and one 1-sided 8 12 11 crib sheet

Name: Student Number:

Circle the section that you are registered in:
Brean Kan (Mon. 11a.m.1p.m.) Kan (Mon. 2p.m.4p.m.)
Kan (Mon. 57p.m.) Kan (Tue.) Yang (Wed. 11a.m.1p.m.)
Yang (Wed. 35p.m.) Yung

Instructions
1. Write all your answers on the examination paper.
2. Answer five out of six questions. Each question is worth 20 marks. Do not answer all
six questions! In the table below, cross out the question that you choose not to answer.

Question Marks

1
2
3
4
5
6

Total

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1. You obtain a $500,000 mortgage loan from Royal bank to buy a house. The mortgage
has a 10-year fixed rate of 4%/year (using Canadian mortgage convention), and the
amortization period of the mortgage is 25 years.
(a) What is the monthly mortgage payment? (5 marks)
(b) For the 24th monthly payment, how much of it is for interest, and how much of it
is for principal repayment? (5 marks)
(c) How much do you owe the bank after the 120th monthly payment? (4 marks)
(d) What is the total amount of principal repayment for the first 120 months? What
is the total amount of interest for the first 120 months? (6 marks)

2. Suppose you have the following utility function

U (C0 , C1 ) = C0 C1 ,

where C0 is todays consumption and C1 is tomorrows consumption. You are endowed

with Y0 = 12 units of goods today and Y1 = 15 units of goods tomorrow. There is a
production opportunity
that if I0 is invested today, then the output tomorrow would
be f (I0 ) = 30 I0 .
(a) Suppose you have access to the production opportunity but do not have access to
the capital market, what is your optimal investment in the production and what is
your optimal consumption plan? (7 marks)
(b) Suppose there is also a capital market where the interest is r = 0.25, i.e., if you
borrow (or lend) 1 unit of goods today, you will pay (or be paid) 1.25 units of goods
tomorrow. How much should you invest in the production? What is your optimal
consumption plan? How much do you borrow from or lend in the capital market?
(8 marks)
(c) Explain what Fishers separation theorem is. Suppose government now starts to
tax on production, and the after-tax payoff of the production is
q
f (I0 ) = (1 )30 I0 ,

where 0 < < 1 is the tax rate. Does Fishers separation theorem continue to hold?
Explain your answer. (5 marks)

3. Today you observe the following market information regarding two level-coupon bonds,
both of which have a face value of $1000 and two years remaining to maturity.
Bond A, with a coupon rate of 10% per year, has a price of $1039.20;
Bond B, with a coupon rate of 2% per year, has a price of $893.72.
Both bonds have annual coupon payments.
(a) What is the term structure of spot rates (r1 and r2 )? (4 marks)

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 (b) What is the forward rate for the second year (f2 )? (3 marks)
(c) What is the yield to maturitiy for Bond A? (4 marks)
(d) There is a third security, which is a two-year annuity with annual payments of $500
(i.e., it pays $500 at the end of year 1 and another $500 at the end of year 2). What
is its fair price? (3 marks)
(e) Suppose you observe that the price of the annuity in part (d) is $800. Also suppose
that you can buy and sell any unit of all three securities (Bond A, Bond B and the
annuity). Can you form a portfolio to make an arbitrage profit? If yes, how? (6 marks)

4. Suppose today you observe the following market information regarding the prevailing
prices for three zero-coupon bonds:
Bond A, which will pay $1000 in one year, has a price of $952.38;
Bond B, which will pay $1000 in two years, has a price of $857.34;
Bond C, which will pay $1000 in three years, has a price of $751.31.
(a) What is the term structure of spot rates (r1 , r2 and r3 ) today? (3 marks)
(b) What are the yields to maturities for the three bonds? (3 marks)
(c) What is the term structure of forward rates for the second year and third year (f2
and f3 )? (3 marks)
(d) Suppose today a friend offers you a forward contract for the third year which
allows you to either borrow or lend $1000 between the end of the second and third
year at a rate of 15%/year. Is there an arbitrage opportunity? If yes, show the exact
transactions that you need to make in order to obtain an arbitrage profit. (6 marks)
(e) One year later, the price of bond B can take two possible values: $943.40 and
$869.57, with equal probabilities. What is the expected one-year spot rate at the
end of year 1? Which theory, expectations hypothesis or liquidity preference theory,
explains better the term structure of interest rates? (5 marks)

5. (a) You plan to make 20 deposits of $100 each, one every 6 months, with the first
deposit being made in 3 months. If the bank pays an interest rate of 3%/year with
monthly compounding, how much will be in your account after 20 years? (6 marks)
(b) Joel and Julianne are saving for the university education of their newborn daughter,
Maria. They estimate that tuitions will run $40,000 per year when their daughter enters
university in 18 years, with the first of Marias four annual tuition payments on her
18th birthday. The effective annual rate of interest for the next few decades is assumed
to be 10 percent. They will make equal deposits on each of her first 17 birthdays, but
no deposit today.
(i) How much money must they deposit in the bank each year so that their daughter
will be completely supported through four years of university? (4 marks)

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 (ii) If Joel and Julianne plan to increase their 17 deposits at a rate of 4 percent per year,
what would their first deposit be so that their daughter will be completely supported
through four years of university? (4 marks)
(iii) If Maria plans to enroll in a 1-year Masters program right after completing 4 years
of university and she needs to pay $40,000 tuition on her 22nd birthday. How much
will she need to earn on a monthly basis working part-time for 2 years while in high
school at 16 and 17 years old to pay for this Masters program? Assume her salary
stays constant and her first paycheque occurs 1 month after turning 16. (6 marks)

6. As a financial analyst, you are tasked with finding the price per share of Infosys, a
software company.
(a) Assume that the Gordon growth model holds. The typical company in the software
industry has a ratio of next periods dividend to current price D1 /P0 = 1%, pays out
40% of earnings as dividends, and generates a return on equity of 15%. Your analysis
suggests that the discount rate of the typical company in the software industry is
appropriate to value Infosyss stock. What is this discount rate? (4 marks)
(b) Instead of using constant growth rate, you assume that the differential dividend
growth approach should be used to correctly value Infosys stock. Infosys just paid
$1.60 per share in dividends. You estimate that dividends will grow at 15% for the
next four years until year 4, then at 7% perpetually. Find the current price per share
of Infosys using the discount rate for the software industry you computed in part (a).
(6 marks)
(c) Suppose the expected earnings of Infosys for next year will be $4.50 per share.
What is the net present value per share of Infosys growth opportunities under the
assumptions of part (b)? (4 marks)
(d) You noticed that a particular company has a higher leading P/E ratio than a
comparable firm in the same industry. List three possible reasons why this is so.
(6 marks)