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ECO359H5 (14)
Sun (12)
Midterm

2011 winter mid-term

7 Pages
125 Views

Department
Economics
Course Code
ECO359H5
Professor
Sun

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Page1of7
First Letter of
LAST NAME
ECO359H5S, Financial Economics II
University of Toronto Mississauga
Midterm Test, February 17th, 2011
Duration: 110 minutes
(Solution)
Student Name: _________________________________________________________________
Student Number: _______________________________________________________________
You must show all your work in order to receive full credit. This test will start promptly at
12:10pm. If you need scratch paper, please raise your hand and someone will bring it to you. All
writing instruments must be down when time has been called. Please remain seated until the test
papers have been collected and counted. If you finish the test with less than 10 minutes before
the end of the test, please remain seated with your exam until time is up. Be sure to print and sign
your name on the sign-in sheet before you leave the test room.
Aids allowed: A non-programmable calculator. No financial calculator. No cellular phone.
Please allocate time appropriately. Good luck!
PLEASE DO NOT TURN THIS SHEET OVER TO LOOK THROUGH THE
EXAM UNTIL EVERYONE HAS AN EXAM IN FRONT OF THEM AND
YOU ARE TOLD TO BEGIN.
Question
(Marks Possible) Marks Earned
1 (20)
2 (25)
3 (25)
4 (30)
Bonus (2)
Total Marks
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Page2of7
Q1. (20 marks total) True/False/Uncertain.
Read the statement carefully. Decide whether the statement is true, false or uncertain and explain
the arguments for your answer. Answers without an explanation will not receive credit. If the
answer you give is based on any assumptions, be sure to state them clearly. Otherwise, you may
not receive full marks for your answer.
Notice that answers without an explanation will not receive credit, even if the answer is
correct.
a) (5 marks) (Non-mutually exclusive) projects that are accepted when using the NPV rule
maybe rejected when applying the Internal Rate of Return criterion.
False. For an independent project, if the NPV of the project is positive, the internal rate of
return will be greater than the required rate of return of the project (assuming no multiple
IRRs), which means that applying the NPV rule or the IRR rule will lead to the same
investment decision.
b) (5 marks) Suppose a firm decreases its fixed costs and increases its variable costs, leaving the
EBIT unchanged. At the same time, it also raises debt to buy back shares. Then the firm's
required rate of return on equity remains constant.
False. The required rate of return on equity can go up or down. :s;
The operating leverage of the firm declines when the fixed costs decrease and the variable
costs increase. As a result, the firm’s beta decreases, so does the required rate of return on
equity.:t; However, rising debt to equity ratio increases the risk of equity, which
increases the required rate of return on equity. :t;
c) (5 marks) The liquidity of stocks refers to the cost of buying and selling stocks. To increase
the liquidity of equity, firms might want to increase the bid-ask spread to lower the cost of
capital.
False. Bid-ask spread is the difference between the bid price (the price a buyer is willing to
pay for a stock) and the ask price (the price a seller is willing to sell). The larger bid-ask
spread, the bigger transaction cost.
So firms have incentive to reduce the bid-ask spread to increase liquidity and hence to lower
the cost of capital.
d) (5 marks) If a firm uses a simple uniform hurdle rate for all investment project returns, then
over time on average, the firm's non-diversifiable risk will increase.
True. A firm should use different discount rates to evaluate different investment projects
according to the risk characteristics of projects. Using a simple uniform hurdle rate might
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Description
First Letter of LAST NAME ECO359H5S, Financial Economics II University of Toronto Mississauga Midterm Test, February 17th, 2011 Duration: 110 minutes (Solution) Student Name: _________________________________________________________________ Student Number: _______________________________________________________________ You must show all your work in order to receive full credit. This test will start promptly at 12:10pm. If you need scratch paper, please raise your hand and someone will bring it to you. All writing instruments must be down when time has been called. Please remain seated until the test papers have been collected and counted. If you finish the test with less than 10 minutes before the end of the test, please remain seated with your exam until time is up. Be sure to print and sign your name on the sign-in sheet before you leave the test room. Aids allowed: A non-programmable calculator. No financial calculator. No cellular phone. Please allocate time appropriately. Good luck! PLEASE DO NOT TURN THIS SHEET OVER TO LOOK THROUGH THE EXAM UNTIL EVERYONE HAS AN EXAM IN FRONT OF THEM AND YOU ARE TOLD TO BEGIN. Question Marks Earned (Marks Possible) 1 (20) 2 (25) 3 (25) 4 (30) Bonus (2) Total Marks Page1of7 www.notesolution.com
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