AP/ADMS 4540 Financial Management
Instructor: Dr. William Lim Time Limit: 2 hours
Instructions: Answer all 6 questions of this exam in the spaces provided on the question sheets. (If necessary,
you may write on the back of the sheet). Any resemblance to actual or TV characters is purely coincidental and
although the stories may appear "plausibly real", they are fictitious. You have 2 hours to work. The marks for
each question are given. Please provide the marker with the greatest opportunity to give you credit by showing
all calculations clearly. Answers without clear calculations will be penalized. Only normal writing
instruments, a calculator and one 8.5"x11" or letter-size page list of hand-written formulas may be used to
write this test. This formula sheet must be submitted with the test; otherwise you will automatically receive a
mark of zero (0).
Question 1 (8 marks)
Calculate the duration and volatility of a 5-year, $1,000 face value, 14 percent coupon bond yielding 15 percent
with coupons paid annually. Using its duration and volatility, calculate what happens to the price of the bond
when the yield to maturity falls to 14 percent. What are the consequences for a financial institution that does not
match the duration of its assets to the duration of its liabilities?
Note: Show all working steps, including calculations of PV, RV and WV, clearly for full credit. Question 2 (15 marks)
With Canadian interest rates still at historical lows, McGraw-Hill-Ryerson (MHR) is considering whether to
take advantage of its lower cost of debt and refund its old bonds. Suppose the old issue comprises $30 million,
12 percent coupon rate (paid yearly) 20-year bonds that were sold 5 years ago. A new issue of $30 million, 15-
year bonds can be sold with a coupon rate of 9 percent (paid yearly). A call premium of 6 percent will be
required to retire the old bonds and floatation costs of $1 million will apply to the new issue. The marginal tax
rate applicable is 50% and it is expected that there will be a one month overlap during which any funds can be
invested in Treasury bills yielding 8 percent. Should MHR refund?
Note: Show all four working steps clearly. Question 3 (15 marks)
Three BAS students and you are interviewing in a roundtable for employment in a prestigious asset
management firm run by George and The Man. The interviewer decides to test potential employees by
presenting them with the following question: “Consider two mutually exclusive projects with net costs and
benefits measured by the following cash flows:
Year Project A Project B
2004 -$1,000 -$1,000
2005 0 +$460
2006 0 +$460
2007 0 +$460
2008 0 0
2009 +$1,925 0
Which project should a firm undertake?”
The three BAS students gave different answers.
Larry: “It’s obvious that a firm should undertake Project A because it offers $545 more in net benefits than
does Project B.”
Curley: “I think a firm should undertake Project B because it has a higher internal rate of return: approximately
19 percent as opposed to approximately 15 percent.”
Moe: “Actually, there is really little difference between the projects. Take any discount rate, say 11.6 percent.
The NPV of each project is about $112. It doesn’t matter which one we choose.”
You are the fourth and final student to speak.
3a. Draw a diagram of the net present value profiles of both projects. (4 marks)
3b. Provide a valid critique of Larry, Curley and Moe’s answers. (8 marks)
3c. Provide a brief description of the correct method by which the projects should be evaluated. (3 marks) Question 4 (32 marks)
After the interview, you meet (Curious) George and The Man (with the Yellow Hat). They are financial
managers who network with other managers and analysts. Hoping to work in the industry, you follow them
around to impress them and their friends with your knowledge of finance.
4a. You next meet Professor Wiseman. She provides you with the following table which gives some
characteristics of two risky assets - stocks and bonds. Also shown are weights in the market portfolio P, which
is assumed to be mean-variance efficient, i.e., it provides the highest expected return for its level of variance.
Asset Weigh in Market Expected Standard Correlation Correlation
Portfolio P Return Deviation With Stocks With Bonds
Stocks 0.50 ? 0.20 1.00 0.40
Bonds 0.50 ? 0.10 0.40 1.00
If the expected return on the market portfolio P, E(rP) is equal to 0.10 or 10 percent, what are the expected
returns on stocks and bonds? Assume the risk-free rate, r , is equal to 0.05 or 5 percent and show all calcula