**Question 58** NPV, inflation, real and nominal returns and cash flows, Annuity

A project to build a toll bridge will take two years to complete, costing three payments of $100 million at the start of each year for the next three years, that is at t=0, 1 and 2.

After completion, the toll bridge will yield a constant $50 million at the end of each year for the next 10 years. So the first payment will be at t=3 and the last at t=12. After the last payment at t=12, the bridge will be given to the government.

The required return of the project is 21% pa given as an effective annual **nominal** rate.

All cash flows are **real** and the expected inflation rate is 10% pa given as an effective annual rate. Ignore taxes.

The Net Present Value is:

A stock **just paid** its annual dividend of $9. The share price is $60. The required return of the stock is 10% pa as an effective annual rate.

What is the implied growth rate of the dividend per year?

**Question 497** income and capital returns, DDM, ex dividend date

A stock will pay you a dividend of $**10** **tonight** if you buy it **today**. Thereafter the annual dividend is expected to grow by **5**% pa, so the next dividend after the $10 one tonight will be $10.50 in one year, then in two years it will be $11.025 and so on. The stock's required return is **10**% pa.

What is the stock price today and what do you expect the stock price to be tomorrow, approximately?

**Question 31** DDM, perpetuity with growth, effective rate conversion

What is the NPV of the following series of cash flows when the discount rate is **5**% given as an effective **annual** rate?

The first payment of $10 is in 4 years, followed by payments every 6 months forever after that which shrink by 2% every 6 months. That is, the growth rate every 6 months is actually **negative 2%**, given as an effective **6 month** rate. So the payment at ## t=4.5 ## years will be ## 10(1-0.02)^1=9.80 ##, and so on.

A stock pays annual dividends which are expected to continue forever. It just paid a dividend of $10. The growth rate in the dividend is 2% pa. You estimate that the stock's required return is 10% pa. Both the discount rate and growth rate are given as effective annual rates. Using the dividend discount model, what will be the share price?

The following equation is the Dividend Discount Model, also known as the 'Gordon Growth Model' or the 'Perpetuity with growth' equation.

### p_0 = \frac{d_1}{r - g} ###

Which expression is **NOT** equal to the expected dividend yield?

**Question 488** income and capital returns, payout policy, payout ratio, DDM

Two companies BigDiv and ZeroDiv are exactly the same except for their dividend payouts.

BigDiv pays large dividends and ZeroDiv doesn't pay any dividends.

Currently the two firms have the same earnings, assets, number of shares, share price, expected total return and risk.

Assume a perfect world with no taxes, no transaction costs, no asymmetric information and that all assets including business projects are fairly priced and therefore zero-NPV.

All things remaining equal, which of the following statements is **NOT** correct?

Your neighbour asks you for a loan of $100 and offers to pay you back $120 in one year.

You don't actually have any money right now, but you can borrow and lend from the bank at a rate of 10% pa. Rates are given as effective annual rates.

Assume that your neighbour will definitely pay you back. Ignore interest tax shields and transaction costs.

The Net Present Value (NPV) of lending to your neighbour is $9.09. Describe what you would do to actually receive a $9.09 cash flow right now with zero net cash flows in the future.

What is the net present value (NPV) of undertaking a full-time Australian undergraduate business degree as an Australian citizen? Only include the cash flows over the duration of the degree, ignore any benefits or costs of the degree after it's completed.

Assume the following:

- The degree takes
**3**years to complete and all students pass all subjects. - There are
**2**semesters per year and**4**subjects per semester. - University fees per subject per semester are
**$1,277**, paid at the**start**of each semester. Fees are expected to stay constant for the next 3 years. - There are
**52**weeks per year. - The first semester is just about to start (t=0). The first semester lasts for 19 weeks (t=
**0**to**19**). - The second semester starts immediately afterwards (t=19) and lasts for another 19 weeks (t=
**19**to**38**). - The summer holidays begin after the second semester ends and last for
**14**weeks (t=**38**to**52**). Then the first semester begins the next year, and so on. - Working full time at the grocery store instead of studying full-time pays
**$20**/hr and you can work**35**hours per week. Wages are paid at the**end**of each week. - Full-time students can work full-time during the summer holiday at the grocery store for the same rate of $20/hr for 35 hours per week. Wages are paid at the end of each week.
- The discount rate is
**9.8%**pa. All rates and cash flows are real. Inflation is expected to be**3%**pa. All rates are effective annual.

The NPV of costs from undertaking the university degree is:

A European bond paying annual coupons of 6% offers a yield of 10% pa.

Convert the yield into an effective monthly rate, an effective annual rate and an effective daily rate. Assume that there are 365 days in a year.

All answers are given in the same order:

### r_\text{eff, monthly} , r_\text{eff, yearly} , r_\text{eff, daily} ###

You just signed up for a 30 year **fully amortising** mortgage loan with monthly payments of $2,000 per month. The interest rate is 9% pa which is not expected to change.

How much did you borrow? After 5 years, how much will be owing on the mortgage? The interest rate is still 9% and is not expected to change.

You just borrowed $400,000 in the form of a 25 year **interest-only** mortgage with monthly payments of $3,000 per month. The interest rate is 9% pa which is not expected to change.

You actually plan to pay more than the required interest payment. You plan to pay $3,300 in mortgage payments every month, which your mortgage lender allows. These extra payments will reduce the principal and the minimum interest payment required each month.

At the maturity of the mortgage, what will be the principal? That is, after the last (300th) interest payment of $3,300 in 25 years, how much will be owing on the mortgage?

A prospective home buyer can afford to pay $2,000 per month in mortgage loan repayments. The central bank recently lowered its policy rate by 0.25%, and residential home lenders cut their mortgage loan rates from 4.74% to 4.49%.

How much more can the prospective home buyer borrow now that interest rates are **4.49%** rather than **4.74%**? Give your answer as a proportional increase over the original amount he could borrow (##V_\text{before}##), so:

Assume that:

- Interest rates are expected to be
**constant**over the life of the loan. - Loans are
**interest-only**and have a life of 30 years. - Mortgage loan payments are made every month in arrears and all interest rates are given as annualised percentage rates compounding per month.

Calculate the price of a newly issued **ten** year bond with a face value of $**100**, a yield of **8**% pa and a fixed coupon rate of **6**% pa, paid **annually**. So there's only one coupon per year, paid in arrears every year.

For a price of $100, Vera will sell you a 2 year bond paying semi-annual coupons of 10% pa. The face value of the bond is $100. Other bonds with similar risk, maturity and coupon characteristics trade at a yield of 8% pa.

**Question 56** income and capital returns, bond pricing, premium par and discount bonds

Which of the following statements about risk free government bonds is **NOT** correct?

**Hint:** Total return can be broken into income and capital returns as follows:

###\begin{aligned} r_\text{total} &= \frac{c_1}{p_0} + \frac{p_1-p_0}{p_0} \\ &= r_\text{income} + r_\text{capital} \end{aligned} ###

The capital return is the growth rate of the price.

The income return is the periodic cash flow. For a bond this is the coupon payment.

Bonds A and B are issued by the same Australian company. Both bonds yield 7% pa, and they have the same face value ($100), maturity, seniority, and payment frequency.

The only difference is that bond A pays coupons of 10% pa and bond B pays coupons of 5% pa. Which of the following statements is true about the bonds' prices?

Which one of the following bonds is trading at a discount?

In these tough economic times, central banks around the world have cut interest rates so low that they are practically zero. In some countries, government bond yields are also very close to zero.

A three year government bond with a face value of $100 and a coupon rate of 2% pa paid semi-annually was just issued at a yield of 0%. What is the price of the bond?

Which firms tend to have **high** forward-looking price-earnings (PE) ratios?

You're trying to save enough money to buy your first car which costs $2,500. You can save $100 at the end of each month starting from now. You currently have no money at all. You just opened a bank account with an interest rate of 6% pa payable monthly.

How many months will it take to save enough money to buy the car? Assume that the price of the car will stay the same over time.

Your main expense is fuel for your car which costs $100 per month. You just refueled, so you won't need any more fuel for another month (first payment at t=1 month).

You have $2,500 in a bank account which pays interest at a rate of 6% pa, payable monthly. Interest rates are not expected to change.

Assuming that you have no income, in how many months time will you not have enough money to **fully** refuel your car?

A student won $**1**m in a lottery. Currently the money is in a bank account which pays interest at **6**% pa, given as an APR compounding per month.

She plans to spend $**20,000** at the **beginning** of every month from now on (so the first withdrawal will be at t=0). After each withdrawal, she will check how much money is left in the account. When there is less than $**500,000** left, she will donate that remaining amount to charity.

In how many months will she make her last withdrawal and donate the remainder to charity?

You're trying to save enough money for a deposit to buy a house. You want to buy a house worth $400,000 and the bank requires a 20% deposit ($80,000) before it will give you a loan for the other $320,000 that you need.

You currently have no savings, but you just started working and can save $2,000 per month, with the first payment in one month from now. Bank interest rates on savings accounts are 4.8% pa with interest paid monthly and interest rates are not expected to change.

How long will it take to save the $80,000 deposit? Round your answer up to the nearest month.

A stock is **just about to pay** a dividend of $1 **tonight**. Future annual dividends are expected to grow by 2% pa. The next dividend of $1 will be paid tonight, and the year after that the dividend will be $1.02 (=1*(1+0.02)^1), and a year later 1.0404 (=1*(1+0.04)^2) and so on forever.

Its required total return is 10% pa. The total required return and growth rate of dividends are given as effective annual rates.

Calculate the current stock price.

**Question 69** interest tax shield, capital structure, leverage, WACC

Which statement about risk, required return and capital structure is the most correct?

A firm changes its capital structure by issuing a large amount of debt and using the funds to repurchase shares. Its assets are unchanged. Ignore interest tax shields.

According to the Capital Asset Pricing Model (CAPM), which statement is correct?