30017 Corporate Finance

Lecture Slides
Session 8: Practice problems

This is a list of practice problems. We are going to review a selection of them in class, you will receive
solutions for all of them. We will work through the problems together in class, probably with you solving the
problem under discussion on the board. This will work best and be most useful if you try to solve the
problems on your own beforehand, as much and as far as you manage. Some of the problems you are
already familiar with, others are new.
1. The Shocking Demise of Mr. Thorndike. It was one of Morse's most puzzling cases. That morning Rupert
Thorndike, the autocratic CEO of Thorndike Oil, was found dead in a pool of blood on his bedroom floor. He
had been shot through the head, but the door and windows were bolted on the inside and there was no sign
of the murder weapon. Morse looked in vain for clues in Thorndike's bedroom and office. He had to take
another tack. He decided to investigate the financial circumstances surrounding Thorndike's demise. The
company's capital structure was as follows:
5% debentures: $250 million face value. The bonds mature in 10 years and offer a yield of 12%.

Stock: 30 million shares, which closed at $9 a share the day before the murder.

10% subordinated convertible notes: The notes mature in one year and are convertible at any time at a
conversion ratio of 110. The day before the murder these notes were priced at 5% more than their conversion
value.

Yesterday Thorndike had flatly rejected an offer by T. Spoone Dickens to buy all of the common stock for $10
a share. With Thorndike out of the way, it appeared that Dickens's offer would be accepted, much to the
profit of Thorndike Oil's other shareholders. Thorndike's two nieces, Doris and Patsy, and his nephew John
all had substantial investments in Thorndike Oil and had bitterly disagreed with Thorndike's dismissal of
Dickens's offer. Their stakes are shown in the following table:

All debt issued by Thorndike Oil would be paid off at face value if Dickens's offer went through. Holders of
the convertible notes could choose to convert and tender their shares to Dickens.

Morse kept coming back to the problem of motive. Which niece or nephew, he wondered, stood to gain most
by eliminating Thorndike and allowing Dickens's offer to succeed?

Question. Help Morse solve the case. Which of Thorndike's relatives stood to gain most from his death?

2. Mr. Mister has 930 income this year and zero income next year. The market interest rate is 10% per year. Mr.
Mister also has an investment opportunity in which he can invest $50 today and receive $80 next year.
Suppose Mr. Mister consumes $30 this year, invests in the project, and invests in the market. What will be
his consumption next year?
3. Consider a consumption graph. Draw the line that connects consumption this year (now) to consumption
next year. Assume you always maximize consumption. What is the slope of this line?
4. Mr. Mister has taken a 170,000 mortgage on his house at an interest rate of r=0.11 per year. If the mortgage
calls for twenty equal annual payments, what is the amount of each payment?
5. Richard Pere is 30 years old today and his salary next year will be $40,000. Richard forecasts that his salary
will increase at a steady rate of 5% per annum until his retirement at age 60. Assume the discount rate is
 r=.10. What is the present value of all future salary payments? If Richard saves 5% of his salary each year
and invests these savings at the discount rate, how much will he have saved by the age of 60?
6. Company AAA is offering free credit on a new $10,000 car. You pay $1,000 down today and then $300 a
month for the next 30 months (payments are always at the end of the month). Company BBB does not offer
free credit but will give you $1,000 off the $10,000 list price, today. If the rate of interest is 0.83% a month,
which company is offering a better deal?
7. You own an investment project that generates $2 million cash in one year's time. The projects' operating
costs are negligible, and it is expected to last for a very, very long time. Unfortunately, annual cash flows are
expected to decline by 4% per year. The discount rate is 10%. What is the present value of the project’s cash
flows if its cash flows are assumed to last forever? What is the present value of the project's cash flows if its
cash flows are instead assumed to last only 20 years?
8. Consider the following three stocks:
Stock AAA is expected to provide a dividend of $10 a share forever.

Stock BBB is expected to pay a dividend of $5 next year. Thereafter, dividend growth is expected to be 4% a
year forever.

Stock CCC is expected to pay a dividend of $5 next year. Thereafter, dividend growth is expected to be 8%
but dividends will only be paid for 24 years (the last dividend will be paid at the end of year 24).

The market capitalization rate for each stock is 14%. Calculate the three stock prices.

9. A project requires an initial investment of 144,000 (i.e. at t=0) and is expected to produce a cash flow before
taxes of 123,000 per year for two years (i.e. cash flows will occur at t = 1 and t = 2). The assets will be
depreciated using the MACRS-3-year schedule: (t = 1, 33%); (t = 2: 45%); (t = 3: 15%); (t = 4: 7%). The
company's tax situation is such that it can make use of all applicable tax shields. The corporate tax rate is
30%. The opportunity cost of capital is 12%. Assume that the asset can be sold for book value after two
years (selling at book value has no tax consequences). Calculate the NPV of the project.
10. XYZ, Inc. (XYZ) in one year's time is expected to pay a $4 dividend. So far it has been reinvesting 40% of
earnings and growing 4% a year. Suppose XYZ continues on this growth trend. What is the expected long-run
rate of return from purchasing the stock at $100? What is the company's EPS?
11. What would you prefer?
a) An investment paying interest of 12 percent per annum compounded annually.
b) An investment paying interest of 11.7 percent per annum compounded semiannually.
c) An investment paying interest of 11.5 percent per annum compounded continuously.
To answer the question, in each case calculate the future value of an investment of $1000 after 5 years.

12. Assume the following spot rates hold in the bond market: One-year spot rate (i.e. the rate per year at which
you invest today, for one year) r01=6.4%, two-year spot rate (i.e. the rate per year at which you invest today,
for two years) r02=6.4%, three-year spot rate r03=6.2% A three-year bond with a face value of 1,000 has
a 1% coupon. What is the price the bond should be selling for according to the quoted spot rates?
13. The following table shows the prices of a sample of U.S Treasury strips in August 2006. Each strip makes a
single payment of 1000 at maturity.
Maturity Price(%)

August 2007 95.53

August 2008 91.07

August 2009 86.20

August 2010 81.08

Calculate the annually compounded, spot interest rate for all four maturities.

14. A 6-year government bond makes annual coupon payments of 5% and offers a yield of 3% annually
compounded. One year later the bond yield has dropped to 2%. Suppose that an investor bought the bond
exactly when it was issued, and sold it exactly one year later, i.e. when the yield has dropped to 2%. What
purchase price did the investor pay initially? At what price did the investor sell the bond? [Hint: Use the
annuity formula to value both bond prices. Note that when the investors sells the bond, it is no longer a
6-year, but a 5-year bond.]
15. A convertible bond is selling for 993. It has 15 years to maturity, 1,000 face value, and pays 8% coupon
interest payments annually. Similar straight bonds (nonconvertible) are priced to yield 8.5%. The conversion
ratio is 20. The stock is currently selling for 45. Calculate the convertible bond's option value.