UNIVERSITY OF TORONTO

Joseph L. Rotman School of Management

Mock Midterm Examination, October 2019

RSM 332H1F – Capital Market Theory

Duration: 2 hours

Name: Student Number:

Circle the section that you are registered in:
Corhay (Thu. 9–11a.m.) Corhay (Thu. 11–1p.m.) Corhay (Thu. 3–5p.m.)
Daroga (Mon. 4–6p.m.) Daroga (Mon. 6–8p.m.)
Geoffrey (Tue. 2–4p.m.) Geoffrey (Wed. 4–6p.m.) Geoffrey (Wed. 6–8p.m.)
Wang (Mon. 3–5p.m.) Wang (Mon. 6–8p.m.)

Instructions
1. Write all your answers on this examination paper. Answer all questions.
2. You are allowed a non programmable, silent calculator.
3. The formula sheet is at the end of the exam. You can take it out but make sure the
rest of the exam stays stapled.
4. The total mark for this exam is 100.

Question Marks

1 /20
2 /16
3 /16
4 /16
5 /16
6 /16

Total /100

RSM332H1F Midterm Exam Page 1 of 8

 1. True or False? Briefly explain your answers (3 sentences at most).
(a) The term structure of spot rates is, on average, upward sloping because of the time-
value of money: longer-term cash-flows are more heavily discounted than shorter-term
cash-flows. (5 marks)
(b) If the yield is equal to the coupon rate, then the clean price is always equal to the
face value. (5 marks)
(c) Over the past two years, Company XYZ did not pay any dividend and its free-
cash flows have been mostly negative. Therefore, any DCF valuation methods would
conclude that the price of a share of XYZ is zero. (5 marks)
(d) As long as discount rates are positive, a zero coupon bond should never trade at a
premium. (5 marks)

RSM332H1F Midterm Exam Page 2 of 8

 2. You just graduated from Rotman Commerce and landed a job on Bay Street. Your
annual salary is $100,000, and your contract is for 5 years. Your salary will stay the
same during the first 5 years (i.e., for year 1 to year 5). If you do well (which we assume
will happen with certainty), you will get a permanent contract. Under this contract,
your salary will grow at the rate of 3% per year, until retirement (i.e., your salary starts
growing in year 6). Retirement will occur exactly 30 years after your contract becomes
permanent. For simplicity, we abstract from income taxes and assume that your salary
is paid at the end of each year. The discount rate, r, is 4%, annually compounded.
(a) What is the present value (as of today) of all your future earnings?(5 marks)
(b) You have just found a $800,000 condo that you plan to buy at the end of year 5.
At that time, you will have to pay a down payment equal to 20% of the value of the
property.
Assume that you save 30% of your annual salary in a savings account, which yields
a return of 4%, annually compounded. Will you have enough savings to afford the
condo (i.e. to pay the 20% down payment) assuming that condo prices stay constant?
(6 marks)
(c) Your calculations in part (b) abstracted from changes in real estate prices. Assume
that the expected change in real estate prices is 2%, annually compounded and that
you still earn a return of 4% on your savings. Would your conclusion from part (b)
change? Show your calculations. (5 marks)

RSM332H1F Midterm Exam Page 3 of 8

 3. You purchase a house at a price of $1.2 million. You make a 25 percent down payment
and fund the remainder of the purchase with a mortgage. You negotiate the following
mortgage: a rate of 6 percent fixed for 3 years, amortized over 20 years and repaid in
monthly payments. Assume that Canadian mortgage conventions apply.
(a) What is each monthly payment? (5 marks)
(b) What will you still owe at the end of the 3-year term? (5 marks)
(c) How much interest will you have paid over the first three years of your mortgage?
(6 marks)

RSM332H1F Midterm Exam Page 4 of 8

 4. You are at your trading desk and obtain information on two bonds issued by the
government of Canada. Bond A has a maturity of two years, a face value of $100 and
an annual coupon rate of 6%. Bond B has a maturity of two years, a face value of $100
and an annual coupon rate of 7%. Prices of bonds A and B are $103.83 and $105.72,
respectively. Assume all bonds have annual coupon payments.
(a) Find the term structure of spot rates, r1 and r2 , as well as the term structure of
forward rates, f1 and f2 . (3 marks)
(b) You consider another 2-year annual coupon bond, Bond C, issued by the govern-
ment of Canada. The face value is $100 and the coupon rate is 8%. The bond is
trading at $108.62.

(i) Is there an arbitrage opportunity? (3 marks)

(ii) If you can trade (by any amount) only these three bonds, how would you trade
to generate an arbitrage profit? (5 marks)

(c) An institution is willing to lend you a one-year loan of exactly $1 million (no more,
no less) at the beginning of year 1 for an annual interest rate of 4.5%. Assuming
that you can borrow/lend using spot rates. Show that an arbitrage opportunity exists.
Construct a strategy to generate an arbitrage profit. (5 marks)

RSM332H1F Midterm Exam Page 5 of 8

 5. (a) Suppose that the current term structure is flat and all spot rates are equal to 10%
per annum. A bond portfolio manager is considering how to protect a short position,
which is equivalent to short-selling a 5-year zero-coupon bond with a present value
of $5 million. Suppose that he can only trade 2-year and 10-year zero-coupon bonds,
both with the face value of $1,000. The manager has $5 million cash today to invest
in these assets. (Assume he can trade these bonds by any amount without transaction
cost.) What should he do so that the overall portfolio of the 2-year and 10-year bonds
plus the short position has duration of 0? (9 marks)
(b) If the term structure is slightly steepened such that the 2-year spot rate decreases
by 0.01%, the 5-year spot rate remains the same, and the 10-year spot rate increases
by 0.01%. How does the value of the overall portfolio from (a) change? You may use
approximations by duration. (7 marks)

RSM332H1F Midterm Exam Page 6 of 8

 6. You work as a stock analyst and your job is to provide an estimate for the price of a
share of company Z using the valuation by comparables approach. You have collected
information about three close competitors in the industry – companies A, B, and C –
and plan to use average valuation ratios in the industry to help you come up with price
estimates for company Z. All accounting and pricing information in the table below
are on a per share basis.

Panel A. Company Information

Peer Group
Company A Company B Company C Company Z
Sales (S) 10.00 (i) 8.75 7.50
Gross Profit (GP) 8.00 1.25 6.00 4.00
Earnings (E) 1.00 0.90 1.50 (ii)
Cash From Operations (CFO) (iii) 2.00 2.00 1.85
Earning Growth Rate 15.0% 25.0% 18.0% 20%
Price (P) 25.00 40.00 45.00

Panel B. Comparables
Company A Company B Company C Peer Average
P/S 2.5 8.89 5.1 5.5
P/E 25.0 44.4 (iv) (v)
P/CFO 8.3 20.0 22.5 16.9

Panel C. Share Price Estimates of Company Z by Comparables

P/S (vi)
P/E 44.75
P/CFO 31.35

(a) You have accidentally spilled coffee on the table above. Find the missing values in
the table above, i.e. (i)-(vi). (6 marks)
(b) Give two reasons why the valuation by comparables could fail to provide a good
estimate of the value of Company Z? (4 marks)
(c) Company Z just paid a dividend of $2, which is expected to grow at 4% forever.
Obtain another estimate for the price of a share of company Z if the required return
on equity r is 10%. (3 marks)
(d) The current share price of Company Z is $28.00. What would you recommend
investors to do, i.e. should they buy/sell shares of company Z? Did you just find an
arbitrage opportunity? Explain why or why not in no more than 3 sentences. (3 marks)

RSM332H1F Midterm Exam Page 7 of 8

 RSM332 Formula Sheet - Midterm Exam 2019

1. Present value 14. Macaulay duration

CT T
P V = (1+r) T X CFt 1
D= t×
2. Future value t=1
(1 + y)t P
dP 1 1
F V = C0 (1 + r)T dy P
= −D × 1+y

3. PV of perpetuity 15. Modified duration

P V = Cr D∗ = 1+y
D

4. PV of annuity
h i 16. Dividend growth rate
P V = Cr 1 − (1+r)
1
T
g = b · ROE
5. PV of growing perpetuity b = 1 − Dividend payout ratio
C
P V = r−g
Total dividends
=1−
6. PV of growing
h annuity Net income

i
1+g T
C
P V = r−g 1 − 1+r Net income
ROE =
Common equity
7. PriceXof an asset
CFt
P = 17. Gordon growth model
t
(1 + r)t
D1 D0 (1 + g)
8. Effective rate at frequency f P = =
r−g r−g
rf = fr̄
Note: r̄ is the stated or quoted rate.
18. Free cash flows
9. Effective annual rate (EAR) Revenues
1 + ra = (1 + rf )f − Costs
= EBITDA
10. Price of a bond using yield y − Depreciation
T
X C F = EBIT
P = t
+ − Taxes
t=1
(1 + y) (1 + y)T
  = EBIAT
C 1 F + Depreciation
= 1− T
+
y (1 + y) (1 + y)T = Operating Cash Flow
− Capital Expenditures
11. Clean vs. dirty prices
− Increase in Net Working Capital
Clean P = Dirty P − Accrued Interest
= Free Cash Flow
12. Price of a bond using spot rates
C C C+F 19. Total equity value unlevered firm
P = (1+r + (1+r 2 + · · · + (1+r )T
1) 2) T
E = P × Number of shares
13. Forward rate X Free Cash Flowt
(1+rt )t E=
ft = (1+r t−1 )
t−1 − 1
t
(1 + r)t

RSM332H1F Midterm Exam Page 8 of 8