Econ 156
Gary Smith
Fall 2011

Midterm (75 minutes)

No calculators allowed; if calculations are needed, write the explicit equation(s), identifying the variables. Do not write "Y = aX; solve for X." You can write "100 = 10X; solve for X." BE SURE TO EXPLAIN YOUR REASONING. If you want extra time, you can buy time at a price of 1 point a minute; for example, if your test is handed in 10 minutes after the scheduled finish time, 10 points will be subtracted from the test score.

1. In July 1986 a household received a letter from their savings bank that began:

We are very pleased to offer you the opportunity to save a minimum of $1,370.91 in future interest on your mortgage loan. Yes, you can save $1,370.91 in future interest by increasing your monthly payment by only $25.00 per month beginning in August. This extra $25.00 per month will also pay off your mortgage 3 years and 7 months early.
An enclosed analysis showed that this couple had an unpaid balance of $8,479.53 on a 7.25 percent loan, with 11 years and 11 months of $89.00 monthly payments remaining, and that by increasing their monthly payment by $25 a month, they could pay off their mortgage 3 years and 7 months early and reduce the total interest paid from $4,185.04 to $2,814.13.

a. Why does an extra $25 a month reduce the total interest paid?

b. Why do you think the bank offered this opportunity to reduce the total interest the bank would receive?

2. Here are some data (millions of dollars) for a hypothetical company:

Assume that the firm's dividends, earnings, and assets are all growing at the same constant rate. Use the dividend-discount model to estimate the value of Tobin's q.

3. Rank order the following assets (from 1 = highest to 4 = lowest) according to how sensitive the market values are to changes in the required return used to discount the cash flows:

a. 30-year amortized mortgage at a 10% interest rate

b. 30-year interest-only mortgage at a 10% interest rate

c. 30-year interest-only mortgage at a 5% interest rate

d. 30-year balloon mortgage

4. Municipal bonds are "great if your tax bracket is above 15%." Use a numerical example to explain why this advice from Fortune magazine isn't always right.

5. What is wrong with this estimate of the fundamental value of General Electric (GE)

The quarterly dividend has increased from 18¢ a share to 25¢ a share over the past five years, an annual growth rate of 6.7%. The current market price of $35.28 is equal to the present value of dividends only if the required return is a relatively low 7.409%:

However, the current price represents not only the present value of dividends, but also the present value of future capital gains. Therefore, we need to add together the present value of future dividends and the present value of future capital gains. Therefore, the required return is much higher than 7.409%.

6. The Federal Reserve recently announced that it will use "Operation Twist," a policy that was tried in the 1960s when the Fed wanted to reduce long-term interest rates to stimulate corporate investment while raising short-term interest rates to improve the balance of payments. The Fed traded short-term and long-term government bonds to twist the term structure so that short-term interest rates would be higher than long-term interest rates. Should they have bought short-term bonds and sold long-term bonds, or vice-versa? What are the implications, if any, of the Expectations Hypothesis for Operation Twist?

7. An article in The Wall Street Journal reported that "many companies are using excess cash to buy their own shares rather than build new plants."

a. The Journal observed that, "Of course, that cash could go into dividend increases. But corporate finance officers find some compelling arguments in favor of stock repurchases." Identify one compelling argument.

b. Explain the observation by The Wall Street Journal that share repurchases substantially boosted the prices of some stocks, but had little or no effect on the prices of other stocks.

8. Explain why you either agree or disagree with this advice from MSN Money Central:

Let's say you've found two stocks that you're weighing as potential buys. Both are projected to grow earnings by a very impressive 39% over the next 12 months, and after doing your own due diligence, you agree with those calculations, The stocks are in pretty much the same industry and trade at the same price-to-earnings ratio. But you've got only enough cash to buy one. Which do you buy?

Obviously, the one with earnings momentum. A stock with a 39% annual earnings growth composed of a +10% quarter, followed by a +9% quarter, a +8% quarter and a +7% quarter, is likely to trace a downhill price path over the course of the year. A stock that has started with a +7% quarter-to-quarter growth, and moved successively up to 8%, 9% and 10% growth quarters, is likely to end the period well above where it began. It's only logical that a stock showing accelerating growth is a better buy than one where the rate of growth is declining.

9. Merrill Lynch routinely tracks the characteristics of the stocks in the S&P 500 and has found that stocks with relatively high dividend yields consistently have low projected earnings growth. How do you explain this empirical relationship?

10. Explain this April 1993 quotation from The Wall Street Journal:

Suppose you buy a 10-year Treasury note today at a yield to maturity of 6% and interest rates shoot up to 8%. What happens to your investment?
A. You lose money.
B. You make money.
C. Nothing happens.
D. All of the above.

The answer: D. All of the above.
How is that possible? The trick is how long you hold the investment.