1. Suppose your personal federal income tax rate is 30%. You are trying to decide which of the following bonds to invest in. Both are BBB rated and therefore equally risky. • State of Illinois Bond has a 3.20% yield • General Electric has a 4.50% yield Which bond would you invest in and why? 2. Below are the financial statements for the Guernica Incorporated (dollars and number of shares are in thousands). Assume Guernica shares are priced at $40 per share.

(a) (5 points) What is Guernica’s 2019 MVA? In your own words, briefly explain what MVA tells us about the firm’s performance.

(b) (5 points) What is Guernica’s 2019 EVA? Assume that the firm’s weighted cost of capital is 10%. In your own words, what does EVA tell us about the firm’s performance? Has Guernica management performed well?

(c) (5 points) What is Guernica’s free cash flow for 2019?

(d) (5 points) Free cash flow is cash flow available to security holders after all profitable investments have been made by the firm. How much of the free cash flow went to debt holders in terms of interest and repurchases of debt? How much went to equity holders in terms of dividends and repurchases of stock? 3. (5 points) A Villanova basketball player just got an offer to join the Milwaukee Bucks. The Bucks are offering him a $10,000,000 contract to play for five years, which can be paid in one of two ways: Payout 1: $2,000,000 per year for five years paid at the end of each year. Payout 2: $2,000,000 signing bonus (i.e., at the beginning of year 1) and $1,600,000 per year for each of the five years paid at the end of each year. Assuming the basketball player can earn 10% on his money, which payout should he take? 4. Suppose you are 25 years old and currently make $70,000 per year. [Obviously, your personal details are different, but once you finish this problem, you will have a retirement calculator built where you can later specify your own age and salary details]. (a) (5 points) Suppose you intend to retire at the age of 65, exactly 40 years now. If the inflation rate over the next 40 years is expected to average 2.5% per year, how much money will you have to be earning at the start of your retirement to have the same purchasing power your $70,000 salary today? For this part and all following parts, please ignore taxes. (b) Assume you believe you will actually need to have $250,000 per year to live comfortably in retirement to allow for your passion for travel and a reasonably comfortable lifestyle. You believe you will live to your 100th year (35 years after retirement) which will be the average life span for people retiring in the year 2058, the year you retire. You believe that the rate of return on your investments will be 5% per year in retirement. How much of a “nest egg” or retirement fund must you have in order to start paying Yourself $250,000 per year on the first day of retirement and the beginning of each year thereafter until your 100th year?

(c) (5 points) Assume you want to start saving for your retirement “nest egg” goal (in part b). Since you are 25, you believe you can be more aggressive with your investments and therefore expect to earn 8% while saving for retirement. Additionally, your grandparents left you with a $50,000 cash inheritance that you will invest (at 8%) to help fund your retirement nest egg. If you start saving at age 25 and plan to save until you retire at age 65, how much must you save each year (at the end of the year) to reach your financial goal in part (b)? (d) (5 points) Suppose you had unusually better luck than expected and earned 9% per year on your portfolio instead of 8% during the 40 years you were saving for retirement. If your annual saving was the amount found in part

(c), how much money would you be able to live on in retirement each year assuming you live to age 100? Again, assume you can earn 5% in retirement and pay yourself at the beginning of each year.

(e) (5 points) Assume instead, that by the time you reach your retirement, you have accumulated a $4,000,000 nest egg. Further, assume you are spendthrift and live on $300,000 per year and you only earn 4% per year on your money instead of 5%. In how many years will you run out of money?

(f) (5 points) Using information from part

(e) (i.e., the $4,000,000 nestegg and 4% interest rate), what is the most that could be withdrawn from your account each year (in equal amounts) so that the account never runs out of money? I.e., it goes on for perpetuity. Remember, you are withdrawing money at the beginning of each year.

5. Wolverine Corporation is a struggling Michigan based company that decides to raise money by issuing 20-year bonds in the market. The funds will be used to update its product line in order to compete more effectively with the highly advanced Buckeye Corporation, headquartered in Columbus, Ohio. Each bond has a face value of $1,000 and a coupon rate of 10% (a rate consistent with its BBB bond rating). Coupons are paid semi-annually.

(a) The bonds were issued at a yield (rd) of 10%. At what price were the bonds issued? (b) (5 points) If Wolverine was able to sell 2,500 bonds in the market, how much money did Wolverine raise in the bond issuance?

(c) Four years after issuing the bonds, Wolverine Corp ran into worse financial trouble and its credit rating deteriorated to a B rating (junk status), pushing the yields on Wolverine bonds to 13%. Compute the new price on the Wolverine bonds.

(d) Suppose that 12 years after issuance, the price of Wolverine bonds increases to $1,216.58. What is the Yield-To-Maturity (YTM) on Wolverine bonds?

(e) In part (a), instead of issuing 20-year bonds, Wolverine’s CFO, Mr. J. Harbaugh, is considering issuing a type of perpetual bond called a Consol. A Consol is a bond that pays a constant coupon forever (i.e., never expires). If the coupon rate on the consuls is 6.5% (on a face value of $1,000) and the required yield (rd) on the bonds is 5.8%, at what price would these bonds sell? Assume coupons are paid annually.

(f) Harbaugh decides that Wolverine doesn’t yet have sufficient cash flow to start paying coupons on the perpetual bonds in part

(e). Therefore, Harbaugh will issue a debt security he calls a “Delayed Consol” where the bonds sold today, but won’t start paying the perpetual coupon for another 5 years (i.e., the first coupon will be in year 5). If Wolverine decides to issue these bonds, at what price would they be issued in the market. Again, assume the coupon rate would be 6.5% and the required yield (rd) on the bonds is 5.8%. Coupons are paid annually.

6. The real risk-free rate, r*, is 2.6%. Inflation is expected to average 2.25% per year for the next 4 years, after which time it is expected to average 3.75%, forever. An 8-year corporate bond Issued by the Vondrell Corporation will yield 9.5%, which includes a maturity risk premium of 0.20 x (t – 1)%, where t is the bond maturity in years. Assume there is no liquidity premium on Vondrell bonds. What is the yield spread between Vondrell and an 8-year Treasury Security? 7. (5 points) Suppose the real risk-free rate is 3.25%, the average future inflation rate is 4.35%, and a maturity risk premium of 0.07% per year to maturity applies to both corporate and T-bonds, i.e., MRP = 0.07%(t), where t is the number of years to maturity. Suppose also that a liquidity premium of 0.50% and a default risk premium of 0.90% apply to A-rated corporate bonds but not to T-bonds. How much higher would the rate of return be on a 10-year A-rated corporate bond than on a 5-year Treasury bond? r r* IP MRP DRP LP Corporate Treasury