• Carolyn just turned 52 years of age and works for the state of California. She started working there on her 23^rd birthday, just after she graduated from college. This coming year will be her 30^th year working for the state and she is considering retiring on her 53^rd birthday as she will have reached 30 years of service. This entitles her to a defined benefit pension in which she receive 90% of her final year pay for the rest of her life, annually increased by the rate of inflation. For instance, if she made $50,000 in her final year working, she would receive $45,000 at the end of the first year of retirement (on her 54^th birthday). Each year thereafter the payment will increase by the rate of inflation. Assume that she is expected to live to age 83, allowing for 30 years of retirement. Also assume that inflation is expected to be 3% each year during her retirement.

If Carolyn made $80,000 in her final year of working for the state, what is the present value of her pension plan if the appropriate opportunity cost of capital were 5.5% per year? Show all calculations.

Name:_______________________________ Financial Management (BUSI 640) Professor Faulkender Midterm Exam: Fall 2016 1) The exam is open book and open notes. You may use Excel and a calculator. 2) Point totals for each question are specified in parentheses. There are 220 total points. 3) Circle your numerical answers. This makes it easier for me to find them. Show all calculations and the inputs of all values solved for using your calculator or Excel. This allows me to determine how your numbers were arrived at. If you get stuck on the math, tell me what the correct answer should be based on your intuition. Incorrect numerical answers based on the correct logic will receive partial credit. 4) Your answer should be given in the space provided. If you need more space, feel free to write on the back of the page, but clearly mark the question number you are answering. If you would like to add pages from your Excel spreadsheet, please staple them following the corresponding question. 5) As always, I expect you to abide by the honor code. I trust that no one will give or receive assistance which gives them an unfair advantage over other students. You should not speak about the exam to anyone who has not yet completed it. Please write the following below, consistent with the Smith School Honor Code: "I pledge on my honor that I have not given or received any unauthorized assistance on this exam." 6) Statements by you which are true, but do not answer the question, will not raise your score. Statements that are incorrect will reduce your score. Question 1 (60) 2 (55) 3 (35) 4 (35) 5 (35) Total (220 possible) Score 1. Carolyn just turned 52 years of age and works for the state of California. She started working there on her 23rd birthday, just after she graduated from college. This coming year will be her 30th year working for the state and she is considering retiring on her 53 rd birthday as she will have reached 30 years of service. This entitles her to a defined benefit pension in which she receive 90% of her final year pay for the rest of her life, annually increased by the rate of inflation. For instance, if she made $50,000 in her final year working, she would receive $45,000 at the end of the first year of retirement (on her 54 th birthday). Each year thereafter the payment will increase by the rate of inflation. Assume that she is expected to live to age 83, allowing for 30 years of retirement. Also assume that inflation is expected to be 3% each year during her retirement. a. If Carolyn made $80,000 in her final year of working for the state, what is the present value of her pension plan if the appropriate opportunity cost of capital were 5.5% per year? Show all calculations. (15) b. The total pay used in the pension calculation is not limited to the base salary of the employee. It also includes any overtime pay that was earned in the final year, a practice known as \"spiking\". Carolyn's $80,000 is based on working 2000 hours (40 hours per week for 50 weeks) during the year at $40 per hour. If she works overtime, she is paid 1.5 of her normal hourly wage ($60 per hour) on any hours above 2000 hours (above 40 hours per week). If she instead worked 2200 hours in her final year, what would be the new present value of her pension plan? What is the true per hour cost of Carolyn's overtime? Show all calculations. (25) c. To fund their employee's retirement, the state of California invests some of their pension assets in the stock market. Historically, their investment portfolio has earned 9% and government pension rules allow states to use that figure to estimate the required pension contribution it must make every year. Above, we used 5.5% as the discount rate because economists argue that the pension obligation is similar in legal obligation to a state bond and these bonds are currently yielding 5.5%. Currently, California is paying $13 billion per year in benefits (payments made annually at the end of the year) and this is expected to grow at 5% per year (partly due to inflation and partly due to growth in the number of employees). At the beginning of this year, they had $200 billion in their pension plan and if the contributions to the plan grow at the 3% inflation rate, assuming a 9% return allows them to only contribute $6.41 billion at the end of this year to the plan and have it be in balance over the 75 year actuarial life of the plan. (Accounting rules require the present value of benefits over the next 75 years to equal the present value of the contributions over the next 75 years plus the current value of the pension plan's assets.) What would be the required annual contribution by the state if they instead used the more appropriate 5.5% discount rate that corporations would be required to use? Show all calculations. (20) 2. The federal government recently announced that the budget deficit for fiscal year 2016 (the year that ran from October 1, 2015 to September 30, 2016) was $616 billion. Of the $3.95 trillion in total spending, $215 billion was spent on interest expense. At the end of the fiscal year, the total federal debt outstanding was $17.4 trillion. a. To finance the budget deficit, the federal treasury issued 30-year bonds recently. The bonds have a $10,000 face value and an annual coupon rate of 2.25% with semi-annual coupons so they pay coupons of $112.50 every April 30 and October 31 from 2017 until 2046. The bonds sold for $9,370. What was the yield to maturity on the bonds? (10) b. The treasury also issued one year bonds that have no coupons and a face value of $10,000. They were priced to yield 82 basis points (0.82%). At what price were the bonds issued? (10) c. For simplicity, assume that the federal government only issues one year bonds and 30 year bonds like those above. At the end of fiscal year 2016, approximately 70% of the debt outstanding had a one-year maturity and the remaining 30% had a 30-year maturity (there are actually more maturities than this but this split approximates the average maturity outstanding). Based on this split, what is your forecast of federal interest expense that will be paid in 2017? (10) d. Given the historically low interest rates, many have called on Treasury to issue more of the debt in the form of 30-year Treasuries rather than one-year bonds. If Treasury were to follow that recommendation such that they instead had 50% of the debt due in 30 years and the other 50% due in one year, what is your revised estimate of federal interest expense that will be paid in 2017? (5) e. Even though Treasury does not have two year bonds outstanding (for purposes of this example), imagine that similar securities suggest that a two-year Treasury bond would have a yield of 1.12%. What does that imply will be the one-year rate on a one-year Treasury issued one year from now? If the debt at the beginning of fiscal year 2018 was expected to be $18 trillion and the US government maintained the mix of 70% one-year and 30% 30-year debt at the yield found in (a), what is your estimate of what federal interest expense will be in 2018? (20) 3. Triantis Industries is a real estate developer. The firm has recently posted a Return on Equity (ROE) of 16% due to the success of some of their recent property developments. As a result, the firm retains much of its earnings, issuing dividends of just 40% of their net income. Triantis Industries has 3 million shares outstanding and their earnings next year are expected to be $1.67 per share. a. What is Triantis' dividend growth rate? (5) b. If shareholders require a 15% rate of return for a stock with this amount of risk and they expect this growth rate (from part a.) to be perpetually sustainable, what would be the price of one share of Triantis Industries? (10) c. You believe that this growth rate is only sustainable for three years, after which Triantis Industries' dividends will grow at a more modest 5% annual rate forever (the dividend in year 4 will be higher than year 3 by the percentage calculated in part a. whereas the dividend in year 5 will be 5% higher than the dividend in year 4). What price would you be willing to pay now for one share of Triantis Industries stock? Explain completely. (20) 4. You have two mutually exclusive projects that you have been asked to evaluate and make a recommendation. Assume that investors opportunity cost of capital is 8% for both projects. Their cash flow projections are as follows: Investment 1 Investment 2 Today -$350,000 -$650,000 Time 1 $100,000 $50,000 Time 2 $125,000 $175,000 Time 3 $150,000 $300,000 Time 4 $175,000 $375,000 Time 5 $200,000 $500,000 a. Calculate the NPV and IRR of the projects. If you cannot solve for an actual number, write down the expression that you are looking to solve. (10) b. Why is the NPV of project 2 higher than project 1 yet it has a lower IRR? (10) c. Explain why your investors would be better off taking the project with the lower rate of return. (15) 5. Now that Andy has his permanent job lined up, he is thinking about replacing his car he bought during undergrad with a nice new BMW 4-series convertible. He estimates that he will get $7,500 for his trade-in which he will use as the down payment on his new vehicle. With taxes, license, and all of his desired upgrades, he estimates the total cost of his new vehicle will run $68,000. a. If he purchases the car, the dealer has offered 2.75% financing for 72 months. If he borrowed the portion not covered by his trade-in, what is your estimate of his monthly payment? (10) b. One alternative is to increase his down payment by using some of his signing bonus. If in addition to the trade-in, he also applied $20,000 in cash towards the down payment and financed the rest, what is your revised estimate of his monthly payment? (5) c. The other alternative is for him to instead lease the car. His trade-in would again serve as the down payment and they have offered him monthly payments of $599 per month for three years. At the end of the three years, he could then purchase the vehicle for $43,000. Under these terms, is he better off purchasing the vehicle or leasing it? Assume that he will still be able to borrow at 2.75% when the lease ends. (20)