Chapter 6, 7, 8 & 9: Interest Rates: Exam 3

Delta Corporation has a bond issue outstanding with an annual coupon rate of 7% and 20 years remaining until maturity. The par value of the bond is $1,000. Determine the current value of the bond if present market conditions justify a 14% nominal annual required rate of return.

$ 536.38 Correct. Calculator solution: Input N = 20, I/YR = 14, PMT = 70, and FV = 1000, and solve for VB = PV = $536.38.

Delta Corporation has a bond issue outstanding with a 7% coupon, semiannual payments, and 4 years remaining until maturity. The par value of the bond is $1,000. Determine the current value of the bond if present market conditions justify a 14% nominal annual required rate of return.

$ 791.00 Correct. Calculator solution: Input: N = 8, (4 years x 2 periods) -- semi annual I/YR = 7, (14% divided by 2 periods) PMT = 35, ($70 annual interest divided by 2 semi-annual payments) and FV = 1000, solve for VB = PV = $791.00.

Delta Corporation has a bond issue outstanding with an annual coupon rate of 7% and 4 years remaining until maturity. The par value of the bond is $1,000. Determine the current value of the bond if present market conditions justify a 14% nominal annual required rate of return.

$ 796.04 Correct. Calculator solution: Input: N = 4, I/YR = 14, PMT = 70, and FV = 1000, and solve for VB = PV = $796.04.

The Club Auto Parts Company has just recently been organized. It is expected to experience no growth for the next 2 years as it identifies its market and acquires its inventory. However, Club will grow at an annual rate of 5% in the third year and, beginning with the fourth year, should attain a 10% growth rate that it will sustain thereafter. The first dividend (D1) to be paid at the end of the first year is expected to be $0.50 per share. Investors require a 15% rate of return on Club's stock. What is the current equilibrium stock price?

$ 8.75 To calculate the current value of a nonconstant growth stock, follow these steps: 1. Determine the expected stream of dividends during the nonconstant growth period. Also, calculate the expec¬ted dividend at the end of the first year of constant growth that will be used later to calculate the stock price. 2. Discount the expected dividends during the nonconstant growth period at the investor's required rate of return to find their present value. 3. Calculate the expected stock price at the end of the final year of nonconstant growth. This occurs at the end of Year 3. Use the Gordon model for this calculation. 4. Add the present value of the stock price expected at the end of Year 3 plus the dividends expected in Years 1, 2, and 3 to find the present value of the stock, P0.

The Club Auto Parts Company has just recently been organized. It is expected to experience no growth for the next 2 years as it identifies its market and acquires its inventory. However, Club will grow at an annual rate of 5% in the third year and, beginning with the fourth year, should attain a 10% growth rate that it will sustain thereafter. The first dividend (D1) to be paid at the end of the first year is expected to be $0.50 per share. Investors require a 15% rate of return on Club's stock. What will Club's stock price be at the end of the first year ()?

$ 9.57

A bond that matures in 6 years sells for $950. The bond has a face value of $1,000 and a 5.5% annual coupon. Its' yield to maturity is 6.53%. Assume that the yield to maturity remains constant for the next two years. What will be the price of the bond two years from today?

$ 964.61 Correct. N = 4; I/YR = 6.5339; PMT = 55; FV = 1000; PV = ? Solve for VB = PV = $964.61

Moerdyk Corporation's bonds have a 15-year maturity, a 7.25% semiannual coupon, and a par value of $1,000. The going interest rate (rd) is 6.20%, based on semiannual compounding. What is the bond's price?

$1,101.58 N = 30 (15 x 2) I = 3.10 (6.20/2) PMT = 36.25 (1000 x .0725) /2 FV = 1,000 PV = 1,101.58

Assume that you are considering the purchase of a 20-year, noncallable bond with an annual coupon rate of 9.5%. The bond has a face value of $1,000, and it makes semiannual interest payments. If you require an 8.4% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond?

$1,105.69 Par value = 1,000 coupon rate = 9.5% periods/year = 2 yrs to maturity = 20 periods = yrs to maturity x periods/yr = 40 (20x2) Required rate = 8.4% Periodic rate = required rate/2 = I/YR = 4.20% PMT per period = coupon rate/2 x par value = 47.50 FV = 1,000 N = 40 I/YR = 4.2 PMT = 47.5 FV = 1000 PV = 1,105.69

Grossnickle Corporation issued 20-year, noncallable, 7.5% annual coupon bonds at their par value of $1,000 one year ago. Today, the market interest rate on these bonds is 5.5%. What is the current price of the bonds, given that they now have 19 years to maturity?

$1,232.15 N = 19 years I =5.5% PMT = $75 (1,000 x 0.075 coupon rate) FV = 1,000 PV = $1,232.15

Emerging Technologies Inc.'s total corporate value is $300 million according to the corporate valuation model. The balance sheet shows $90 million of notes payable, $30 million of long-term debt, $40 million of preferred stock, and $100 million of common equity. The company has 10 million shares of stock outstanding. What is the best estimate of Emerging Technologies Inc. stock's price per share?

$14.00 Assuming the book value of debt is close to its market value , the total market value of the firm's equity is total corporate value: $300 notes payable: 90 mill Long-term debt: 30 Preferred stock 40 Shares outstanding 10 Value of equity = Total MV - Long term debt - short term debt - preferred stock 300 - 90 - 30 - 40 = 140 Stock price = value of equity/shares outstanding = 140 / 10 = $14.00

Based on the corporate valuation model, Morgan Inc.'s total corporate value is $300 million. The balance sheet shows $90 million of notes payable, $30 million of long-term debt, $40 million of preferred stock, and $100 million of common equity. The company has 10 million shares of stock outstanding. What is the best estimate of the stock's price per share?

$14.00 total corporate value: $300 notes payable: 90 mill Long-term debt: 30 Preferred stock 40 Shares outstanding 10 Value of equity = Total MV - Long term debt - short term debt - preferred stock 300 - 90 - 30 - 40 = 140 Stock price = value of equity/shares outstanding = 140 / 10 = $14.00

Chadmark Corporation is expanding rapidly, and it currently needs to retain all of its earnings, hence it does not pay any dividends. However, investors expect Chadmark to begin paying dividends, with the first dividend of $0.75 coming 2 years from today. The dividend should grow rapidly, at a rate of 40% per year, during Years 3 and 4. After Year 4, the company should grow at a constant rate of 10% per year. If the required return on the stock is 16%, what is the value of the stock today?

$16.93

Some investors expect Endicott Industries to have an irregular dividend pattern for several years, and then to grow at a constant rate. Suppose Endicott has D0 = $2.00; no growth is expected for 2 years; then the expected growth rate is 8% for 2 years; and finally the growth rate is expected to be constant at 15% thereafter. If the required return is 20%, what will be the value of the stock?

$31.31

Today is December 31, 2013. The following information applies to Harrison Corporation: After-tax operating income [EBIT(1 - T)] for 2014 is expected to be $950 million. The company's depreciation expense for 2014 is expected to be $190 million. The company's capital expenditures for 2014 are expected to be $380 million. No change is expected in the company's net operating working capital. The company's free cash flow is expected to grow at a constant rate of 4% per year. The company's cost of equity is 13%. The company's WACC is 9%. The market value of the company's debt is $5.2 billion. The company has no preferred stock. The company has 250 million shares of stock outstanding. Using the corporate valuation model, what should be the company's stock price today?

$40.00

You have been assigned the task of using the corporate, or free cash flow, model to estimate Petry Corporation's intrinsic value. The firm's WACC is 10.00%, its end-of-year free cash flow (FCF1) is expected to be $75.0 million, the FCFs are expected to grow at a constant rate of 5.00% a year in the future, the company has $200 million of long-term debt and preferred stock, and it has 30 million shares of common stock outstanding. What is the firm's estimated intrinsic value per share of common stock?

$43.33 FCF = 75 mill g = 5% WACC = 10% Value of debt & preferred stock = $200 Total firm value = FCF / (WACC - g) = 75 / (0.10 - 0.05) = 1,500 Value of equity = Firm value - debt & preferred stock = 1,500 - 200 = $1,300 Value per share = equity value / shares outstanding = 1,300 / 30 = $43.33

Hidden Technologies Inc. (HTI) is expected to generate $75 million in free cash flow next year, and it is expected to grow at a constant rate of 6% per year. The firm has no debt or preferred stock and has a WACC of 9%. HTI has 50 million shares of stock outstanding. Using the corporate valuation model, what is the value of the company's stock per share?

$50.00 Firm Value = FCF / (WACC - g) = 75 / (0.09 -0.06) = 2,500 Equity value per share = equity value / shares outstanding = 2,500 / 50 = $ 50.00

Assume that Steed & Associates' bonds have a par value of $1,000, mature in 8 years, and make an annual coupon interest payment of $65. If the market requires an interest rate of 8.2% on these bonds, what is the bond's price?

$903.04 N = 8 years I = 8.2 % PMT = $65 FV = $1000 PV = $903.04

What is the coefficient of variation of the expected dollar returns given the following distribution of returns?

0.6383 Correct. Use the given probability distribution of returns to calculate the expected value, variance, standard deviation, and coefficient of variation. Use the standard deviation and the expected return to calculate the coefficient of variation: CV = S.D. / Expected rate of return $14.3614/$22.5 = 0.6383.

View each of the below-listed provisions that are often contained in bond indentures alone. Which of these provisions would tend to REDUCE the yield to maturity that investors would otherwise require on a newly issued bond? Fixed assets are used as security for a bond. A given bond is subordinated to other classes of debt. The bond can be converted into the firm's common stock. The bond has a sinking fund. The bond has a call provision. The indenture contains covenants that restrict the use of additional debt.

1, 3, 4, 6 Correct. Fixed assets used as security, having the ability to convert into common stock, having a sinking fund, and including covenants that restrict the use of additional debt would all tend to reduce the yield to maturity

Jan Middleton owns a 3-stock portfolio with a total investment value equal to $300,000. What is the weighted average beta of Jan's 3-stock portfolio?

1.0 Correct. The calculation of the portfolio's beta is as follows: Weight1 = 100/300 w2 = 100/300 w3 = 100/300 bp = (1/3)(0.5) + (1/3)(1.0) + (1/3)(1.5) = 1.0.

Lucas Laboratories' last dividend was $1.50. Its current equilibrium stock price is $15.75, and its expected growth rate is a constant 5%. If the stockholders' required rate of return is 15%, what is the expected dividend yield and expected capital gains yield for the coming year?

10%; 5% Correct. The dividend yield is: D(1+g)/P = $1.50(1.05)/$15.75 = 10%. The capital gains yield is (P(1+g) - P)/P = ($16.5375 - $15.75)/$15.75 = g = 5%.

You have determined the following data for a given bond: Real risk-free rate (r*) = 3%; inflation premium = 8%; default risk premium = 2%; liquidity premium = 2%; and maturity risk premium = 1%. What is the nominal risk-free rate, rRF?

11% .rRF = r* + IP = 3% + 8% = 11%

Consider the following information for the Alachua Retirement Fund, with a total investment of $4 million. The market required rate of return is 12%, and the risk-free rate is 6%. What is its required rate of return?

11.01% Correct. Determine the weight each stock represents in the portfolio, and multiply that by each beta, and then add them together to get the portfolio beta, which is bp = 0.8350 = Portfolio beta. Then, write out the SML equation, and substitute known values including the portfolio beta. Solve for the required portfolio return: rp = rRF + (rM - rRF)bp = 6% + (12% - 6%)0.8350 = 6% + 5.01% = 11.01%

Delta Corporation has a bond issue outstanding with an annual coupon rate of 7% and 20 years remaining until maturity. The par value of the bond is $1,000 and present market conditions justify a 14% nominal annual required rate of return. What is the bond's current yield?

13.05% INPUT: N = 20 I/Y = 14 PMT = 70 FV = 1000 Solve: PV = 536.38 Next solve for current yield: Current yield = Annual Interest/Current price of bond $70 / $536.38

Acme Products has a bond issue outstanding with 8 years remaining to maturity, a coupon rate of 10% with interest paid annually, and a par value of $1,000. If the current market price of the bond issue is $814.45, what is the yield to maturity, rd?

14% Correct. Calculator solution: Input N = 8, PV = -814.45, PMT = 100, and FV = 1000, and solve for I/YR = rd = 14.00% rd = yield to maturity

If rRF = 5%, rM = 11%, and b = 1.3 for Stock X, what would rX be if investors expected the inflation rate to increase by 2 percentage points? Assume that investors' risk aversion has not changed.

14.8% Correct. rX = rRF + (rM - rRF)b X = 7% + (13% - 7%)1.3 = 14.8%. A change in the inflation premium does not change the market risk premium (rM - rRF) since both rM and rRF are affected. Changes in the market risk premium reflect changes in investors' risk aversion.

Suppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-year Treasury Inflation Protected Security (TIPS) is 2.15%. Suppose further that the MRP on a 10-year T-bond is 0.90%, that no MRP is required on a TIPS, and that no liquidity premium is required on any T-bond. Given this information, what is the expected rate of inflation over the next 10 years? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

2.00% Inflation = Rt - r* - MRP = 5.05% - 2.15% - 0.90% = 2.00%

McCue Inc.'s bonds currently sell for $1,250. They pay a $90 annual coupon, have a 25-year maturity, and a $1,000 par value, but they can be called in 5 years at $1,050. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. What is the difference between this bond's YTM and its YTC? (Subtract the YTC from the YTM; it is possible to get a negative answer.)

2.62% YTM = N = 25 PV = - 1250 PMT = 90 FV = 1000 I = 6.88% YTC = Yield To Call N = 5 years PV = - 1250 PMT = 90 FV = 1,050 I = 4.26 Difference = YTM - YTC = 6.88% - 4.26% = 2.62%

If all interest rates in the economy fall by 1%, which of the following bonds would have the greatest percentage increase in value?

20-year, zero coupon bond. Correct. A long-term zero coupon bond will experience more price change than a shorter-term zero or a coupon bond.

Stock A has a beta of 1.2, Stock B has a beta of 0.6, the expected rate of return on an average stock is 12%, and the risk-free rate of return is 7%. By how much does the required return on the riskier stock exceed the required return on the less risky stock?

3.00%

A stock is expected to pay a dividend of $2.25 at the end of the year (D1 = $2.25). The dividend is expected to grow at a constant rate of 4% a year. The stock has a required return of 11%. What is the expected price of the stock five years from today?

39.11 P0 = D0 (1+g)/(rs-g) $2.25 (1+.04)^5 / (0.11 - 0.04)^5 or First solve for current price P0 = P1 / (rs - g) = $2.25 / (0.11-0.04) = 32.14 P-hat-5 (P5) = P0 (1+g)^5 = 32.14 (1 + 0.04)^5 = 39.11

Stock A has the following probability distribution of expected returns. What is Stock A's expected rate of return and standard deviation?

5.0%; 9.5% Correct. rA = 0.1(-15%) + 0.2(0%) + 0.4(5%) + 0.2(10%) + 0.1(25%) = 5.0%. Variance = 0.1(-0.15 - 0.05)2 + 0.2(0.0 - 0.05)2 + 0.4(0.05 - 0.05)2 + 0.2(0.10 - 0.05)2 + 0.1(0.25 - 0.05)2 = 0.009. Standard deviation = 0.0949 = 9.5%.

Helen's Pottery Co.'s stock recently paid a $1.50 dividend (D0 = $1.50). This dividend is expected to grow by 15% for the next 3 years, and then grow forever at a constant rate, g. The current stock price is $40.92. If rs = 10%, at what constant rate is the stock expected to grow following Year 3?

5.00%

The real risk-free rate of interest is 2%. Inflation is expected to be 3% the next 2 years and 5% during the next 3 years after that. Assume that the maturity risk premium is zero. What is the yield on 3-year Treasury securities?

5.7% r* = 2%; Inflation1 = 3%; I2 = 3%; I3 = 5%; I4 = 5%; I5 = 5%; MRP = 0; rT3 = ? Since these are Treasury securities, DRP = LP = 0. rT3 = r* + IP3. IP3 = (3% + 3% + 5%)/3 = 3.67%. rT3 = 2% + 3.67% = 5.67% ≈ 5.7%

A bond that matures in 6 years sells for $950. The bond has a face value of $1,000 and a 5.5% annual coupon. What is the bond's current yield?

5.79% Correct. VB = $950; M = $1,000; INT = 0.055 $1,000 = $55. Current yield = Annual interest/Current price of bond = $55.00/$950.00 = 5.79%

Porter Inc.'s stock has an expected return of 12.25%, a beta of 1.25, and is in equilibrium. If the risk-free rate is 5.00%, what is the market risk premium?

5.80% required return = Risk free rate (rRF) + beta x Market risk premium (RPm) 12.25% = 5.00% +1.25 x RPm RPm = 5.80

The real risk-free rate of interest is 2%. Inflation is expected to be 3% the next 2 years and 5% during the next 3 years after that. Assume that the maturity risk premium is zero. What is the yield on 5-year Treasury securities?

6.2%

Suppose the interest rate on a 1-year T-bond is 5.00% and that on a 2-year T-bond is 6.00%. Assume that the pure expectations theory is NOT valid, and the MRP is zero for a 1-year T-bond but 0.40% for a 2-year bond. What is the yield on a 1-year T-bond expected to be one year from now?

6.20% 1-year rate today: 5.00% 2-year rate today: 6.00% MRP on 2-year bonds = 0.40% Expected annualized return on a series of 1-year bonds = 2 year rate - MRP 6.00% - 0.40% = 5.60% Compound return on series of 1-year bonds at above rate: (1.056)(1.056) = 1.115136 Compound return on series of 1-year bonds: = (1.05) (1 + X) = 1.1151 Expected Yield on a 1-year bond 1 year from now: X in the equation: (1.05) (1 + X) = 1.1151 X = (1.1151/1.05) - 1 X = 6.20%

Keenan Industries has a bond outstanding with 15 years to maturity, an 8.25% nominal coupon, semiannual payments, and a $1,000 par value. The bond has a 6.50% nominal yield to maturity, but it can be called in 6 years at a price of $1,120. What is the bond's nominal yield to call?

6.53%

A bond that matures in 6 years sells for $950. The bond has a face value of $1,000 and a 5.5% annual coupon. What is the bond's yield to maturity, rd?

6.53% Correct. N = 6; PV = -950; PMT = 55; FV = 1000; YTM = ? Solve for I/YR = YTM = 6.5339% ≈ 6.53%

The real risk-free rate is 3.55%, inflation is expected to be 3.15% this year, and the maturity risk premium is zero. Taking account of the cross-product term, i.e., not ignoring it, what is the equilibrium rate of return on a 1-year Treasury bond?

6.812% rRF = (1+r*)(1+IP) - 1 = (1+.0355)(1+.0315) - 1 = 6.812%

A bond that matures in 8 years has a 10% coupon rate, semiannual payments, a face value of $1,000, and an 8.5% current yield. What is the bond's nominal yield to maturity (YTM)?

7.1% Solve for PV using the 8.5% current yield Current yield =Annual interest payment/current bond price 8.5% = $100/Current bond price Vb = $100/.085 Vb = 1,176.47 N = 16 (8x2) PV = - 1,176.47 PMT = 50 (.05 x 1000) or (.1 x 1,000)/2 FV = 1,000 I = 7.1%

Interest rates on 4-year Treasury securities are currently 6.5%, while 6-year Treasury securities yield 6.8%. If the pure expectations theory is correct, what does the market believe that 2-year securities will be yielding 4 years from now? Use the geometric average to arrive at your answer.

7.4% 4R2 = (1.065)^4(1+X)^2 = (1.068)^6 1.2865(1+X) = 1.4840 1+X = (1.4840/1.2865)^1/2 X = 7.4%

Carter's preferred stock pays a dividend of $1.00 per quarter. If the price of the stock is $45.00, what is its nominal (not effective) annual rate of return

8.89% Preferred quarterly dividend: $1.00 Annual dividend = $1.00 x 4 periods = $4.00 Preferred stock price = $45.00 Nominal rate = Dp/Vp = $4.00 / $45.00 = 8.89%

Dothan Inc.'s stock has a 25% chance of producing a 30% return, a 50% chance of producing a 12% return, and a 25% chance of producing a −18% return. What is the firm's expected rate of return?

9.00%

Suppose the interest rate on a 1-year T-bond is 5.0% and that on a 2-year T-bond is 7.0%. Assuming the pure expectations theory is correct, what is the market's forecast for 1-year rates 1 year from now?

9.04%

Hooper Printing, Inc. has a bond issue outstanding with 14 years left to maturity. The bond issue has a 7% annual coupon rate and a par value of $1,000, but due to changes in interest rates, each bond's value has fallen to $749.04. The capital gains yield earned by investors over the last year was 25.10%. What is the expected current yield for the next year on this bond issue?

9.35% Correct. The current yield is defined as the annual coupon payment divided by the current price. CY = $70/$749.04 = 9.35%

Taggart Inc.'s stock has a 50% chance of producing a 25% return, a 30% chance of producing a 10% return, and a 20% chance of producing a −28% return. What is the firm's expected rate of return?

9.90%

Bond market data show the following information: The Treasury yield curve is downward sloping. Empirical data indicate that a positive maturity risk premium applies to both Treasury and corporate bonds. Empirical data also indicate that there is no liquidity premium for Treasury securities but that a positive liquidity premium is built into corporate bond yields. On the basis of this information, which of the following statements is most CORRECT?

A 5-year corporate bond must have a higher yield than a 10-year Treasury bond. Correct. If a short-term maturity has a higher yield than a longer-term maturity, the yield curve must be downward sloping.

Of the following, identify the CORRECT statement.

A bond's current yield must always be either equal to its yield to maturity or between its yield to maturity and its coupon rate. Correct. This is correct because YTM = Current yield +/− Capital gains yield, so Current yield = YTM +/− Capital gains yield. The capital gains yield will be positive or negative depending on whether the coupon rate is above or below the YTM That means that the current yield must either equal the YTM or be between the YTM and the coupon rate

Which of the following would be most likely to lead to increases in nominal interest rates?

A new technology such as the Internet has just been introduced, and it increases investment opportunities.

When stockholders assign their right to vote to another party, this is called

A proxy. Proxy fights occur when a dissident group of stockholders solicits proxies in competition with the firm's management. If the dissident group obtains a majority of the proxies, then it can gain control of the board of directors and oust existing management.

Taussig Corp.'s bonds currently sell for $1,150. They have a 6.35% annual coupon rate and a 20-year maturity, but they can be called in 5 years at $1,067.50. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. Under these conditions, what rate of return should an investor expect to earn if he or she purchases these bonds?

Answer: 4.20% Par Value = 1,000 Coupon = 6.35% N = 20 PV = - 1150 PMT = 63.50 FV = 1,000 I - YTM = 5.13% If Called YTC: Par Value = 1,000 Coupon = 6.35% N = 5 PV = -1150 PMT = 63.50 FV = 1057 I YTC = 4.20 % Expected rate of return = YTC if coupon > YTM 6.35 > 5.13 Thus, expected rate of return = YTC = 4.20%

Which of the following situations would be most likely to lead to an increase in interest rates in the economy?

Corporations step up their expansion plans and thus increase their demand for capital.

The marginal investor determines the price at which a new issue of stock will trade when it is brought to market.

Correct. The marginal trade is the one that closes the IPO and sets the price of trading

Stability Inc. has maintained a dividend rate of $4 per share for many years. The same rate is expected to be paid in future years. If investors require a 12% rate of return on similar investments, determine the present value of the company's stock

Correct. This is a zero growth stock, or perpetuity: P0= D/rs = $4.00/0.12 = $33.33.

Interest rates on 20-year Treasury and corporate bonds with different ratings, all noncallable, are as follows: T-bond = 6.32% AAA = 7.78% A = 8.46% BBB = 9.28% The differences in rates among these issues were most probably caused by:

Default and liquidity risk differences.

If interest rates on 20-year Treasury and corporate bonds are as follows: Then differences in these rates were probably caused primarily by:

Default and liquidity risk differences. Treasury and corporate bonds face similar tax structures, maturity risk, inflation risk, and real rate of interest

Assume interest rates on 30-year government and corporate bonds were as follows: T-bond = 7.72%; AAA = 8.72%; A = 9.64%; BBB = 10.18%. The differences in rates among these issues are caused primarily by:

Default risk differences. The tax obligation, maturity risk, and inflation differences affect these four bonds differently. The only difference is the default risk.

If a stock has a beta of zero, it will be riskless when held in isolation.

False Correct. A zero beta stock could be made riskless if it were combined with enough other zero beta stocks, but it would still have diversifiable risk and be risky when held in isolation.

A zero coupon bond pays no interest. It is offered at par value, which is where it sells initially. These bonds provide compensation to investors in the form of capital appreciation.

False A zero coupon bond pays no interest and is sold at a discount below par value. See Section 7.2, Key Characteristics of Bonds.

The "penalty" for having a low bond rating is less severe when the Security Market Line is relatively steep than when it is not so steep.

False Correct. A steeper SML implies a higher risk premium on risky securities and thus a greater "penalty" on lower-rated bonds

We should expect to see interest rates decline if the federal deficit increased sharply from one year to the next, the Federal Reserve kept the money supply constant, and all other things held constant.

False Correct. An increase in the deficit and a constant money supply will cause interest rates to increase, all else being equal.

If the appropriate rate of interest on a bond is greater than its coupon rate, the market value of that bond will be above par value.

False Correct. It will sell at a discount, so its market value will be less than its par value.

To find the total return on a share of stock, find the dividend yield and subtract any commissions paid when the stock is purchased and sold.

False Correct. Total return is dividend yield plus capital appreciation.

An investor using the DCF stock valuation model would assign a value based on the length of time he or she plans to hold the stock.

False correct. The investor needs to consider the value during the holding period as well as the price at which the share will be sold to someone else

Of the many factors that affect the cost of money, one of the four most fundamental factors is the expected rate of inflation. A predictable correlation between inflation and interest rates is this: If inflation is expected to be relatively high, then interest rates will tend to be relatively low, other things held constant.

False Inflation is one of the fundamental factors that affect interest rates, the cost of money in the economy. If inflation is high, rates will be, too.

Which of the following statements is false? In all of the statements, assume that "other things are held constant." Price sensitivity—that is, the change in price due to a given change in the required rate of return—increases as a bond's maturity increases. A 20-year zero-coupon bond has less reinvestment risk than a 20-year coupon bond. For any given maturity, a given percentage point increase in the interest rate causes a smaller dollar capital loss than the capital gain stemming from an identical decrease in the interest rate. For a given bond of any maturity, a given percentage point increase in the going interest rate (rd) causes a larger dollar capital loss than the capital gain stemming from an identical decrease in the interest rate. From a borrower's point of view, interest paid on bonds is tax deductible.

For a given bond of any maturity, a given percentage point increase in the going interest rate (rd) causes a larger dollar capital loss than the capital gain stemming from an identical decrease in the interest rate. Statements a, c, d, and e are true. To determine which of the remaining statements is false, it is best to use an example. Assume you have a 10-year, 10% annual coupon bond that sold at par. If interest rates increase to 13%, the value of the bond decreases to $837.21, while if interest rates decrease to 7%, the value of the bond increases to $1,210.71. Thus, the capital gain is greater than the capital loss and statement b is false

Which of the following statements about interest rates is CORRECT, all other things held constant?

If expected inflation increases, interest rates are likely to increase.

Which of the following statements about the yield curve is CORRECT?

If inflation is expected to increase in the future and the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping. Correct: The Treasury yield curve will slope upward if inflation is expected to increase and the maturity risk premium is greater than zero. Both factors must be in place

A noncallable 10-year T-bond has a 12% annual coupon, the yield curve is flat, and it has a10% yield to maturity. A 15-year noncallable T-bond has an 8% annual coupon, the yield curve is flat, and is has a 10% yield to maturity. Which of the following statements is CORRECT?

If interest rates decline, the prices of both bonds would increase, but the 15-year bond would have a larger percentage increase in price This is correct. Based on our data table, the 15-year, 8% coupon bond is more sensitive to a decline in rates and shows a larger gain. Solve for current price of each bond and then solve for the price of the bond if YTM interest rates declined Take difference of bond price of 10 year bonds and divide the difference by the original price to do the same for 15 year bonds. The

Which of the following statements about bond price risk is CORRECT, assuming that all else is equal?

Long-term bonds have less reinvestment risk than short-term bonds. Correct. High-coupon bonds and short-term bonds have the most reinvestment risk. Long-term bonds and low-coupon bonds have the most price risk.

Family Traditions Home Fashions would call its outstanding callable bonds if:

Market interest rates decline sharply Correct. A company is most likely to call a bond if the coupon is higher than the market rate of interest. A downgrade, increase in interest rates, increase in inflation, or deterioration of finances would make the market rate higher than the coupon.

Imagine that you see a yield curve for a current corporate bond that is upward sloping. What can you determine from this information?

Maturity risk premiums could help to explain the yield curve's upward slope.

Your sister-in-law, a stockbroker at Invest Inc., is trying to sell you a stock with a current market price of $25. The stock's last dividend (D0) was $2.00, and earnings and dividends are expected to increase at a constant growth rate of 10%. Your required return on this stock is 20%. From a strict valuation standpoint, you should:Your sister-in-law, a stockbroker at Invest Inc., is trying to sell you a stock with a current market price of $25. The stock's last dividend (D0) was $2.00, and earnings and dividends are expected to increase at a constant growth rate of 10%. Your required return on this stock is 20%. From a strict valuation standpoint, you should:

Not buy the stock; it is overvalued by $3.00. Correct. P0= D(1+g)/(r-g) = $2.00(1.10)/(0.20-0.10) = $22.00. As the stock is currently selling for $25.00, the stock is not in equilibrium and is overvalued by $3.00.

If the U.S. Treasury were to issue $50 billion of short-term securities and sell them to the public, what would be the most likely effect on short-term securities' prices and interest rates? Assume that other factors are held constant.

Prices would decline and interest rates would rise.

The preemptive right is important to shareholders because it:

Protects the current shareholders against a dilution of their ownership interests. Feedback: Correct. A preemptive right is used to maintain shareholder positions if new shares are issued.

Assume that a company's dividends are expected to grow at a rate of 25% per year for 5 years and then to slow down and to grow at a constant rate of 5% thereafter. The required (and expected) total return, rs, is expected to remain constant at 12%. Which of the following statements is correct?

Right now, it would be easier (require fewer calculations) to find the dividend yield expected in Year 7 than the dividend yield expected in Year 3. Statement b is correct. We know that after Year 5, the stock will have a constant growth rate, and the capital gains yield will be equal to that growth rate. We also know that the total return is expected to be constant. Therefore, we could find the expected dividend yield in Year 7 simply by subtracting the growth rate from the total return: Yield = 12% - 5% = 7% in Year 7. The other statements are all false. This could be confirmed by thinking about how the dividend growth rate starts high, ends up at the constant growth rate, and must lie between these two rates and be declining between Years 1 and 5. The average growth rate in dividends during Years 1 through 5 will be (25 + 5)/2 = 15%, which is above rs = 12%, so statements c and d must be false

Founders' shares are a common type of classified stock that are used to differentiate shares of common stock that have different privileges.

Some classes of common stock are entitled to more votes per share than other classes. Correct. Classified stock is a way to differentiate shares of common stock that have different privileges, but not all firms have classified stock.

Apply the pure expectations theory to the following: Assume that the real risk-free rate of interest is expected to remain constant at 3% for the foreseeable future but that inflation is expected to increase steadily over the next 30 years, giving the Treasury yield curve an upward slope. You are considering two corporate bonds, one with a 5-year maturity and one with a 10-year maturity, both of which have the same default and liquidity risks. Again, assuming the pure expectations theory holds, which of these statements is CORRECT?

The 10-year corporate bond must have a higher yield than the 5-year corporate bond. Correct. Under the pure expectations theory, forward rates represent expected future rates. Expected future rates will increase due to inflation.

In a portfolio of three different stocks, which of the following could not be true?

The beta of the portfolio is less than the beta of each of the individual stocks. Correct. The beta of the portfolio is a weighted average of the individual securities' betas, so it could not be less than the betas of all of the stocks.

Eagle Enterprises Inc. can issue a 20-year bond with a 6% annual coupon at par. This bond is not convertible, not callable, and has no sinking fund. On the other hand, Eagle Enterprises could issue a 20-year bond that is convertible into common equity, may be called, and has a sinking fund. Which of the following most accurately describes the coupon rate that Eagle Enterprises would have to pay on the second bond, the convertible, callable bond with the sinking fund, to have it sell initially at par?

The coupon rate could be less than, equal to, or greater than 6%, depending on the specific terms set, but in the real world the convertible feature would probably cause the coupon rate to be less than 6%. Correct: The second bond's convertible feature and sinking fund would tend to lower its required rate of return, but the call feature would raise its rate. Given these opposing forces, the second bond's required coupon rate could be above or below that of the first bond. However, the convertible feature generally dominates in the real world, so convertibles' coupon rates are generally less than comparable nonconvertible issues' rates

Assume that the rate on a 1-year bond is now 6%. Investors expect 1-year rates to be 7% one year from now and then 8% two years from now. If the pure expectations theory holds, so that the maturity risk premium equals zero, which of the following statements would be CORRECT?

The interest rate today on a 3-year bond should be approximately 7%. Correct. Under the pure expectations theory, forward rates represent expected future rates. Thus, the three year rate today would be the average of 6%, 7%, and 8%

Which of the following assumptions would cause the constant growth stock valuation model to be invalid? The constant growth model is given below:

The required rate of return is less than the growth rate. Correct. If this equation is used in situations when rs is less than g, the results will be both wrong and meaningless

Which of the following statements about bond markets is CORRECT?

The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond A corporate bond will have more default risk than a Treasury bond, and thus have a higher yield. The other relationships vary with market conditions. .

Suppose that a 2% rate of inflation is expected for the next 2 years, after which inflation is expected to increase to 4%, the real risk-free rate is expected to remain constant at 3% in the future, and there is a positive maturity risk premium that increases with years to maturity. Given these conditions, which of the following statements is CORRECT?

The yield on a 5-year Treasury bond must exceed that of a 2-year Treasury bond. The information given covers six years, so we cannot make estimates about 7-year maturities. We do know that inflation will be greater in 5 years than in 2 years, which means that 2-year yields will be lower than the 5-year yields.

When the U.S. economy is very strong, the Federal Reserve tends to take action to increase interest rates, but when the U.S. economy is weak, the Federal Reserve tends to decrease interest rates.

True In a weak economy, the Federal Reserve will lower the interest rates to help increase business investment and stimulate the economy.

If management is sure that the economy is at the peak of a boom and is about to enter a recession, a firm that needs to borrow money should probably use short-term rather than long-term debt.

True Correct. The firm should borrow short-term until interest rates drop due to the recession, then go long-term. Predicting interest rates is extremely difficult because managers can rarely be sure about what is going to happen to the economy.

The type of classified stock where the shares are owned by the firm's founders is called founder's shares. With founders' shares, shareholders generally have more votes per share than with other classes of common stock.

True Founders' shares are a common type of classified stock that are used to differentiate shares of common stock that have different privileges.

"Interest rate risk," also known as "price risk," is the risk that interest rates will increase, and that increase will lead to a decline in the prices of outstanding bonds.

True An increase in rates reduces prices, which is known as "interest rate risk" or "price risk."

A 20-year, annual coupon bond with one year left to maturity has the same price risk as a 10-year, annual coupon bond with one year left to maturity. Both bonds are of equal risk, have the same coupon rate, and the prices of the two bonds are equal.

True Both bonds are valued as 1-year bonds regardless of their original issue dates, and as they are of equal risk and have the same coupon rate, their prices must be equal

In order to prevent dilution of control or dilution of value, shareholders use preemptive rights to purchase, on a pro rata basis, any new shares issued by the firm

True Correct. A preemptive right is used to maintain shareholder positions if new shares are issued.

A document that gives one party the authority to act for another party is a proxy. This includes the power to vote shares of common stock. Proxies can be important tools relating to control of firms.

True Correct. A proxy is used by shareholders to vote their common shares.

Because stock has a residual claim rather than a contractual obligation, the cash flows associated with common stock are more difficult to estimate than those related to bonds.

True Correct. Bonds are paid before common stock, and it is difficult to estimate what will be left over.

Classified stock is the differentiation of different shares of common stock. It gives companies a way to meet special needs such as when owners of a start-up firm need additional equity capital but do not want to relinquish voting control.

True Correct. Classified stock is a way to differentiate shares of common stock that have different privileges.

Because most corporations earn returns for their stockholders by acquiring and operating tangible and intangible assets, the relevant risk of each asset should be measured in terms of its effect on the risk of the firm's stockholders.

True Correct. Corporate managers need to look at returns for shareholders, not the effects on a market portfolio.

To find the firm's total corporate value, discount projected free cash flows at the firm's weighted average cost of capital.

True Correct. Corporate value is based on cash flows discounts at the weighted average cost of capital.

Suppose the Fed takes actions that lower expectations for inflation this year by 1 percentage point, but these same actions raise expectations for inflation in Years 2 and thereafter by 2 percentage points. Other things held constant, the yield curve becomes steeper.

True Correct. The yield curve becomes steeper. Although interest rates in Year 1 decrease by 1%, interest rates in the following years increase by 2%, making the yield curve steeper.

A predictable correlation between the demand curve for funds and the supply curve is this: If the demand curve for funds increases but the supply curve remains constant, then the total amount of funds supplied and demanded increase and interest rates in general also increase.

True If demand increases relative to supply, then the price goes up and so does the amount supplied.

Of the many factors that affect the cost of money, one of the four most fundamental factors is the availability of production opportunities and their expected rates of return. A predictable correlation between production opportunities and interest rates is this: If opportunities are relatively good, then interest rates will tend to be relatively high, other things held constant.

True Production opportunities are one of the fundamental factors that affect interest rates, the cost of money in the economy.

Of the many factors that affect the cost of money, one of the four most fundamental factors is the risk inherent in a given security. A predictable correlation between risk and required return is this: The higher the risk, the higher the security's required return, other things held constant.

True Risk is one of the fundamental factors that affect interest rates, the cost of money in the economy.

Of the following statements about default risk, which one is CORRECT?

Under Chapter 7 of the Bankruptcy Act, the assets of a firm that declares bankruptcy must be liquidated, and the sale proceeds must be used to pay off claims against it according to the priority of the claims as spelled out in the Bankruptcy Act. Secured debt and senior debt have less risk than other types of debt, expected return is lower if there is default, and bond ratings are affected by all relevant factors. Chapter 7 is the liquidation process.