Finance Final Exam

(6) TRUE/FALSE: Because the maturity risk premium is normally positive, the yield curve must have an upward slope. If you measure the yield curve and find a downward slope, you much have done something wrong.

False

(7) TRUE/FALSE: A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, companies call bond if interest rates rise and do not call them if interest rates decline.

False

(7) TRUE/FALSE: Because short-term interest rates are much more volatile than long-term rates, you would, in the real world, generally be subject to much more price risk if you purchased a 30-day bond than if you bought a 30-year bond.

False

(7) TRUE/FALSE: Income bonds pay interest only if the issuing company actually earns the indicated interest.. Thus, these securities cannot bankrupt a company, and this makes them safer from an investor's perspective than regular bonds.

False

(8) An individual stock's diversifiable risk, which is measured by its beta, can be lowered by adding more stocks to the portfolio in which the stock is held.

False

(8) TRUE/FALSE: A stock with beta equal to -1.0 has zero systematic (or market) risk.

False

(8) TRUE/FALSE: A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio.

False

(8) TRUE/FALSE: If the investors become less averse to risk, the slope of the Security Market Line (SML) will increase.

False

(9) TRUE/FALSE: Preferred Stock is a hybrid - a sort of cross between a common stock & a bond - in the sense that it pays dividends that normally increase annually like a stock but its payments are contractually guaranteed like interest on a bond.

False

(10) TRUE/FALSE: If a firm's marginal tax rate is increased, this would (other things held constant) lower the cost of debt used to calculate its WACC.

True

(10) TRUE/FALSE: The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

True

(10) TRUE/FALSE: The cost of debt, rd, is normally less than rs, so rd(1-T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1-T).

True

(6) TRUE/FALSE: An upward-sloping yield curve is often called a "normal" yield curve, while a downward-sloping yield curve is called "abnormal."

True

(6) TRUE/FALSE: During periods when inflation is increasing, interest rates tend to increase, while interest rates tend to fall when inflation is declining.

True

(6) TRUE/FALSE: If investors expect a zero rate of inflation, the nominal rate of return on a very short-term US Treasury bond should be equal to the real risk-free rate, r*.

True

(6) TRUE/FALSE: If investors expect the rate of inflation to increase sharply in the future, then we should not be surprised to see an upward-sloping yield curve.

True

(6) TRUE/FALSE: One of the four most fundamental factors that affect the cost of money as discussed in the text is the risk inherent in a given security. The higher the risk, the higher the securities' required return, other things held constant.

True

(6) TRUE/FALSE: The yield curve shows the relationship between bonds' maturities & their yields.

True

(7) TRUE/FALSE: A bond has a $1,000 par value, makes annual interest payments of $100, has 5 years to maturity, cannot be called, and is not expected to default. The bond should sell at a premium if the market interest rates are below 10% and at a discount if interest rates are greater than 10%.

True

(7) TRUE/FALSE: The price sensitivity of a bond to a given change in interest rate is generally greater the longer the bond's remaining maturity.

True

(7) TRUE/FALSE: There is an inverse relationship between bonds' quality rating and their required rates of return. Thus, the required return is lowest for AAA-rated bonds, and required returns increase as the ratings get lower.

True

(8) TRUE/FALSE: According to the Capital Asset Pricing Model (CAPM), investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a well-diversified portfolio.

True

(8) TRUE/FALSE: Diversification will normally reduce the riskiness of a portfolio of stocks.

True

(8) TRUE/FALSE: It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is negative.

True

(8) TRUE/FALSE: Since the market return represents the expected return on an average stock, the market return reflects a certain amount of risk. As a result, there exists a market risk premium, which is the amount over & above the risk-free rate that is required to compensate stock investors for assuming an average amount of risk.

True

(8) TRUE/FALSE: Someone who is risk averse has a general dislike for risk and a preference for certainty. If risk aversion exists in the market, then investors in general are willing to accept somewhat lower returns on less risky securities. Different investors have different degrees of risk aversion, and the end result is that investors with greater risk aversion tend to hold securities with lower risk (and therefore a lower expected return) than investors who have more tolerance for risk.

True

(9) TRUE/FALSE: According to the non-constant growth model discussed in the textbook, the discount rate used to find the present value of the expected cash flows during the initial growth period is the same as the discount rate used to find the PVs of cash flows during the subsequent constant growth period.

True

(9) TRUE/FALSE: From an investor's perspective, a firm's preferred stock is generally considered to be less risky than its common stock but more risky than its bonds. However, from a corporate issuer's standpoint, these risk relationships are reversed: bonds are the most risky for the firm, preferred is next, and common is least risky.

True

(9) TRUE/FALSE: If a stock's market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell the stock until its price has fallen down to the level of the investor's estimate of the intrinsic value.

True

(7) Three $1,000 face value, 10-year, non-callable bonds have the same amount of risk, hence their YTMs are equal. Bond 8 has an 8% annual coupon, Bond 10 has a 10% annual coupon, and Bond 12 has a 12% annual coupon. Bond 10 sells at par. Assuming that interest rates remain constant for the next 10 years, which of the following statements is CORRECT? a. Bond 8 sells at a discount (its price is less than par), and its price is expected to increase over the next year. b. Bond 8's current yield will increase each year. c. Over the next year, Bond 8's price is expected to decrease, Bond 10's price is expected to stay the same, and Bond 12's price is expected to increase. d. Since the bonds have the same YTM, they should all have the same price, and since interest rates are not expected to change, their prices should all remain at their current levels until maturity. e. Bond 12 sells at a premium (its price is greater than par), and its price is expected to increase over the next year.

a. Bond 8 sells at a discount (its price is less than par), and its price is expected to increase over the next year.

(6) Which of the following statements is CORRECT? a. 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. b. If the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping. c. If the maturity risk premium (MRP) equals zero, the Treasury bond yield curve must be flat. d. If the expectations theory holds, the Treasury bond yield curve will never be downward sloping. e. Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds.

a. 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.

(7) A 10-year bond with a 9% annual coupon has TYM of 8%. Which of the following statements is CORRECT? a. If the yield to maturity remains constant, the bond's price one year from now will be lower than its current price. b. The bond is selling below its par value. c. If the yield to maturity remains constant, the bond's price one year from now will be higher than its current price. d. The bond's current yield is greater than 9%. e. The bond is selling at a discount.

a. If the yield to maturity remains constant, the bond's price one year from now will be lower than its current price.

(9) Which of the following statements is CORRECT? a. The constant growth model takes into consideration the capital gains investors expect to earn on a stock. b. Two firms with the same expected dividend and growth rate must also have the same stock price. c. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant. d. If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. e. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate.

a. The constant growth model takes into consideration the capital gains investors expect to earn on a stock.

(8) Assume that investors have recently become more risk averse, so the market risk premium has increased. Also assume that the risk-free rate and expected inflation have not changed. Which of the following is most likely to occur? a. The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium. b. The required rate of return for each individual stock in the market will increase by an amount equal to the increase in the market risk premium. c. The required rate of return on the market, rM, will not change as a result of these changes. d. The required rate of return on a riskless bond will decline. e. The required rate of return will decline for stocks whose betas are less than 1.0.

a. The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium.

(9) Which of the following statements is CORRECT? a. To implement the corporate valuation model, we discount projected free cash flows at the weighted average cost of capital. b. To implement the corporate valuation model, we discount net operating profit after taxes (NOPAT) at the weighted average cost of capital. c. The corporate valuation model requires the assumption of a constant growth rate in all years. d. To implement the corporate valuation model, we discount projected net income at the weighted average cost of capital. e. To implement the corporate valuation model, we discount projected free cash flows at the cost of equity capital.

a. To implement the corporate valuation model, we discount projected free cash flows at the weighted average cost of capital.

(7) Which of the following statements is CORRECT? a. If a bond's yield to maturity exceeds its coupon rate, the bond will sell at a premium over par. b. All else equal, if a bond's yield to maturity increases, its price will fall. c. A zero coupon bond's current yield is equal to its yield to maturity. d. If a bond's yield to maturity exceeds its coupon rate, the bond will sell at par. e. All else equal, if a bond's yield to maturity increases, its current yield will fall.

b. All else equal, if a bond's yield to maturity increases, its price will fall.

(7) A 10-year Treasury bond has an 8% coupon, and an 8-year Treasury bond has a 10% coupon. Neither is callable, and both have the same yield to maturity. If the YTM of both bonds increases by the same amount, which of the following statements would be CORRECT? a. The prices of both bonds will decrease by the same amount. b. Both bonds would decline in price, but the 10-year bond would have the greater percentage decline in price. c. The prices of both bonds would increase by the same amount. d. One bond's price would increase, while the other bond's price would decrease. e. The prices of the two bonds would remain constant.

b. Both bonds would decline in price, but the 10-year bond would have the greater percentage decline in price.

(10) Bankston Corp. forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock? a. Increase the dividend payout ratio for the upcoming year. b. Increase the percentage of debt in the target capital structure. c. Increase the proposed capital budget. d. Reduce the amount of short-term bank debt in order to increase the current ratio. e. Reduce the percentage of debt in the target capital structure.

b. Increase the percentage of debt in the target capital structure.

(6) Assume that the current corp. bond yield curve is upward sloping, or normal. Under this condition, we can be sure that: a. Long-term bonds are a better buy than short-term bonds. b. Maturity risk premiums could help to explain the yield curve's upward slope. c. The economy is not in a recession. d. Long-term interest rates are more volatile than short-term rates. e. Inflation is expected to decline in the future.

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

(7) A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000). Which of the following statements is CORRECT? a. The bond's yield to maturity is above 9%. b. The bond's expected capital gains yield is zero. c. The bond's current yield is above 9%. d. The bond's current yield is less than its expected capital gains yield. e. If the bond's yield to maturity declines, the bond will sell at a discount.

b. The bond's expected capital gains yield is zero.

(10) Which of the following statements is CORRECT? a. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity. b. The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity. c. Suppose some of a publicly-traded firm's stockholders are not diversified; they hold only the one firm's stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm's intrinsic value. d. The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm's outstanding debt. e. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital.

b. The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity.

(6) Assuming that the term structure of interest rates is determined as posited by the pure expectations theory, which of the following statements is CORRECT? a. In equilibrium, long-term rates must be equal to short-term rates. b. The maturity risk premium is assumed to be zero. c. An upward-sloping yield curve implies that future short-term rates are expected to decline. d. Inflation is expected to be zero. e. Consumer prices as measured by an index of inflation are expected to rise at a constant rate.

b. The maturity risk premium is assumed to be zero.

(6) If the pure expectation theory holds, which of the following statements is CORRECT? a. If 2-year bonds yield more than 1-year bonds, an investor with a 2-year time horizon would almost certainly end up with more money if he or she bought 2-year bonds. b. The maturity risk premium would be zero. c. The yield curve for both Treasury and corporate bonds should be flat. d. The yield curve for Treasury securities would be flat, but the yield curve for corporate securities might be downward sloping. e. The yield curve for Treasury securities cannot be downward sloping.

b. The maturity risk premium would be zero.

(6) Which of the following statements is CORRECT? a. The yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5-year AAA-rated corporate bond. b. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond. c. The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond. d. The following represents a "possibly reasonable" formula for the maturity risk premium on bonds: MRP = −0.1%(t), where t is the years to maturity. e. The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond.

b. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.

(7) Which of the following statements is CORRECT? a. The expected return on a corporate bond must be greater than its promised return if the probability of default is greater than zero. b. 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 Act. c. A company's bond rating is affected by its financial ratios but not by provisions in its indenture. d. All else equal, secured debt is more risky than unsecured debt. e. All else equal, senior debt has more default risk than subordinated debt.

b. 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 Act.

(7) Which of the following statements is CORRECT? a. The longer the time to maturity, the smaller the change in the value of a bond in response to a given change in interest rates. b. You hold two bonds, a 10-year, zero coupon, issue and a 10-year bond that pays a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from its current level, the zero coupon bond will experience the larger percentage decline. c. The time to maturity does not affect the change in the value of a bond in response to a given change in interest rates. d. The shorter the time to maturity, the greater the change in the value of a bond in response to a given change in interest rates, other things held constant. e. You hold two bonds. One is a 10-year, zero coupon, bond and the other is a 10-year bond that pays a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience the smaller percentage decline.

b. You hold two bonds, a 10-year, zero coupon issue and a 10-year bond that pays a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from its current level, the zero coupon bond will experience the larger percentage decline.

(6) A bond trader observes the following information: - the Treasury yield curve is downward sloping. - empirical data indicates that a positive maturity risk premium applies to both Treasury & corp. bonds - empirical data also indicates that there is no liquidity premium for Treasury securities but that a positive liquidity premium is built into corp. bond yields On the basis of this info, which of the following statements is most CORRECT? a. A 10-year Treasury bond must have a higher yield than a 10-year corporate bond. b. A 10-year corporate bond must have a higher yield than a 5-year Treasury bond. c. A 5-year corporate bond must have a higher yield than a 10-year Treasury bond. d. Since the Treasury yield curve is downward sloping, the corporate yield curve must also be downward sloping. e. The corporate yield curve must be flat.

c. A 5-year corporate bond must have a higher yield than a 10-year Treasury bond.

(10) Duval Inc. uses only equity capital, and it has two equally-sized division. Division A's cost of capital is 10%, Division B's cost is 14%, and the corp. (composite) WACC is 12%. All of Division A's projects are equally risky, as are all of Division B's projects. However the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept? a. A Division B project with a 13% return. b. A Division B project with a 12% return. c. A Division A project with an 11% return. d. A Division A project with a 9% return. e. A Division B project with an 11% return.

c. A Division A project with an 11% return.

(7) Which of the following statements is CORRECT? a. All else equal, high-coupon bonds have less reinvestment risk than low-coupon bonds. b. All else equal, short-term bonds have less reinvestment risk than long-term bonds. c. All else equal, long-term bonds have less reinvestment risk than short-term bonds. d. All else equal, low-coupon bonds have less price risk than high-coupon bonds. e. All else equal, long-term bonds have less price risk than short-term bonds.

c. All else equal, long-term bonds have less reinvestment risk than short-term bonds.

(8) Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this info, which of the following statements is CORRECT? a. An index fund with beta = 1.0 should have a required return less than 11%. b. An index fund with beta = 1.0 should have a required return greater than 11%. c. An index fund with beta = 1.0 should have a required return of 11%. d. If a stock has a negative beta, its required return must also be negative. e. If a stock's beta doubles, its required return must also double.

c. An index fund with beta = 1.0 should have a required return of 11%.

(8) Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.) a. If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%. b. The effect of a change in the market risk premium depends on the slope of the yield curve. c. If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0. d. The effect of a change in the market risk premium depends on the level of the risk-free rate. e. If the market risk premium increases by 1%, then the required return will increase for stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0.

c. If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.

(7) An investor is considering buying one of two 10-year, $1,000 face value, non-callable bonds: Bond A has a 7% annual coupon, while Bond B has a 9% annual coupon. Both bonds have a YTM of 8% and the YTM is expected to remain constant for the next 10 years. Which of the following statements is correct? a. Bond A's current yield is greater than 8%. b. Both bonds have the same price today, and the price of each bond is expected to remain constant until the bonds mature. c. One year from now, Bond A's price will be higher than it is today. d. Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price. e. Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price.

c. One year from now, Bond A's price will be higher than it is today.

(9) Which of the following statements is CORRECT? a. The constant growth model is often appropriate for evaluating start-up companies that do not have a stable history of growth but are expected to reach stable growth within the next few years. b. The constant growth model cannot be used for a zero growth stock, where the dividend is expected to remain constant over time. c. The stock valuation model, P0 = D1/(rs − g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate. d. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate. e. If a stock has a required rate of return rs = 12% and its dividend is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%.

c. The stock valuation model, P0 = D1/(rs − g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate.

(6) Inflation is expected to increase steadily over the next 10 years, there is a positive maturity risk premium on both Treasury and corp. bonds, and the real risk-free rate of interest is expected to remain constant. Which of the following statements is CORRECT? a. The stated conditions cannot all be true—they are internally inconsistent. b. The yield on any corporate bond must exceed the yields on all Treasury bonds. c. The yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities. d. The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope. e. The yield on 7-year corporate bonds must exceed the yield on 10-year Treasury bonds.

c. The yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities.

(6) The real risk-free rate is expected to remain constant at 3% in the future, a 2% rate of inflation is expected for the next 2 years, after which inflation is expected to increase to 4%, and there is a positive maturity risk premium that increases with years to maturity. Given these conditions, which of the following statements is CORRECT? a. The yield on a 2-year T-bond must exceed that on a 5-year T-bond. b. The yield on a 7-year Treasury bond must exceed that of a 5-year corporate bond. c. The yield on a 5-year Treasury bond must exceed that on a 2-year Treasury bond. d. The conditions in the problem cannot all be true—they are internally inconsistent. e. The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope.

c. The yield on a 5-year Treasury bond must exceed that on a 2-year Treasury bond.

(10) Which of the following statements is CORRECT? a. The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital. b. The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year. c. There is an "opportunity cost" associated with using retained earnings, hence they are not "free." d. The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt. e. The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets.

c. There is an "opportunity cost" associated with using retained earnings, hence they are not "free."

(7) Bond A has a 9% annual coupon, while Bond B has a 7% annual coupon. Both bonds have the same maturity, a face value of $1,000, an 8% YTM, and are non-callable. Which of the following statements is CORRECT? a. If the yield to maturity for both bonds remains at 8%, Bond A's price one year from now will be higher than it is today, but Bond B's price one year from now will be lower than it is today. b. Bond A's capital gains yield is greater than Bond B's capital gains yield. c. If the yield to maturity for both bonds immediately decreases to 6%, Bond A's bond will have a larger percentage increase in value. d. Bond A's current yield is greater than that of Bond B. e. Bond A trades at a discount, whereas Bond B trades at a premium.

d. Bond A's current yield is greater than that of Bond B.

(7) Which of the following statements is CORRECT? a. The current yield on Bond A exceeds the current yield on Bond B. Therefore, Bond A must have a higher yield to maturity than Bond B. b. If a coupon bond is selling at a discount, then the bond's expected capital gains yield is negative. c. If a bond is selling at a discount, the yield to call is a better measure of the expected return than the yield to maturity. d. If a coupon bond is selling at par, its current yield equals its yield to maturity. e. If a coupon bond is selling at a premium, then the bond's current yield is zero.

d. If a coupon bond is selling at par, its current yield equals its yield to maturity.

(7) Which of the following statements is CORRECT? a. If interest rates increase, the price of a 10-year coupon bond will decline by a greater percentage than the price of a 10-year zero coupon bond. b. If a coupon bond is selling at a discount, its price will continue to decline until it reaches its par value at maturity. c. If a bond's yield to maturity exceeds its annual coupon, then the bond will trade at a premium. d. If a coupon bond is selling at par, its current yield equals its yield to maturity. e. If a coupon bond is selling at a premium, its current yield equals its yield to maturity.

d. If a coupon bond is selling at par, its current yield equals its yield to maturity.

(6) Which of the following statements is CORRECT? a. Yield curves must be either upward or downward sloping—they cannot first rise and then decline. b. The actual shape of the yield curve depends only on expectations about future inflation. c. If the yield curve is upward sloping, the maturity risk premium must be positive and the inflation rate must be zero. d. If the pure expectations theory is correct, a downward-sloping yield curve indicates that interest rates are expected to decline in the future. e. Downward-sloping yield curves are inconsistent with the expectations theory.

d. If the pure expectations theory is correct, a downward-sloping yield curve indicates that interest rates are expected to decline in the future.

(8) The risk-free rate is 6% and the market risk premium is 5%. Your $1 million portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a stock that has a beta of 0.8. Which of the following statements is CORRECT? a. If the stock market is efficient, your portfolio's expected return should equal the expected return on the market, which is 11%. b. The required return on the market is 10%. c. The portfolio's required return is less than 11%. d. If the risk-free rate remains unchanged but the market risk premium increases by 2%, your portfolio's required return will increase by more than 2%. e. If the market risk premium remains unchanged but expected inflation increases by 2%, your portfolio's required return will increase by more than 2%.

d. If the risk-free rate remains unchanged but the market risk premium increases by 2%, your portfolio's required return will increase by more than 2%.

(7) Bond A, B, & C all have a maturity of 10 years and a TYM of 7%. Bond A's price exceeds its par value, Bond B's price equals its par value, and Bond C's price is less than it par value. None of the bonds can be called. Which of the following statements is CORRECT? a. If the yield to maturity on each bond decreases to 6%, Bond A will have the largest percentage increase in its price. b. Bond A has the most price risk. c. If the yield to maturity on the three bonds remains constant, the prices of the three bonds will remain the same over the next year. d. If the yield to maturity on each bond increases to 8%, the prices of all three bonds will decline. e. Bond C sells at a premium over its par value.

d. If the yield to maturity on each bond increases to 8%, the prices of all three bonds will decline.

(10) For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT? a. The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet. b. The WACC is calculated on a before-tax basis. c. The WACC exceeds the cost of equity. d. The cost of equity is always equal to or greater than the cost of debt. e. The cost of retained earnings typically exceeds the cost of new common stock.

d. The cost of equity is always equal to or greater than the cost of debt.

(7) Tucker Corporation is planning to issue new 20-year bonds. The current plan is to make the bonds non-callable, but this may be changed. If the bonds are made callable after 5 years at 5% call premium, how would this affect their required rate of return? a. Because of the call premium, the required rate of return would decline. b. There is no reason to expect a change in the required rate of return. c. The required rate of return would decline because the bond would then be less risky to a bondholder. d. The required rate of return would increase because the bond would then be more risky to a bondholder. e. It is impossible to say without more information.

d. The required rate of return would increase because the bond would then be more risky to a bondholder.

(9) The expected return on Natter Corp.'s stock is 14%. The stock's dividend is expected to grow at a constant rate of 8%, and it currently sells for $50 a share. Which of the following statements is CORRECT? a. The stock's dividend yield is 7%. b. The stock's dividend yield is 8%. c. The current dividend per share is $4.00. d. The stock price is expected to be $54 a share one year from now. e. The stock price is expected to be $57 a share one year from now.

d. The stock price is expected to be $54 a share one year from now.

(6) Assume that interest rates on 20-year treasury & corp. bonds are as follows: T-bond = 772% AAA = 8.72% A = 9.64% BBB = 10.18% The differences in these rates were probably caused primarily by: a. Tax effects. b. Real risk-free rate differences. c. Maturity risk differences. d. Inflation differences. e. Default and liquidity risk differences.

e. Default and liquidity risk differences.

(10) Which of the following statements is CORRECT? a. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation. b. All else equal, an increase in a company's stock price will increase its marginal cost of retained earnings, rs. c. All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re. d. Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt. e. If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.

e. If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.

(7) Which of the following statements is CORRECT? a. The current yield on Bond A exceeds the current yield on Bond B; therefore, Bond A must have a higher yield to maturity than Bond B. b. On an expected yield basis, the expected current yield will always be positive because an investor would not purchase a bond that is not expected to pay any cash coupon interest. c. On an expected yield basis, the expected capital gains yield will always be positive because an investor would not purchase a bond with an expected capital loss. d. If a bond is selling at a discount, the yield to call is a better measure of return than is the yield to maturity. e. If a coupon bond is selling at par, its current yield equals its yield to maturity, and its expected capital gains yield is zero.

e. If a coupon bond is selling at par, its current yield equals its yield to maturity, and its expected capital gains yield is zero.

(7) A 12-year bond has an annual coupon of 9%. The coupon rate will remain fixed until bond matures. The bond has a yield to maturity of 7%. Which of the following statements is CORRECT? a. If market interest rates decline, the price of the bond will also decline. b. The bond is currently selling at a price below its par value. c. The bond should currently be selling at its par value. d. If market interest rates remain unchanged, the bond's price one year from now will be higher than it is today. e. If market interest rates remain unchanged, the bond's price one year from now will be lower than it is today.

e. If market interest rates remain unchanged, the bond's price one year from now will be lower than it is today.

(7) Which of the following events would make it more likely that a company would call its outstanding callable bonds? a. The company's financial situation deteriorates significantly. b. Market interest rates rise sharply. c. Inflation increases significantly. d. The company's bonds are downgraded. e. Market interest rates decline sharply.

e. Market interest rates decline sharply.

(7) A 15-year bond with a face value of $1,000 currently sells for $850. Which of the following statements is CORRECT? a. The bond's current yield exceeds its yield to maturity. b. If the yield to maturity stays constant until the bond matures, the bond's price will remain at $850. c. The bond's coupon rate exceeds its current yield. d. The bond's current yield is equal to its coupon rate. e. The bond's yield to maturity is greater than its coupon rate.

e. The bond's yield to maturity is greater than its coupon rate.

(9) A stock is expected to pay a year-end dividend of $2.00 , i.e. D1 = $2. The dividend is expected to decline at a rate of 5% a year forever (g = -5%). If the company is in equilibrium and its expected and required rate of return is 15%, which of the following statements is CORRECT? a. The company's current stock price is $20. b. The company's dividend yield 5 years from now is expected to be 10%. c. The constant growth model cannot be used because the growth rate is negative. d. The company's expected capital gains yield is 5%. e. The company's expected stock price at the beginning of next year is $9.50.

e. The company's expected stock price at the beginning of next year is $9.50. (Response Feedback: Rationale: Note that P0 = $2/(0.15 + 0.05) = $10. That price is expected to decline by 5% each year, so P1 must be $10(0.95) = $9.50. Therefore, answer e is correct, while the others are all false. )

(6) Assume that the rate on a 1-year bond is now 6%, but all investors expect 1-year rates to be 7% one year from now and then rise to 8% two years from now. Assume also that the pure expectations theory holds, hence the maturity risk premium equals zero. Which of the following statements is CORRECT? a. The interest rate today on a 3-year bond should be approximately 8%. b. The interest rate today on a 2-year bond should be approximately 7%. c. The interest rate today on a 2-year bond should be approximately 6%. d. The yield curve should be downward sloping, with the rate on a 1-year bond at 6%. e. The interest rate today on a 3-year bond should be approximately 7%.

e. The interest rate today on a 3-year bond should be approximately 7%.

(6) Which of the following statements is CORRECT? a. Most evidence suggests that the maturity risk premium is zero. b. The real risk-free rate is higher for corporate than for Treasury bonds. c. Liquidity premiums are higher for Treasury than for corporate bonds. d. The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond. e. The pure expectations theory states that the maturity risk premium for long-term Treasury bonds is zero and that differences in interest rates across different Treasury maturities are driven by expectations about future interest rates.

e. The pure expectations theory states that the maturity risk premium for long-term Treasury bonds is zero and that differences in interest rates across different Treasury maturities are driven by expectations about future interest rates.

(6) In the foreseeable future, the real risk-free rate of interest, r*, is expected to remain at 3%, inflation is expected to steadily increase, and the maturity risk premium is expected to be 0.1(t-1)%, where t is the number of years until the bond matures. Given this info, which of the following statements is CORRECT? a. The yield on 5-year corporate bonds must exceed the yield on 8-year Treasury bonds. b. The yield curve must be "humped." c. The yield on 2-year Treasury securities must exceed the yield on 5-year Treasury securities. d. The yield on 5-year Treasury securities must exceed the yield on 10-year corporate bonds. e. The yield curve must be upward sloping.

e. The yield curve must be upward sloping.