Midterm 2: Multiple Choice Questions

The required returns of Stocks X and Y are r_x = 10% and r_y = 12%. Which of the following statements is CORRECT? a. If the market is in equilibrium and if Stock Y has the lower expected dividend yield, then it must have the higher expected growth rate. b. If Stock Y and Stock X have the same dividend yield, then Stock Y must have a lower expected capital gains yield than Stock X. c. If Stock X and Y have the same current dividend and the same expected dividend growth rate, then Stock Y must sell for a higher price. d. The stocks must sell for the same price. e. Stock Y must have a higher dividend yield than Stock X.

a. If the market is in equilibrium and if Stock Y has the lower expected dividend yield, then it must have the higher expected growth rate.

One of the four most fundamental factors that affect the cost of money as discussed in the text is the time preference for consumption. The higher the time preference, the lower the cost of money, other things held constant. True or False

False

The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) the skill level of the economy's labor force. True or False

False

An upward-sloping yield curve is often call a "normal" yield curve, while a downward-sloping yield curve is called "abnormal." True or False

True

Junk bonds are high-risk, high-yield debt instruments. They are often used to finance leveraged buyouts and mergers, and to provide financing to companies of questionable financial strength. True or False

True

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 security's required return, other things held constant. True or False

True

Sinking funds are provisions included in bond indentures that require companies to retire bonds on a scheduled basis prior to their final maturity. Many indentures allow the company to acquire bonds for sinking fund purposes by either (1) purchasing bonds on the open market at the going market price or (2) selecting the bonds to be called by a lottery administered by the trustee, in which case the price paid is the bond's face value. True or False

True

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

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

Which of the following would be most likely to lead to a higher level of interest rates in the economy? a. The level of inflation begins to decline b. Corporations step up their expansion plans and thus increase their demand for capital c. The economy moves from a boom to a recession d. The Federal Reserve decides to try to stimulate the economy e. Households start saving a larger percentage of their income.

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

Which of the following statements is CORRECT? a. The yield curve can never be downward sloping b. If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the Treasury yield curve will have an upward slope c. 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 d. If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope e. If the maturity risk premium (MRP) equals zero, the yield curve must be flat

b. If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the Treasury yield curve will have an upward slope

Assume that the current corporate bond yield curve is upward sloping, or normal. Under this condition, we could 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. Inflation is expected to decline in the future e. Long-term interest rates are more volatile than short-term rates.

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

A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is r_s = 10.5%, and the expected constant growth rate is g = 6.4%. What is the stock's current price? a. $17.39 b. $17.84 c. $18.29 d. $18.75 e. $19.22

c. $18.29

Which of the following factors would be most likely to lead to an increase in nominal interest rates? a. There is a decrease in expected inflation b. Households reduce their consumption and increase their savings c. A new technology like the Internet has just been introduced, and it increases investment opportunities d. The economy falls into a recession e. The Federal Reserve decides to try to stimulate the economy

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

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

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

Assume that interest rates on 20-year Treasury and corporate bonds are as follows: T-bond = 7.72% AAA = 8.72% A = 9.64% BBB = 10.18% The differences in these rates were probably caused primarily by: a.Maturity risk differences b.Inflation differences c.Real risk-free rate differences d.Default and liquidity risk differences e. Tax effects

d. Default and liquidity risk differences

A 10-year bond pays an annual coupon, its YTM is 8%, and it currently trades at a premium. Which of the following statements is CORRECT? a. If the yield to maturity remains at 8%, then the bond's price will remain constant over the next year b. The bond's current yield is less than 8% c. The bond's coupon rate is less than 8% d. If the yield to maturity remains at 8%, then the bond's price will decline over the next year e. If the yield to maturity increases, then the bond's price will increase

d. If the yield to maturity remains at 8%, then the bond's price will decline over the next year

A Treasury bond has an 8% annual coupon and a 7.5% yield to maturity. Which of the following statements is CORRECT? a. The bond sells at a price below par b. The bond's required rate of return is less than 7.5% c. The bond sells at a discount d. If the yield to maturity remains constant, the price of the bond will decline over time e. The bond has a current yield greater than 8%

d. If the yield to maturity remains constant, the price of the bond will decline over time

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 current yield is less than its expected capital gains yield c. If the bond's yield to maturity declines, the bond will sell at a discount d. The bond's expected capital gains yield is zero e. The bond's current yield is above 9%.

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

The expected return on Natter Corporation'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

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

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

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. Inflation increases significantly c. The company's bonds are downgraded d. Market interest rates rise sharply e. Market interest rates decline sharply

e. Market interest rates decline sharply

Which of the following statements is CORRECT? a. Sinking fund provisions never require companies to retire their debt; they only establish "targets" for the company to reduce its debt over time b. Most sinking funds require the issuer to provide funds to a trustee, who holds the money so that it will be available to pay off bondholders when the bonds mature c. A sinking fund provision makes a bond more risky to investors at the time of issuance d. If interest rates increase after a company has issued bonds with a sinking fund, the company will be less likely to buy bonds on the open market to meet its sinking fund obligation and more likely to call them in at the sinking fund call price e. Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond was issued

e. Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond was issued

Which of the following statements is CORRECT? a. The yield on a 3-year Treasury bond should always exceed the yield on a 2-year Treasury bond b. The real risk-free rate should increase if people expect inflation to increase c. If inflation is expected to increase, then the yield on a 2-year bond should exceed that on a 3-year bond d. The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond e. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond

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