FIN3320

Exam Two; Chapters 5-8

1. You plan to analyze the value of a potential investment by calculating the sum of the
present values of its expected cash flows. Which of the following would lower the
calculated value of the investment?

a. The cash flows are in the form of a deferred annuity, and they total to
$100,000. You learn that the annuity lasts for only 5 rather than 10 years,
hence that each payment is for $20,000 rather than for $10,000.

B. The discount rate increases.

c. The riskiness of the investment’s cash flows decreases.

d. The total amount of cash flows remains the same, but more of the cash flows
are received in the earlier years and less are received in the later years.

e. The discount rate decreases.

2. Your bank account pays an 8% nominal rate of interest. The interest is

compounded quarterly. Which of the following statements is CORRECT?

a. The periodic rate of interest is 2% and the effective rate of interest is 4%.

b. The periodic rate of interest is 8% and the effective rate of interest is greater
than 8%.

c. The periodic rate of interest is 4% and the effective rate of interest is less than
8%.

D. The periodic rate of interest is 2% and the effective rate of interest is greater
than 8%.

e. The periodic rate of interest is 8% and the effective rate of interest is also 8%.
3. Which of the following investments would have the highest future value at
the end of 10 years? Assume that the effective annual rate for all investments
is the same and is greater than zero.

A. Investment A pays $250 at the beginning of every year for the next 10 years
(a total of 10 payments).

b. Investment B pays $125 at the end of every 6-month period for the next 10
years (a total of 20 payments).

c. Investment C pays $125 at the beginning of every 6-month period for the next
10 years (a total of 20 payments).

d. Investment D pays $2,500 at the end of 10 years (just one payment).

e. Investment E pays $250 at the end of every year for the next 10 years (a total
of 10 payments).

4. You deposit $1,000 today in a savings account that pays 3.5% interest,
compounded annually. How much will your account be worth at the end of 25
years?

a. $2,245.08

B. $2,363.24

c. $2,481.41

d. $2,605.48

e. $2,735.75

5. Suppose the real risk-free rate is 2.50% and the future rate of inflation is expected to
be constant at 3.05%. What rate of return would you expect on a 5-year Treasury
security, assuming the pure expectations theory is valid? Disregard cross-product
terms, i.e., if averaging is required, use the arithmetic average.

a. 5.15%

b. 5.25%
 c. 5.35%

d. 5.45%

E. 5.55%

r = r* + IP + DRP + LP + MRP

r = 2.50% + 3.05% = 5.55%

6. Suppose the real risk-free rate is 3.50%, the average future inflation rate is 2.25%,
and a maturity premium of 0.10% per year to maturity applies, i.e., MRP =
0.10%(t), where t is the years to maturity. What rate of return would you expect on
a 1-year Treasury security, assuming the pure expectations theory is NOT
valid? Disregard cross-product terms, i.e., if averaging is required, use the
arithmetic average.

a. 5.75%

B. 5.85%

c. 5.95%

d. 6.05%

e. 6.15%

r = r* + IP + DRP + LP + MRP

r = 3.50% + 2.25% + 0 + 0 + .10% = 5.85%

7. The real risk-free rate is 2.50%, inflation is expected to be 3.00% 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?

a. 4.975%

b. 5.175%

c. 5.375%

D.5.575%

e. 5.775%
(1 + r) = (1 + r*) ( 1+ IP)

(1+r) = (1.025) (1.03) = 1.05575 - 1 = 5.575%

<>8. Suppose the U.S. Treasury offers to sell you a bond for $3,000. No
payments will be made until the bond matures 10 years from now, at which
time it will be redeemed for $5,000. What interest rate would you earn if you
bought this bond at the offer price?

a. 3.82%

b. 4.25%

c. 4.72%

D.5.24%

e. 5.77%

n = 10
i= ?
PV = -3000
PMT = 0
FV = 5000

Solve for "i" which will be 5.2410 %

9. Keys Corporation's 5-year bonds yield 6.50%, and T-bonds with the same maturity yield
4.40%. The default risk premium for Keys' bonds is DRP = 0.40%, the liquidity premium
on Keys' bonds is LP = 1.70% versus zero on T-bonds, inflation premium (IP) is 1.5%, and
the maturity risk premium (MRP) on 5-year bonds is 0.40%. What is the real risk-free rate,
r*?

a. 2.10%

b. 2.20%

c. 2.30%

d. 2.40%

E. . 2.50%
 Simply subtract the IP of 1.50% and the MRP of .40% from the
T-bond yield of 4.40% to arrive at 2.50%

10. The Carter Company's bonds mature in 10 years have a par value of
$1,000 and an annual coupon payment of $80. The market interest rate for
the bonds is 9%. What is the price of these bonds?

A. $935.82

b. $941.51

c. $958.15

d. $964.41

e. $979.53

n = 10
i= 9
PV = ? = $935.82
PMT = 80
FV = 1000

11. Brown Enterprises’ bonds currently sell for $1,025. They have a 9-year
maturity, an annual coupon of $80, and a par value of $1,000. What is their
yield to maturity?

a. 6.87%

b. 7.03%

c. 7.21%

d. 7.45%

E.7.61%

n = 9
i = ? = 7.6063%
PV = -1025
PMT = 80
FV = 1000
12. Highfield Inc's bonds currently sell for $1,275 and have a par value of
$1,000. They pay a $120 annual coupon and have a 20-year maturity, but
they can be called in 5 years at $1,120. What is their yield to call (YTC)?

a. 7.00%

b. 7.13%

c. 7.28%

D.7.31%

e. 7.42%

n = 5
i = ? = 7.3109%
PV = -1275
PMT = 120
FV = 1120

13. Moussawi Ltd's outstanding bonds have a $1,000 par value, and they
mature in 5 years. Their yield to maturity is 9%, based on semiannual
compounding, and the current market price is $853.61. What is the bond's
annual coupon interest rate?

a. 5.10%

b. 5.20%

C. 5.30%

d. 5.40%

e. 5.50%

n = 10
i = 4.5
PV = -853.61
PMT = ? = $26.4994
FV = 1000
 Annual Rate = 26.4994/1000 = 2.64994% times 2 = 5.2999%

14. 14. Which of the following statements is CORRECT?

a. 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.

b. 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.

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.You hold a 10-year, zero coupon, bond and a 10-year bond that has 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 larger percentage
decline.

e. You hold a 10-year, zero coupon, bond and a 10-year bond that has 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.

15. Which of the following would be most likely to increase the coupon rate that is required to
enable a bond to be issued at par?

A. Adding a call provision.

b. Adding additional restrictive covenants that limit management's actions.

c. Adding a sinking fund.

d. The rating agencies change the bond's rating from Baa to Aaa.

e. Making the bond a first mortgage bond rather than a debenture.

16. A 12-year bond has an annual coupon rate 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. The bond is currently selling at a price below its par value.

b. If market interest rates decline, the price of the bond will also decline.

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

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 should currently be selling at its par value.

17. What annual payment must you receive in order to earn a 6.5% rate of
return on a perpetuity that has a cost of $1,250?

a. $77.19

B. $81.25

c. $85.31

d. $89.58

e. $94.06

1250 * .065 = $81.25

18. You sold a car and accepted a note with the following cash flow stream as your
payment. What was the effective price you received for the car assuming an interest rate
of 6.0%?

Years: 0 1 2 3 4

|
| | | |

CFs: $0 $1,000 $2,000 $2,000 $2,000

 A. $5,987

b. $6,286

c. $6,600

d. $6,930

e. $7,277

Put in CF registers with a rate of 6% and find the PV

19. 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. 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.

d. The effect of a change in the market risk premium depends on the level of the
risk-free rate.

e. The effect of a change in the market risk premium depends on the slope of the
yield curve.

20. In the next year, the market risk premium, (rM - rRF), is expected to fall, while the
risk-free rate, rRF, is expected to remain the same. Given this forecast, which of
the following statements is CORRECT?

a. The required return for all stocks will fall by the same amount.

B. The required return will fall for all stocks, but it will fall more for stocks with
higher betas.

c. The required return will fall for all stocks, but it will fall less for stocks with
higher betas.
 d. The required return will increase for stocks with a beta less than 1.0 and will
decrease for stocks with a beta greater than 1.0.

e. The required return on all stocks will remain unchanged.

21. You have the following data on three stocks:

Stock Standard Deviation Beta

A 20% 0.59

B 10% 0.61

C 12% 1.29

If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in
isolation and Stock ____ if it is to be held as part of a well-diversified portfolio.

a. A; A.

b. A; B.

C. B; A.

d. C; A.

e. C; B.

22. Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following
statements must be true about these securities? (Assume market
equilibrium.)

a. When held in isolation, Stock A has more risk than Stock B.

b. Stock B must be a more desirable addition to a portfolio than A.

c. Stock A must be a more desirable addition to a portfolio than B.

D. The expected return on Stock A should be greater than that on B.

e. The expected return on Stock B should be greater than that on A.

23. Cooley Company's stock has a beta of 1.40, the risk-free rate is 4.25%,
and the market risk premium is 5.50%. What is the firm's required rate of
return?

a. 11.36%

b. 11.65%

C. 11.95%

d. 12.25%

e. 12.55%

Rate of Return = Risk Free + Beta (Market Risk Premium)

Return = 4.25% + 1.4 (5.50%) = 11.95%

24. Company A has a beta of 0.70, while Company B's beta is 1.20. The
required return on the stock market is 11.00%, and the risk-free rate is
4.25%. What is the difference between A's and B's required rates of
return? (Hint: First find the market risk premium, then find the required returns
on the stocks.)

a..2.75%

b. 2.89%

c. 3.05%

d. 3.21%

E. 3.38%

Risk Premium is 11% minus 4.25% = 6.75% Feed into the CAPM and
you can find the returns of 8.975% for A and 12.35% for B

25. Mulherin's stock has a beta of 1.23, its required return is 11.75%, and the
risk-free rate is 4.30%. What is the required rate of return on the
market? (Hint: First find the market risk premium.)

A. 10.36%
b. 10.62%

c. 10.88%

d. 11.15%

e. 11.43%

11.75% = 4.30% + 1.23( Market Risk Premium)

Market Risk Premium = (11.75% - 4.30%) divided by 1.23 = 6.06%
Return on Market = Market Risk Premium + Risk Free = 6.06% + 4.30% =
10.36%