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FIN 534 Week 4 Quiz 3 Chapter 4 and 5 Click the link (blue) below to purchase A+ Quiz Solution

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Strayer FIN 534 Quiz 3 chapter 4 and 5 Solution FIN 534 Quiz Chapter 4 and Chapter 5 Solved All Possible Questions with Answers CHAPTER 4 TIME VALUE OF MONEY (Difficulty Levels: , /, , , and )

Please see the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines.

Multiple Choice: True/False

(4.2) Compounding

FJ

Answer:

.

Starting to invest early for retirement increases the benefits of compound interest.

a.

True

b.

False


(4.2) Compounding

FJ

Answer:

.

Starting to invest early for retirement reduces the benefits of compound interest.

a.

True

b.

False

(4.2) Compounding

FJ

Answer:

.

A time line is meaningful even if all cash flows do not occur annually.

a.

True

b.

False

(4.2) Compounding

FJ

Answer:

.

A time line is not meaningful unless all cash flows occur annually.

a.

True

b.

False

(4.2) Compounding

FJ

Answer:

. Time lines can be constructed in situations where some of the cash flows occur annually but others occur quarterly.

a.

True

b.

False


(4.2) Compounding

FJ

Answer:

. Time lines cannot be constructed in situations where some of the cash flows occur annually but others occur quarterly.

a.

True

b.

False

(4.2) Compounding

FJ

Answer:

. Time lines can be constructed for annuities where the payments occur at either the beginning or the end of the periods.

a.

True

b.

False

(4.2) Compounding

FJ

Answer:

. Time lines cannot be constructed for annuities unless all the payments occur at the end of the periods.

a.

True

b.

False

(4.2) Compounding

FJ

Answer:

. Some of the cash flows shown on a time line can be in the form of annuity payments while others can be uneven amounts.


a.

True

b.

False

(4.2) Compounding

FJ

Answer:

. Some of the cash flows shown on a time line can be in the form of annuity payments but none can be uneven amounts.

a.

True

b.

False

(4.3) PV versus FV

CJ

Answer:

. If the discount (or interest) rate is positive, the present value of an expected series of payments will always exceed the future value of the same series.

a.

True

b.

False

(4.3) PV versus FV

CJ

Answer:

. If the discount (or interest) rate is positive, the future value of an expected series of payments will always exceed the present value of the same series.

a.

True

b.

False

(4.3) PV versus FV

CJ

Answer:


. Disregarding risk, if money has time value, it is impossible for the present value of a given sum to exceed its future value.

a.

True

b.

False

(4.3) PV versus FV

CJ

Answer:

. Disregarding risk, if money has time value, it is impossible for the future value of a given sum to exceed its present value.

a.

True

b.

False

(4.15) Effective annual rate

CJ

Answer:

. If a bank compounds savings accounts quarterly, the nominal rate will exceed the effective annual rate.

a.

True

b.

False

(4.15) Effective annual rate

CJ

Answer:

. If a bank compounds savings accounts quarterly, the effective annual rate will exceed the nominal rate.

a.

True

b.

False


(4.18) Growing annuity C J

Answer:

. A “growing annuity” is a cash flow stream that grows at a constant rate for a specified number of periods.

a.

True

b.

False

(4.18) Growing annuity C J

Answer:

.

A “growing annuity” is any cash flow stream that grows over time.

a.

True

b.

False

(4.2) Compounding

CJ

Answer:

. The greater the number of compounding periods within a year, then (1) the greater the future value of a lump sum investment at Time 0 and (2) the greater the present value of a given lump sum to be received at some future date.

a.

True

b.

False


(4.2) Compounding

CJ

Answer:

. The greater the number of compounding periods within a year, then (1) the greater the future value of a lump sum investment at Time 0 and (2) the smaller the present value of a given lump sum to be received at some future date.

a.

True

b.

False

(4.2) Comparative compounding

CJ

Answer:

. Suppose Sally Smith plans to invest $1,000. She can earn an effective annual rate of 5% on Security A, while Security B has an effective annual rate of 12%. After 11 years, the compounded value of Security B should be more than twice the compounded value of Security A. (Ignore risk, and assume that compounding occurs annually.)

a.

True

b.

False

(4.2) Comparative compounding

CJ

Answer:

. Suppose Randy Jones plans to invest $1,000. He can earn an effective annual rate of 5% on Security A, while Security B has an effective annual rate of 12%. After 11 years, the compounded value of Security B should be somewhat less than twice the compounded value of Security A. (Ignore risk, and assume that compounding occurs annually.)

a.

True

b.

False


(4.3) PV of a dollar

CJ

Answer:

. The present value of a future sum decreases as either the discount rate or the number of periods per year increases, other things held constant.

a.

True

b.

False

(4.3) PV of a sum

CJ

Answer:

. The present value of a future sum increases as either the discount rate or the number of periods per year increases, other things held constant.

a.

True

b.

False

(4.9) PV of an annuity

CJ

Answer:

. All other things held constant, the present value of a given annual annuity decreases as the number of periods per year increases.

a.

True

b.

False

(4.9) PV of an annuity

CJ

Answer:

. All other things held constant, the present value of a given annual annuity increases as the number of periods per year increases.

a.

True

b.

False


(4.15) Periodic and nominal rates

CJ

Answer:

. If we are given a periodic interest rate, say a monthly rate, we can find the nominal annual rate by multiplying the periodic rate by the number of periods per year.

a.

True

b.

False

(4.15) Periodic and nominal rates

CJ

Answer:

. If we are given a periodic interest rate, say a monthly rate, we can find the nominal annual rate by dividing the periodic rate by the number of periods per year.

a.

True

b.

False

(4.15) Effective and nominal rates

CJ

Answer:

. As a result of compounding, the effective annual rate on a bank deposit (or a loan) is always equal to or greater than the nominal rate on the deposit (or loan).

a.

True

b.

False

(4.15) Effective and nominal rates

CJ

Answer:

. As a result of compounding, the effective annual rate on a bank deposit (or a loan) is always equal to or less than the nominal rate on the deposit (or loan).

a.

True


b.

False

(4.17) Amortization

CJ

Answer:

. When a loan is amortized, a relatively high percentage of the payment goes to reduce the outstanding principal in the early years, and the principal repayment's percentage declines in the loan's later years.

a.

True

b.

False

(4.17) Amortization

CJ

Answer:

. When a loan is amortized, a relatively low percentage of the payment goes to reduce the outstanding principal in the early years, and the principal repayment's percentage increases in the loan's later years.

a.

True

b.

False

(4.17) Amortization

CJ

Answer:

. The payment made each period on an amortized loan is constant, and it consists of some interest and some principal. The closer we are to the end of the loan's life, the greater the percentage of the payment that will be a repayment of principal.

a.

True

b.

False


(4.17) Amortization

CJ

Answer:

. The payment made each period on an amortized loan is constant, and it consists of some interest and some principal. The closer we are to the end of the loan's life, the smaller the percentage of the payment that will be a repayment of principal.

a.

True

b.

False

(4.17) Amortization

CJ

Answer:

. Midway through the life of an amortized loan, the percentage of the payment that represents interest must be equal to the percentage that represents repayment of principal. This is true regardless of the original life of the loan or the interest rate on the loan.

a.

True

b.

False

(4.17) Amortization

CJ

Answer:

. Midway through the life of an amortized loan, the percentage of the payment that represents interest could be equal to, less than, or greater than to the percentage that represents repayment of principal. The proportions depend on the original life of the loan and the interest rate.

a.

True

b.

False

Multiple Choice: Conceptual


The correct answers to most of these questions can be determined without doing any calculations. However, calculations are required for a few of them, and calculations are useful to confirm the answers to several others. You can see from the answer where calculations are required. Those questions generally take students longer to answer.

(4.1) Time lines F J

Answer:

.

Which of the following statements is CORRECT?

a.

A time line is not meaningful unless all cash flows occur annually.

b.

Time lines are useful for visualizing complex problems prior to doing actual calculations.

c. Time lines cannot be constructed in situations where some of the cash flows occur annually but others occur quarterly. d. Time lines cannot be constructed for annuities where the payments occur at the beginning of the periods. e. Some of the cash flows shown on a time line can be in the form of annuity payments, but none can be uneven amounts.

(4.1) Time lines F J

Answer:

.

Which of the following statements is CORRECT?

a.

A time line is not meaningful unless all cash flows occur annually.

b.

Time lines are not useful for visualizing complex problems prior to doing actual calculations.

c. Time lines cannot be constructed in situations where some of the cash flows occur annually but others occur quarterly. d. Time lines can be constructed for annuities where the payments occur at either the beginning or the end of the periods.


e. Some of the cash flows shown on a time line can be in the form of annuity payments, but none can be uneven amounts.

(4.1) Time lines F J

Answer:

.

Which of the following statements is CORRECT?

a.

A time line is not meaningful unless all cash flows occur annually.

b.

Time lines are not useful for visualizing complex problems prior to doing actual calculations.

c. Time lines can be constructed to deal with situations where some of the cash flows occur annually but others occur quarterly. d. Time lines can only be constructed for annuities where the payments occur at the end of the periods, i.e., for ordinary annuities. e. Time lines cannot be constructed where some of the payments constitute an annuity but others are unequal and thus are not part of the annuity.

(4.1) Time lines F J

Answer:

.

Which of the following statements is CORRECT?

a.

A time line is not meaningful unless all cash flows occur annually.

b.

Time lines are not useful for visualizing complex problems prior to doing actual calculations.

c. Time lines cannot be constructed to deal with situations where some of the cash flows occur annually but others occur quarterly. d. Time lines can only be constructed for annuities where the payments occur at the end of the periods, i.e., for ordinary annuities. e. Time lines can be constructed where some of the payments constitute an annuity but others are unequal and thus are not part of the annuity.


(4.3) Effects of factors on PVs

CJ

Answer:

. 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.

(4.3) Effects of factors on PVs

CJ

Answer:

. 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 increase 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 10 years rather than 5 years, hence that each payment is for $10,000 rather than for $20,000. b.

The discount rate decreases.

c.

The riskiness of the investment’s cash flows increases.

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

The discount rate increases.

(4.6) Annuities F J

Answer:

.

Which of the following statements is CORRECT?

a.

The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods.

b. If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is by definition an annuity. c.

The cash flows for an annuity due must all occur at the ends of the periods.

d. The cash flows for an annuity must all be equal, and they must occur at regular intervals, such as once a year or once a month. e. If some cash flows occur at the beginning of the periods while others occur at the ends, then we have what the textbook defines as a variable annuity.

(4.6) Annuities F J

Answer:


.

Which of the following statements is CORRECT?

a.

The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods.

b. If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is by definition an annuity. c.

The cash flows for an annuity due must all occur at the beginning of the periods.

d. The cash flows for an annuity may vary from period to period, but they must occur at regular intervals, such as once a year or once a month. e. If some cash flows occur at the beginning of the periods while others occur at the ends, then we have what the textbook defines as a variable annuity.

(4.15) Quarterly compounding C J

Answer:

. Your bank account pays a 6% nominal rate of interest. The interest is compounded quarterly. Which of the following statements is CORRECT?

a.

The periodic rate of interest is 1.5% and the effective rate of interest is 3%.

b.

The periodic rate of interest is 6% and the effective rate of interest is greater than 6%.

c.

The periodic rate of interest is 1.5% and the effective rate of interest is greater than 6%.

d.

The periodic rate of interest is 3% and the effective rate of interest is 6%.

e.

The periodic rate of interest is 6% and the effective rate of interest is also 6%.

(4.15) Quarterly compounding C J

Answer:

. 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%.

(4.17) Amortization

CJ

Answer:

. A $50,000 loan is to be amortized over 7 years, with annual end-of-year payments. Which of these statements is CORRECT?

a.

The annual payments would be larger if the interest rate were lower.

b. If the loan were amortized over 10 years rather than 7 years, and if the interest rate were the same in either case, the first payment would include more dollars of interest under the 7-year amortization plan. c. The proportion of each payment that represents interest as opposed to repayment of principal would be lower if the interest rate were lower. d.

The last payment would have a higher proportion of interest than the first payment.

e. The proportion of interest versus principal repayment would be the same for each of the 7 payments.

(4.17) Amortization

CJ

Answer:

. A $150,000 loan is to be amortized over 7 years, with annual end-of-year payments. Which of these statements is CORRECT?

a.

The annual payments would be larger if the interest rate were lower.

b. If the loan were amortized over 10 years rather than 7 years, and if the interest rate were the same in either case, the first payment would include more dollars of interest under the 7-year amortization plan.


c. The proportion of each payment that represents interest as opposed to repayment of principal would be higher if the interest rate were lower. d. The proportion of each payment that represents interest versus repayment of principal would be higher if the interest rate were higher. e. The proportion of interest versus principal repayment would be the same for each of the 7 payments.

(4.17) Amortization

CJ

Answer:

. Which of the following statements regarding a 15-year (180-month) $125,000, fixed-rate mortgage is CORRECT? (Ignore taxes and transactions costs.)

a. The remaining balance after three years will be $125,000 less one third of the interest paid during the first three years. b. Because it is a fixed-rate mortgage, the monthly loan payments (which include both interest and principal payments) are constant. c. Interest payments on the mortgage will increase steadily over time, but the total amount of each payment will remain constant. d. The proportion of the monthly payment that goes towards repayment of principal will be lower 10 years from now than it will be the first year. e.

The outstanding balance declines at a slower rate in the later years of the loan’s life.

(4.17) Amortization

CJ

Answer:

. Which of the following statements regarding a 15-year (180-month) $125,000, fixed-rate mortgage is CORRECT? (Ignore taxes and transactions costs.)

a. The remaining balance after three years will be $125,000 less one third of the interest paid during the first three years. b. Because the outstanding balance declines over time, the monthly payments will also decline over time.


c. Interest payments on the mortgage will increase steadily over time, but the total amount of each payment will remain constant. d. The proportion of the monthly payment that goes towards repayment of principal will be lower 10 years from now than it will be the first year. e.

The outstanding balance declines at a faster rate in the later years of the loan’s life.

(4.17) Amortization

CJ

Answer:

. Which of the following statements regarding a 30-year monthly payment amortized mortgage with a nominal interest rate of 10% is CORRECT?

a.

The monthly payments will decline over time.

b. A smaller proportion of the last monthly payment will be interest, and a larger proportion will be principal, than for the first monthly payment. c. The total dollar amount of principal being paid off each month gets smaller as the loan approaches maturity. d. The amount representing interest in the first payment would be higher if the nominal interest rate were 7% rather than 10%. e.

Exactly 10% of the first monthly payment represents interest.

(4.17) Amortization

CJ

Answer: b

. Which of the following statements regarding a 30-year monthly payment amortized mortgage with a nominal interest rate of 10% is CORRECT?

a.

The monthly payments will increase over time.

b. A larger proportion of the first monthly payment will be interest, and a smaller proportion will be principal, than for the last monthly payment. c. The total dollar amount of interest being paid off each month gets larger as the loan approaches maturity.


d. The amount representing interest in the first payment would be higher if the nominal interest rate were 7% rather than 10%. e.

Exactly 10% of the first monthly payment represents interest.

(Comp.) Time value concepts

CJ

Answer:

. 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).

(Comp.) Time value concepts

CJ

Answer:

. Which of the following investments would have the lowest present value? Assume that the effective annual rate for all investments is the same and is greater than zero.

a.

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

(Comp.) Time value concepts

CJ

Answer:

. A U.S. Treasury bond will pay a lump sum of $1,000 exactly 3 years from today. The nominal interest rate is 6%, semiannual compounding. Which of the following statements is CORRECT?

a.

The periodic interest rate is greater than 3%.

b.

The periodic rate is less than 3%.

c.

The present value would be greater if the lump sum were discounted back for more periods.

d. The present value of the $1,000 would be smaller if interest were compounded monthly rather than semiannually. e. The PV of the $1,000 lump sum has a higher present value than the PV of a 3-year, $333.33 ordinary annuity.

(Comp.) Time value concepts

CJ

Answer:

. A U.S. Treasury bond will pay a lump sum of $1,000 exactly 3 years from today. The nominal interest rate is 6%, semiannual compounding. Which of the following statements is CORRECT?

a.

The periodic interest rate is greater than 3%.

b.

The periodic rate is less than 3%.

c.

The present value would be greater if the lump sum were discounted back for more periods.

d. The present value of the $1,000 would be larger if interest were compounded monthly rather than semiannually. e. The PV of the $1,000 lump sum has a smaller present value than the PV of a 3-year, $333.33 ordinary annuity.


(Comp.) Time value concepts

CJ

Answer:

. Which of the following statements is CORRECT, assuming positive interest rates and holding other things constant?

a. The present value of a 5-year, $250 annuity due will be lower than the PV of a similar ordinary annuity. b. A 30-year, $150,000 amortized mortgage will have larger monthly payments than an otherwise similar 20-year mortgage. c.

A bank loan's nominal interest rate will always be equal to or less than its effective annual rate.

d. If an investment pays 10% interest, compounded annually, its effective annual rate will be less than 10%. e. Banks A and B offer the same nominal annual rate of interest, but A pays interest quarterly and B pays semiannually. Deposits in Bank B will provide the higher future value if you leave your funds on deposit.

(Comp.) Time value concepts

CJ

Answer:

. Which of the following statements is CORRECT, assuming positive interest rates and holding other things constant?

a. The present value of a 5-year, $250 annuity due will be lower than the PV of a similar ordinary annuity. b. A 30-year, $150,000 amortized mortgage will have larger monthly payments than an otherwise similar 20-year mortgage. c. rate.

A bank loan's nominal interest rate will always be equal to or greater than its effective annual

d. If an investment pays 10% interest, compounded quarterly, its effective annual rate will be greater than 10%. e. Banks A and B offer the same nominal annual rate of interest, but A pays interest quarterly and B pays semiannually. Deposits in Bank B will provide the higher future value if you leave your funds on deposit.


(Comp.) Time value concepts .

CJ

Answer:

Which of the following statements is CORRECT?

a. The present value of a 3-year, $150 annuity due will exceed the present value of a 3-year, $150 ordinary annuity. b.

If a loan has a nominal annual rate of 8%, then the effective rate can never be greater than 8%.

c. If a loan or investment has annual payments, then the effective, periodic, and nominal rates of interest will all be different. d. The proportion of the payment that goes toward interest on a fully amortized loan increases over time. e. An investment that has a nominal rate of 6% with semiannual payments will have an effective rate that is smaller than 6%.

(Comp.) Time value concepts .

CJ

Answer:

Which of the following statements is CORRECT?

a. The present value of a 3-year, $150 ordinary annuity will exceed the present value of a 3-year, $150 annuity due. b.

If a loan has a nominal annual rate of 8%, then the effective rate will never be less than 8%.

c. If a loan or investment has annual payments, then the effective, periodic, and nominal rates of interest will all be different. d. The proportion of the payment that goes toward interest on a fully amortized loan increases over time. e. An investment that has a nominal rate of 6% with semiannual payments will have an effective rate that is smaller than 6%.

(Comp.) Annuities

CJ

Answer:


. You are considering two equally risky annuities, each of which pays $5,000 per year for 10 years. Investment ORD is an ordinary (or deferred) annuity, while Investment DUE is an annuity due. Which of the following statements is CORRECT?

a. The present value of ORD must exceed the present value of DUE, but the future value of ORD may be less than the future value of DUE. b. The present value of DUE exceeds the present value of ORD, while the future value of DUE is less than the future value of ORD. c. The present value of ORD exceeds the present value of DUE, and the future value of ORD also exceeds the future value of DUE. d. The present value of DUE exceeds the present value of ORD, and the future value of DUE also exceeds the future value of ORD. e. If the going rate of interest decreases from 10% to 0%, the difference between the present value of ORD and the present value of DUE would remain constant.

(Comp.) Annuities

CJ

Answer:

. You are considering two equally risky annuities, each of which pays $5,000 per year for 10 years. Investment ORD is an ordinary (or deferred) annuity, while Investment DUE is an annuity due. Which of the following statements is CORRECT?

a. A rational investor would be willing to pay more for DUE than for ORD, so their market prices should differ. b. The present value of DUE exceeds the present value of ORD, while the future value of DUE is less than the future value of ORD. c. The present value of ORD exceeds the present value of DUE, and the future value of ORD also exceeds the future value of DUE. d. The present value of ORD exceeds the present value of DUE, while the future value of DUE exceeds the future value of ORD. e. If the going rate of interest decreases from 10% to 0%, the difference between the present value of ORD and the present value of DUE would remain constant.


(4.14) Solving for I: uneven CFs C J .

Answer:

Which of the following statements is CORRECT?

a. If you have a series of cash flows, each of which is positive, you can solve for I, where the solution value of I causes the PV of the cash flows to equal the cash flow at Time 0. b. If you have a series of cash flows, and CF0 is negative but each of the following CFs is positive, you can solve for I, but only if the sum of the undiscounted cash flows exceeds the cost. c. To solve for I, one must identify the value of I that causes the PV of the positive CFs to equal the absolute value of the PV of the negative CFs. This is, essentially, a trial-and-error procedure that is with a computer or financial calculator but quite difficult otherwise. d.

If you solve for I and get a negative number, then you must have made a mistake.

e.

If CF0 is positive and all the other CFs are negative, then you cannot solve for I.

(4.14) Solving for I: uneven CFs C J .

Answer:

Which of the following statements is CORRECT?

a. If you have a series of cash flows, each of which is positive, you can solve for I, where the solution value of I causes the PV of the cash flows to equal the cash flow at Time 0. b. If you have a series of cash flows, and CF0 is negative but each of the following CFs is positive, you can solve for I, but only if the sum of the undiscounted cash flows exceeds the cost. c. To solve for I, one must identify the value of I that causes the PV of the positive CFs to equal the absolute value of the FV of the negative CFs. It is impossible to find the value of I without a computer or financial calculator. d.

If you solve for I and get a negative number, then you must have made a mistake.

e.

If CF0 is positive and all the other CFs are negative, then you can still solve for I.

(4.15) Effective annual rate .

CJ

Answer:

Which of the following bank accounts has the highest effective annual return?


a.

An account that pays 8% nominal interest with monthly compounding.

b.

An account that pays 8% nominal interest with annual compounding.

c.

An account that pays 7% nominal interest with daily (365-day) compounding.

d.

An account that pays 7% nominal interest with monthly compounding.

e.

An account that pays 8% nominal interest with daily (365-day) compounding.

(4.15) Effective annual rate

CJ

Answer:

.

Which of the following bank accounts has the lowest effective annual return?

a.

An account that pays 8% nominal interest with monthly compounding.

b.

An account that pays 8% nominal interest with annual compounding.

c.

An account that pays 7% nominal interest with daily (365-day) compounding.

d.

An account that pays 7% nominal interest with monthly compounding.

e.

An account that pays 8% nominal interest with daily (365-day) compounding.

(4.15) Effective annual rate

CJ

Answer:

. You plan to invest some money in a bank account. Which of the following banks provides you with the highest effective rate of interest?

a.

Bank 1; 6.1% with annual compounding.

b.

Bank 2; 6.0% with monthly compounding.

c.

Bank 3; 6.0% with annual compounding.

d.

Bank 4; 6.0% with quarterly compounding.


e.

Bank 5; 6.0% with daily (365-day) compounding.

Multiple Choice: Problems

(4.2) FV of a lump sum C J

Answer:

. Ellen now has $125. How much would she have after 8 years if she leaves it invested at 8.5% with annual compounding?

a.

$205.83

b.

$216.67

c.

$228.07

d.

$240.08

e.

$252.08

(4.2) FV of a lump sum C J

Answer:

. Jose now has $500. How much would he have after 6 years if he leaves it invested at 5.5% with annual compounding?

a.

$591.09

b.

$622.20

c.

$654.95

d.

$689.42

e.

$723.89


(4.2) FV of a lump sum C J

Answer:

. Suppose you have $1,500 and plan to purchase a 5-year certificate of deposit (CD) that pays 3.5% interest, compounded annually. How much will you have when the CD matures?

a.

$1,781.53

b.

$1,870.61

c.

$1,964.14

d.

$2,062.34

e.

$2,165.46

(4.2) FV of a lump sum C J

Answer:

. Suppose you have $2,000 and plan to purchase a 10-year certificate of deposit (CD) that pays 6.5% interest, compounded annually. How much will you have when the CD matures?

a.

$3,754.27

b.

$3,941.99

c.

$4,139.09

d.

$4,346.04

e.

$4,563.34

(4.2) FV of a lump sum C J

Answer:

. Last year Rocco Corporation's sales were $225 million. If sales grow at 6% per year, how large (in millions) will they be 5 years later?


a.

$271.74

b.

$286.05

c.

$301.10

d.

$316.16

e.

$331.96

(4.2) FV of a lump sum C J

Answer:

. Last year Tempe Corporation's sales were $525 million. If sales grow at 7.5% per year, how large (in millions) will they be 8 years later?

a.

$845.03

b.

$889.51

c.

$936.33

d.

$983.14

e.

$1,032.30

(4.2) FV of a lump sum C J

Answer:

.

How much would $1, growing at 3.5% per year, be worth after 75 years?

a.

$12.54

b.

$13.20

c.

$13.86

d.

$14.55

e.

$15.28

(4.2) FV of a lump sum C J

Answer:


.

How much would $100, growing at 5% per year, be worth after 75 years?

a.

$3,689.11

b.

$3,883.27

c.

$4,077.43

d.

$4,281.30

e.

$4,495.37

(4.2) FV of a lump sum C J

Answer:

. 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

(4.2) FV of a lump sum C J

Answer:

. You deposit $500 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.

$1,122.54

b.

$1,181.62

c.

$1,240.70


d.

$1,302.74

e.

$1,367.88

(4.3) PV of a lump sum C J

Answer:

. Suppose a State of New York bond will pay $1,000 ten years from now. If the going interest rate on these 10-year bonds is 5.5%, how much is the bond worth today?

a.

$585.43

b.

$614.70

c.

$645.44

d.

$677.71

e.

$711.59

(4.3) PV of a lump sum C J

Answer:

. Suppose a State of California bond will pay $1,000 eight years from now. If the going interest rate on these 8-year bonds is 5.5%, how much is the bond worth today?

a.

$651.60

b.

$684.18

c.

$718.39

d.

$754.31

e.

$792.02


(4.3) PV of a lump sum C J

Answer:

.

How much would $20,000 due in 50 years be worth today if the discount rate were 7.5%?

a.

$438.03

b.

$461.08

c.

$485.35

d.

$510.89

e.

$537.78

(4.3) PV of a lump sum C J

Answer:

.

How much would $5,000 due in 25 years be worth today if the discount rate were 5.5%?

a.

$1,067.95

b.

$1,124.16

c.

$1,183.33

d.

$1,245.61

e.

$1,311.17

(4.3) PV of a lump sum C J

Answer:

. Suppose a U.S. treasury bond will pay $2,500 five years from now. If the going interest rate on 5-year treasury bonds is 4.25%, how much is the bond worth today?


a.

$1,928.78

b.

$2,030.30

c.

$2,131.81

d.

$2,238.40

e.

$2,350.32

(4.3) PV of a lump sum C J

Answer:

. Suppose an ExxonMobil Corporation bond will pay $4,500 ten years from now. If the going interest rate on safe 10-year bonds is 4.25%, how much is the bond worth today?

a.

$2,819.52

b.

$2,967.92

c.

$3,116.31

d.

$3,272.13

e.

$3,435.74

(4.4) Finding I

CJ

Answer:

. Suppose the U.S. Treasury offers to sell you a bond for $747.25. No payments will be made until the bond matures 5 years from now, at which time it will be redeemed for $1,000. What interest rate would you earn if you bought this bond at the offer price?

a.

4.37%

b.

4.86%

c.

5.40%

d.

6.00%

e.

6.60%


(4.4) Finding I

CJ

Answer:

. 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%

(4.4) Growth rate

CJ

Answer:

. Ten years ago, Spielberg Inc. earned $0.50 per share. Its earnings this year were $2.20. What was the growth rate in earnings per share (EPS) over the 10-year period?

a.

15.17%

b.

15.97%

c.

16.77%

d.

17.61%


e.

18.49%

(4.4) Growth rate

CJ

Answer:

. Five years ago, Greenery Inc. earned $1.50 per share. Its earnings this year were $3.20. What was the growth rate in earnings per share (EPS) over the 5-year period?

a.

15.54%

b.

16.36%

c.

17.18%

d.

18.04%

e.

18.94%

(4.5) Finding N C J

Answer:

. Wendy has $5,000 invested in a bank that pays 3.8% annually. How long will it take for her funds to triple?

a.

23.99

b.

25.26

c.

26.58

d.

27.98

e.

29.46


(4.5) Finding N C J

Answer:

. Chuck has $2,500 invested in a bank that pays 4% annually. How long will it take for his funds to double?

a.

14.39

b.

15.15

c.

15.95

d.

16.79

e.

17.67

(4.5) Finding N C J

Answer:

. Last year Ellis Inc's earnings per share were $3.50, and its growth rate during the prior 5 years was 9.0% per year. If that growth rate were maintained, how many years would it take for Ellis’ EPS to triple?

a.

9.29

b.

10.33

c.

11.47

d.

12.75

e.

14.02

(4.5) Finding N C J

Answer:

. You plan to invest in securities that pay 8.0%, compounded annually. If you invest $5,000 today, how many years will it take for your investment to grow to $9,140.20?


a.

5.14

b.

5.71

c.

6.35

d.

7.05

e.

7.84

(4.5) Finding N C J

Answer:

. You plan to invest in bonds that pay 6.0%, compounded annually. If you invest $10,000 today, how many years will it take for your investment to grow to $30,000?

a.

12.37

b.

13.74

c.

15.27

d.

16.97

e.

18.85

(4.7) FV of ordinary annuity

CJ

Answer:

. You want to buy a new sports car 3 years from now, and you plan to save $4,200 per year, beginning one year from today. You will deposit your savings in an account that pays 5.2% interest. How much will you have just after you make the 3rd deposit, 3 years from now?

a.

$11,973

b.

$12,603

c.

$13,267

d.

$13,930

e.

$14,626


(4.7) FV of ordinary annuity

CJ

Answer:

. You want to buy a new ski boat 2 years from now, and you plan to save $8,200 per year, beginning one year from today. You will deposit your savings in an account that pays 6.2% interest. How much will you have just after you make the 2nd deposit, 2 years from now?

a.

$15,260

b.

$16,063

c.

$16,908

d.

$17,754

e.

$18,642

(4.7) FV of ordinary annuity

CJ

Answer:

. You want to go to Europe 5 years from now, and you can save $3,100 per year, beginning one year from today. You plan to deposit the funds in a mutual fund that you think will return 8.5% per year. Under these conditions, how much would you have just after you make the 5th deposit, 5 years from now?

a.

$18,369

b.

$19,287

c.

$20,251

d.

$21,264

e.

$22,327

(4.8) FV of annuity due C J

Answer:


. You want to quit your job and go back to school for a law degree 4 years from now, and you plan to save $3,500 per year, beginning immediately. You will make 4 deposits in an account that pays 5.7% interest. Under these assumptions, how much will you have 4 years from today?

a.

$16,112

b.

$16,918

c.

$17,763

d.

$18,652

e.

$19,584

(4.8) FV of annuity due C J

Answer:

. You want to quit your job and return to school for an MBA degree 3 years from now, and you plan to save $7,000 per year, beginning immediately. You will make 3 deposits in an account that pays 5.2% interest. Under these assumptions, how much will you have 3 years from today?

a.

$20,993

b.

$22,098

c.

$23,261

d.

$24,424

e.

$25,645

(4.9) PV of ordinary annuity

CJ

Answer:

. What is the PV of an ordinary annuity with 10 payments of $2,700 if the appropriate interest rate is 5.5%?

a.

$16,576

b.

$17,449


c.

$18,367

d.

$19,334

e.

$20,352

(4.9) PV of ordinary annuity

CJ

Answer:

. What is the PV of an ordinary annuity with 5 payments of $4,700 if the appropriate interest rate is 4.5%?

a.

$16,806

b.

$17,690

c.

$18,621

d.

$19,601

e.

$20,633

(4.9) PV of ordinary annuity

CJ

Answer:

. You have a chance to buy an annuity that pays $2,500 at the end of each year for 3 years. You could earn 5.5% on your money in other investments with equal risk. What is the most you should pay for the annuity?

a.

$5,493.71

b.

$5,782.85

c.

$6,087.21

d.

$6,407.59

e.

$6,744.83

(4.9) PV of ordinary annuity

CJ

Answer:


. You just inherited some money, and a broker offers to sell you an annuity that pays $5,000 at the end of each year for 20 years. You could earn 5% on your money in other investments with equal risk. What is the most you should pay for the annuity?

a.

$50,753

b.

$53,424

c.

$56,236

d.

$59,195

e.

$62,311

(4.9) PV of ordinary annuity

CJ

Answer:

. Your aunt is about to retire, and she wants to sell some of her stock and buy an annuity that will provide her with income of $50,000 per year for 30 years, beginning a year from today. The going rate on such annuities is 7.25%. How much would it cost her to buy such an annuity today?

a.

$574,924

b.

$605,183

c.

$635,442

d.

$667,214

e.

$700,575

(4.9) PV of annuity due C J .

Answer:

What is the PV of an annuity due with 5 payments of $2,500 at an interest rate of 5.5%?


a.

$11,262.88

b.

$11,826.02

c.

$12,417.32

d.

$13,038.19

e.

$13,690.10

(4.11) PV of a perpetuity

CJ

Answer:

. What’s the present value of a perpetuity that pays $250 per year if the appropriate interest rate is 5%?

a.

$4,750

b.

$5,000

c.

$5,250

d.

$5,513

e.

$5,788

(4.11) Return on a perpetuity

CJ

Answer:

. year?

What’s the rate of return you would earn if you paid $950 for a perpetuity that pays $85 per

a.

8.95%

b.

9.39%

c.

9.86%

d.

10.36%

e.

10.88%


(4.9) PV of annuity due C J

Answer:

. You have a chance to buy an annuity that pays $550 at the beginning of each year for 3 years. You could earn 5.5% on your money in other investments with equal risk. What is the most you should pay for the annuity?

a.

$1,412.84

b.

$1,487.20

c.

$1,565.48

d.

$1,643.75

e.

$1,725.94

(4.9) PV of annuity due C J

Answer:

. You have a chance to buy an annuity that pays $5,000 at the beginning of each year for 5 years. You could earn 4.5% on your money in other investments with equal risk. What is the most you should pay for the annuity?

a

20,701

b.

$21,791

c.

$22,938

d.

$24,085


e.

$25,289

(4.9) PV of annuity due C J

Answer:

. Your uncle is about to retire, and he wants to buy an annuity that will provide him with $75,000 of income a year for 20 years, with the first payment coming immediately. The going rate on such annuities is 5.25%. How much would it cost him to buy the annuity today?

a.

$825,835

b.

$869,300

c.

$915,052

d.

$963,213

e.

$1,011,374

(4.9) PV of annuity due C J

Answer:

. Your father is about to retire, and he wants to buy an annuity that will provide him with $85,000 of income a year for 25 years, with the first payment coming immediately. The going rate on such annuities is 5.15%. How much would it cost him to buy the annuity today?

a.

$1,063,968

b.

$1,119,966

c.

$1,178,912

d.

$1,240,960

e.

$1,303,008

(4.9) PV of annuity due C J

Answer:


. You inherited an oil well that will pay you $25,000 per year for 25 years, with the first payment being made today. If you think a fair return on the well is 7.5%, how much should you ask for it if you decide to sell it?

a.

$284,595

b.

$299,574

c.

$314,553

d.

$330,281

e.

$346,795

(4.9) PV of annuity due C J

Answer:

. Sam was injured in an accident, and the insurance company has offered him the choice of $25,000 per year for 15 years, with the first payment being made today, or a lump sum. If a fair return is 7.5%, how large must the lump sum be to leave him as well off financially as with the annuity?

a.

$225,367

b.

$237,229

c.

$249,090

d.

$261,545

e.

$274,622

(4.9) PV of ord. ann. & end. pmt.

CJ

Answer:

. What’s the present value of a 4-year ordinary annuity of $2,250 per year plus an additional $3,000 at the end of Year 4 if the interest rate is 5%?

a.

$8,509

b.

$8,957


c.

$9,428

d.

$9,924

e.

$10,446

(4.10) Payments on ord. annuityC J

Answer:

. Suppose you inherited $275,000 and invested it at 8.25% per year. How much could you withdraw at the end of each of the next 20 years?

a.

$28,532

b.

$29,959

c.

$31,457

d.

$33,030

e.

$34,681

(4.10) Payments on ord. annuityC J

Answer:

. Your uncle has $375,000 and wants to retire. He expects to live for another 25 years and to earn 7.5% on his invested funds. How much could he withdraw at the end of each of the next 25 years and end up with zero in the account?

a.

$28,843.38

b.

$30,361.46

c.

$31,959.43

d.

$33,641.50

e.

$35,323.58

(4.10) Payments on annuity due C J

Answer:


. Your uncle has $375,000 and wants to retire. He expects to live for another 25 years, and he also expects to earn 7.5% on his invested funds. How much could he withdraw at the beginning of each of the next 25 years and end up with zero in the account?

a.

$28,243.21

b.

$29,729.70

c.

$31,294.42

d.

$32,859.14

e.

$34,502.10

(4.10) Payments on annuity due C J

Answer:

. Your grandmother just died and left you $100,000 in a trust fund that pays 6.5% interest. You must spend the money on your college education, and you must withdraw the money in 4 equal installments, beginning immediately. How much could you withdraw today and at the beginning of each of the next 3 years and end up with zero in the account?

a.

$24,736

b.

$26,038

c.

$27,409

d.

$28,779

e.

$30,218

(4.10) Payments on annuity due C J

Answer:

. Suppose you inherited $275,000 and invested it at 8.25% per year. How much could you withdraw at the beginning of each of the next 20 years?


a.

$22,598.63

b.

$23,788.03

c.

$25,040.03

d.

$26,357.92

e.

$27,675.82

(4.10) Years to deplete ord. ann.

CJ

Answer:

. Your father's employer was just acquired, and he was given a severance payment of $375,000, which he invested at a 7.5% annual rate. He now plans to retire, and he wants to withdraw $35,000 at the end of each year, starting at the end of this year. What is the maximum number of whole payments that can be withdrawn before the account is exhausted; i.e., before the account balance would become negative? (Hint: Round down to the nearest whole number.)

a.

22

b.

23

c.

24

d.

25

e.

26

(4.10) Years to deplete ord. ann.

CJ

Answer:

. Your uncle has $300,000 invested at 7.5%, and he now wants to retire. He wants to withdraw $35,000 at the end of each year, beginning at the end of this year. He also wants to have $25,000 left to give you when he ceases to withdraw funds from the account. What is the maximum number of $35,000 withdrawals that he can make and still have at least $25,000 left in the account? (Hint: If your solution for N is not an integer, round down to the nearest whole number.)

a.

12

b.

13

c.

14


d.

15

e.

16

(4.10) Years to deplete ann. dueC J

Answer:

. Your Aunt Elsa has $500,000 invested at 6.5%, and she plans to retire. She wants to withdraw $40,000 at the beginning of each year, starting immediately. What is the maximum number of whole payments that can be withdrawn before the account is exhausted; i.e., before the account balance would become negative? (Hint: Round down to the nearest whole number.)

a.

18

b.

19

c.

20

d.

21

e.

22

(4.10) Years to deplete ann. dueC J

Answer:


. Your aunt has $500,000 invested at 5.5%, and she now wants to retire. She wants to withdraw $45,000 at the beginning of each year, beginning immediately. She also wants to have $50,000 left to give you when she ceases to withdraw funds from the account. What is the maximum number of $45,000 withdrawals that she can make and still have at least $50,000 left in the account? (Hint: If your solution for N is not an integer, round down to the nearest whole number.)

a.

13

b.

14

c.

15

d.

16

e.

17

(4.10) Int. rate implicit: annuity C J

Answer:

. Suppose you just won the state lottery, and you have a choice between receiving $2,550,000 today or a 20-year annuity of $250,000, with the first payment coming one year from today. What rate of return is built into the annuity? Disregard taxes.

a.

7.12%

b.

7.49%

c.

7.87%

d.

8.26%

e.

8.67%


(4.10) Int. rate implicit: annuity C J

Answer:

. Your girlfriend just won the Florida lottery. She has the choice of $15,000,000 today or a 20year annuity of $1,050,000, with the first payment coming one year from today. What rate of return is built into the annuity?

a.

3.44%

b.

3.79%

c.

4.17%

d.

4.58%

e.

5.04%

(4.10) Int. rate implicit: annuity due

CJ

Answer:

. Assume that you own an annuity that will pay you $15,000 per year for 12 years, with the first payment being made today. You need money today to start a new business, and your uncle offers to give you $120,000 for the annuity. If you sell it, what rate of return would your uncle earn on his investment?

a.

6.85%

b.

7.21%

c.

7.59%

d.

7.99%


e.

8.41%

(4.11) Payments on a perpetuityC J

Answer:

. 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

(4.12) PV of uneven cash flows C J .

Answer:

What is the present value of the following cash flow stream at a rate of 6.25%?

Years: 0

1

2

3

4

|

|

|

|

|

CFs:

$0

$75

$225

$0

$300

a.

$411.57

b.

$433.23

c.

$456.03

d.

$480.03

e.

$505.30


(4.12) PV of uneven cash flows C J .

Answer:

What is the present value of the following cash flow stream at a rate of 12.0%?

Years: 0

1

2

3

4

|

|

|

|

|

CFs:

$0

$1,500 $3,000 $4,500 $6,000

a.

$9,699

b.

$10,210

c.

$10,747

d.

$11,284

e.

$11,849

(4.12) PV of uneven cash flows C J .

Answer:

What is the present value of the following cash flow stream at a rate of 8.0%?

Years: 0

1

2

3

|

|

|

|

CFs:

$750

$2,450 $3,175 $4,400

a.

$7,917

b.

$8,333

c.

$8,772

d.

$9,233

e.

$9,695


(4.12) PV of uneven cash flows C J

Answer:

. 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

(4.13) FV of uneven cash flows C J .

Answer:

At a rate of 6.5%, what is the future value of the following cash flow stream?


Years: 0

1

2

3

4

|

|

|

|

|

CFs:

$0

$75

$225

$0

$300

a.

$526.01

b.

$553.69

c.

$582.83

d.

$613.51

e.

$645.80

(4.14) Rate in uneven cash flows

CJ

Answer:

. Your father paid $10,000 (CF at t = 0) for an investment that promises to pay $750 at the end of each of the next 5 years, then an additional lump sum payment of $10,000 at the end of the 5th year. What is the expected rate of return on this investment?

a.

6.77%

b.

7.13%

c.

7.50%

d.

7.88%

e.

8.27%


(4.14) Rate in uneven cash flows

CJ

Answer:

. You are offered a chance to buy an asset for $7,250 that is expected to produce cash flows of $750 at the end of Year 1, $1,000 at the end of Year 2, $850 at the end of Year 3, and $6,250 at the end of Year 4. What rate of return would you earn if you bought this asset?

a.

4.93%

b.

5.19%

c.

5.46%

d.

5.75%

e.

6.05%

(4.15) FV, semiannual compounding

CJ

Answer:

. What’s the future value of $1,500 after 5 years if the appropriate interest rate is 6%, compounded semiannually?

a.

$1,819

b.

$1,915

c.

$2,016

d.

$2,117

e.

$2,223


(4.15) FV, semiannual compounding

CJ

Answer:

. What’s the present value of $4,500 discounted back 5 years if the appropriate interest rate is 4.5%, compounded semiannually?

a.

$3,089

b.

$3,251

c.

$3,422

d.

$3,602

e.

$3,782

(4.15) FV, monthly compounding

CJ

Answer:

. What’s the future value of $1,200 after 5 years if the appropriate interest rate is 6%, compounded monthly?

a.

$1,537.69

b.

$1,618.62

c.

$1,699.55

d.

$1,784.53

e.

$1,873.76

(4.15) PV, monthly compounding

CJ

Answer:

. What’s the present value of $1,525 discounted back 5 years if the appropriate interest rate is 6%, compounded monthly?

a.

$969

b.

$1,020

c.

$1,074


d.

$1,131

e.

$1,187

(4.15) APR vs. EFF%

CJ

Answer:

. Master Card and other credit card issuers must by law print the Annual Percentage Rate (APR) on their monthly statements. If the APR is stated to be 18.00%, with interest paid monthly, what is the card's EFF%?

a.

18.58%

b.

19.56%

c.

20.54%

d.

21.57%

e.

22.65%

(4.15) Comparing EFF% C J

Answer:

. Riverside Bank offers to lend you $50,000 at a nominal rate of 6.5%, compounded monthly. The loan (principal plus interest) must be repaid at the end of the year. Midwest Bank also offers to lend you the $50,000, but it will charge an annual rate of 7.0%, with no interest due until the end of the year.


How much higher or lower is the effective annual rate charged by Midwest versus the rate charged by Riverside?

a.

0.52%

b.

0.44%

c.

0.36%

d.

0.30%

e.

0.24%

(4.15) Nominal rate vs. EFF%

CJ

Answer:

. Suppose United Bank offers to lend you $10,000 for one year at a nominal annual rate of 8.00%, but you must make interest payments at the end of each quarter and then pay off the $10,000 principal amount at the end of the year. What is the effective annual rate on the loan?

a.

8.24%

b.

8.45%

c.

8.66%

d.

8.88%

e.

9.10%

(4.15) Nominal rate vs. EFF%

CJ

Answer:

. Suppose a bank offers to lend you $10,000 for 1 year on a loan contract that calls for you to make interest payments of $250.00 at the end of each quarter and then pay off the principal amount at the end of the year. What is the effective annual rate on the loan?

a.

8.46%


b.

8.90%

c.

9.37%

d.

9.86%

e.

10.38%

(4.15) Nominal rate vs. EFF%

CJ

Answer:

. Pacific Bank pays a 4.50% nominal rate on deposits, with monthly compounding. What effective annual rate (EFF%) does the bank pay?

a.

3.72%

b.

4.13%

c.

4.59%

d.

5.05%

e.

5.56%

(4.15) Nominal rate vs. EFF%

CJ

Answer:

. Suppose your credit card issuer states that it charges a 15.00% nominal annual rate, but you must make monthly payments, which amounts to monthly compounding. What is the effective annual rate?

a.

15.27%

b.

16.08%

c.

16.88%

d.

17.72%

e.

18.61%


(4.16) Simple interest

CJ

Answer:

. Pasco Co. borrowed $20,000 at a rate of 7.25%, simple interest, with interest paid at the end of each month. The bank uses a 360-day year. How much interest would Pasco have to pay in a 30-day month?

a.

$120.83

b.

$126.88

c.

$133.22

d.

$139.88

e.

$146.87

(4.16) Fractional time periods

CJ

Answer:

. Suppose you deposited $5,000 in a bank account that pays 5.25% with daily compounding based on a 360-day year. How much would be in the account after 8 months, assuming each month has 30 days?

a.

$5,178.09

b.

$5,436.99

c.

$5,708.84

d.

$5,994.28

e.

$6,294.00


(4.17) Amortization: payment

CJ

Answer:

. Suppose you borrowed $12,000 at a rate of 9.0% and must repay it in 4 equal installments at the end of each of the next 4 years. How large would your payments be?

a.

$3,704.02

b.

$3,889.23

c.

$4,083.69

d.

$4,287.87

e.

$4,502.26

(4.17) Amortization: payment

CJ

Answer:

. Suppose you are buying your first condo for $145,000, and you will make a $15,000 down payment. You have arranged to finance the remainder with a 30-year, monthly payment, amortized mortgage at a 6.5% nominal interest rate, with the first payment due in one month. What will your monthly payments be?

a.

$741.57

b.

$780.60

c.

$821.69

d.

$862.77

e.

$905.91


(4.17) Amortization: payment

CJ

Answer:

. Your uncle will sell you his bicycle shop for $250,000, with "seller financing," at a 6.0% nominal annual rate. The terms of the loan would require you to make 12 equal end-of-month payments per year for 4 years, and then make an additional final (balloon) payment of $50,000 at the end of the last month. What would your equal monthly payments be?

a.

$4,029.37

b.

$4,241.44

c.

$4,464.67

d.

$4,699.66

e.

$4,947.01

(4.17) Amortization: interest

CJ

Answer:

. Suppose you borrowed $14,000 at a rate of 10.0% and must repay it in 5 equal installments at the end of each of the next 5 years. How much interest would you have to pay in the first year?

a.

$1,200.33

b.

$1,263.50

c.

$1,330.00

d.

$1,400.00

e.

$1,470.00

(4.17) Amortization: interest

CJ

Answer:

. You plan to borrow $35,000 at a 7.5% annual interest rate. The terms require you to amortize the loan with 7 equal end-of-year payments. How much interest would you be paying in Year 2?


a.

$1,994.49

b.

$2,099.46

c.

$2,209.96

d.

$2,326.27

e.

$2,442.59

(4.17) Amortization: interest

CJ

Answer:

. Your bank offers to lend you $100,000 at an 8.5% annual interest rate to start your new business. The terms require you to amortize the loan with 10 equal end-of-year payments. How much interest would you be paying in Year 2?

a.

$7,531

b.

$7,927

c.

$8,323

d.

$8,740

e.

$9,177

(Comp.) N, ann. due, monthly comp.

CJ

Answer:

. You are considering an investment in a Third World bank account that pays a nominal annual rate of 18%, compounded monthly. If you invest $5,000 at the beginning of each month, how many months would it take for your account to grow to $250,000? Round fractional months up.

a.

23

b.

27

c.

32

d.

38


e.

44

(Comp.) N, ann. due, monthly comp.

CJ

Answer:

. You are considering investing in a bank account that pays a nominal annual rate of 7%, compounded monthly. If you invest $3,000 at the end of each month, how many months will it take for your account to grow to $150,000?

a.

39.60

b.

44.00

c.

48.40

d.

53.24

e.

58.57

(Comp.) Rate, ord. ann., monthly comp. C J

Answer:

. Your child’s orthodontist offers you two alternative payment plans. The first plan requires a $4,000 immediate up-front payment. The second plan requires you to make monthly payments of $137.41, payable at the end of each month for 3 years. What nominal annual interest rate is built into the monthly payment plan?

a.

12.31%

b.

12.96%

c.

13.64%

d.

14.36%

e.

15.08%

(4.10) N, lifetime vs. yearly

CJ

Answer:


. Your subscription to Investing Wisely Weekly is about to expire. You plan to subscribe to the magazine for the rest of your life, and you can renew it by paying $85 annually, beginning immediately, or you can get a lifetime subscription for $850, also payable immediately. Assuming that you can earn 6.0% on your funds and that the annual renewal rate will remain constant, how many years must you live to make the lifetime subscription the better buy?

a.

7.48

b.

8.80

c.

10.35

d.

12.18

e.

14.33

(4.15) Non-annual compounding

CJ

Answer:

. You just deposited $2,500 in a bank account that pays a 4.0% nominal interest rate, compounded quarterly. If you also add another $5,000 to the account one year (4 quarters) from now


and another $7,500 to the account two years (8 quarters) from now, how much will be in the account three years (12 quarters) from now?

a.

$15,234.08

b.

$16,035.88

c.

$16,837.67

d.

$17,679.55

e.

$18,563.53

(4.15) Comparing EFF% C J

Answer:

. Farmers Bank offers to lend you $50,000 at a nominal rate of 5.0%, simple interest, with interest paid quarterly. Merchants Bank offers to lend you the $50,000, but it will charge 6.0%, simple interest, with interest paid at the end of the year. What's the difference in the effective annual rates charged by the two banks?

a.

1.56%

b.

1.30%

c.

1.09%

d.

0.91%

e.

0.72%

(4.17) Amortization: princ. repymt.

CJ

Answer:

. Suppose you borrowed $15,000 at a rate of 8.5% and must repay it in 5 equal installments at the end of each of the next 5 years. By how much would you reduce the amount you owe in the first year?

a.

$2,404.91


b.

$2,531.49

c.

$2,658.06

d.

$2,790.96

e.

$2,930.51

(4.17) Amortization: ending bal. C J

Answer:

. Suppose you borrowed $15,000 at a rate of 8.5% and must repay it in 5 equal installments at the end of each of the next 5 years. How much would you still owe at the end of the first year, after you have made the first payment?

a.

$10,155.68

b.

$10,690.19

c.

$11,252.83

d.

$11,845.09

e.

$12,468.51

(Comp.) Retirement planning

CJ

Answer:

. Your sister turned 35 today, and she is planning to save $7,000 per year for retirement, with the first deposit to be made one year from today. She will invest in a mutual fund that's expected to provide a return of 7.5% per year. She plans to retire 30 years from today, when she turns 65, and she expects to live for 25 years after retirement, to age 90. Under these assumptions, how much can she spend each year after she retires? Her first withdrawal will be made at the end of her first retirement year.

a.

$58,601

b.

$61,686

c.

$64,932

d.

$68,179

e.

$71,588


(4.10) Finding I in annuity due

CJ

Answer:

. You agree to make 24 deposits of $500 at the beginning of each month into a bank account. At the end of the 24th month, you will have $13,000 in your account. If the bank compounds interest monthly, what nominal annual interest rate will you be earning?

a.

7.62%

b.

8.00%

c.

8.40%

d.

8.82%

e.

9.26%

(4.17) Amortization

CJ

Answer:

. Your company has just taken out a 1-year installment loan for $72,500 at a nominal rate of 11.0% but with equal end-of-month payments. What percentage of the 2nd monthly payment will go toward the repayment of principal?

a.

73.67%

b.

77.55%

c.

81.63%

d.

85.93%

e.

90.45%

(4.17) Amortization: interest

CJ

Answer:

. On January 1, 2009, your brother's business obtained a 30-year amortized mortgage loan for $250,000 at a nominal annual rate of 7.0%, with 360 end-of-month payments. The firm can deduct the interest paid for tax purposes. What will the interest tax deduction be for 2009?


a.

$17,419.55

b.

$17,593.75

c.

$17,769.68

d.

$17,947.38

e.

$18,126.85

(4.18) Growing annuity C J

Answer:

. You borrowed $50,000 which you must repay in 10 years. You plan to make an initial deposit today, then make 9 more deposits at the beginning of each the next 9 years, but with the deposits increasing at the inflation rate. You expect to earn 5% on your funds, and you expect a 3% inflation rate. To the nearest dollar, how large must your initial deposit be to enable you to reach your $50,000 target?

a.

$3,008

b.

$3,342

c.

$3,676

d.

$4,044

e.

$4,448

(4.18) Growing annuity C J

Answer:

. Your 75-year-old grandmother expects to live for another 15 years. She currently has $1,000,000 of savings, which is invested to earn a guaranteed 5% rate of return. If inflation averages 2% per year, how much can she withdraw (to the nearest dollar) at the beginning of each year and keep the withdrawals constant in real terms, i.e., growing at the same rate as inflation and thus enabling her to maintain a constant standard of living?

a.

$65,632


b.

$72,925

c.

$81,027

d.

$89,130

e.

$98,043

(Comp.) Retirement planning

CJ

Answer:

. Steve and Ed are cousins who were both born on the same day, and both turned 25 today. Their grandfather began putting $2,500 per year into a trust fund for Steve on his 20th birthday, and he just made a 6th payment into the fund. The grandfather (or his estate's trustee) will make 40 more $2,500 payments until a 46th and final payment is made on Steve's 65th birthday. The grandfather set things up this way because he wants Steve to work, not be a "trust fund baby," but he also wants to ensure that Steve is provided for in his old age. Until now, the grandfather has been disappointed with Ed, hence has not given him anything. However, they recently reconciled, and the grandfather decided to make an equivalent provision for Ed. He will make the first payment to a trust for Ed today, and he has instructed his trustee to make 40 additional equal annual payments until Ed turns 65, when the 41st and final payment will be made. If both trusts earn an annual return of 8%, how much must the grandfather put into Ed's trust today and each subsequent year to enable him to have the same retirement nest egg as Steve after the last payment is made on their 65th birthday?

a.

$3,726

b.

$3,912

c.

$4,107

d.

$4,313

e.

$4,528


(Comp.) FV comb. CF lump sum & ann. C J

Answer:

. After graduation, you plan to work for Dynamo Corporation for 12 years and then start your own business. You expect to save and deposit $7,500 a year for the first 6 years (t = 1 through t = 6) and $15,000 annually for the following 6 years (t = 7 through t = 12). The first deposit will be made a year from today. In addition, your grandfather just gave you a $25,000 graduation gift which you will deposit immediately (t = 0). If the account earns 9% compounded annually, how much will you have when you start your business 12 years from now?

a.

$238,176

b.

$250,712

c.

$263,907

d.

$277,797

e.

$291,687

(Comp.) CF for given return

CJ

Answer:

. You are negotiating to make a 7-year loan of $25,000 to Breck Inc. To repay you, Breck will pay $2,500 at the end of Year 1, $5,000 at the end of Year 2, and $7,500 at the end of Year 3, plus a fixed but currently unspecified cash flow, X, at the end of each year from Year 4 through Year 7. Breck is essentially riskless, so you are confident the payments will be made. You regard 8% as an appropriate rate of return on a low risk but illiquid 7-year loan. What cash flow must the investment provide at the end of each of the final 4 years, that is, what is X?


a.

$4,271.67

b.

$4,496.49

c.

$4,733.15

d.

$4,969.81

e.

$5,218.30

(Comp.) Saving for college

CJ

Answer:

. John and Daphne are saving for their daughter Ellen's college education. Ellen just turned 10 at (t = 0), and she will be entering college 8 years from now (at t = 8). College tuition and expenses at State U. are currently $14,500 a year, but they are expected to increase at a rate of 3.5% a year. Ellen should graduate in 4 years--if she takes longer or wants to go to graduate school, she will be on her own. Tuition and other costs will be due at the beginning of each school year (at t = 8, 9, 10, and 11). So far, John and Daphne have accumulated $15,000 in their college savings account (at t = 0). Their long-run financial plan is to add an additional $5,000 in each of the next 4 years (at t = 1, 2, 3, and 4). Then they plan to make 3 equal annual contributions in each of the following years, t = 5, 6, and 7. They expect their investment account to earn 9%. How large must the annual payments at t = 5, 6, and 7 be to cover Ellen's anticipated college costs?

a.

$1,965.21

b.

$2,068.64

c.

$2,177.51

d.

$2,292.12

e.

$2,412.76

CHAPTER 5 BONDS, BOND VALUATION, AND INTEREST RATES

Please see the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines.


True/False

:

(5.2) Issuing bonds

FG

Answer:

. If a firm raises capital by selling new bonds, it is called the "issuing firm," and the coupon rate is generally set equal to the required rate on bonds of equal risk.

a.

True

b.

False

(5.2) Call provision

FG

Answer:

. A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, calls are exercised if interest rates rise, because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at higher rates.

a.

True

b.

False

(5.2) Sinking fund

FG

Answer:

. Sinking funds are devices used to force companies to retire bonds on a scheduled basis prior to their maturity. Many bond indentures allow the company to acquire bonds for a sinking fund by either purchasing bonds in the market or selecting the bonds to be acquired by a lottery administered by the trustee through a call at face value.

a.

True


b.

False

(5.2) Zero coupon bond

FG

Answer:

. A zero coupon bond is a bond that pays no interest and is offered (and subsequently sells initially) at par. These bonds provide compensation to investors in the form of capital appreciation.

a.

True

b.

False

(5.2) Floating-rate debt

FG

Answer:

. The desire for floating-rate bonds, and consequently their increased usage, arose out of the experience of the early 1980s, when inflation pushed interest rates up to very high levels and thus caused sharp declines in the prices of outstanding bonds.

a.

True

b.

False

(5.3) Discounted cash flows

FG

Answer:

. The market value of any real or financial asset, including stocks, bonds, or art work purchased in hope of selling it at a profit, may be estimated by determining future cash flows and then discounting them back to the present.

a.

True

b.

False

(5.3) Bond prices and interest rates

FG

Answer:

. For bonds, price sensitivity to a given change in interest rates is generally greater the longer before the bond matures.


a.

True

b.

False

(5.11) Mortgage bond

FG

Answer:

. As a general rule, a company's debentures have higher required interest rates than its mortgage bonds because mortgage bonds are backed by specific assets while debentures are unsecured.

a.

True

b.

False

(5.11) Debt coupon rate

FG

Answer:

. Other things equal, a firm will have to pay a higher coupon rate on its subordinated debentures than on its second mortgage bonds.

a.

True

b.

False

(5.11) Bond ratings and required returns

FG

Answer:

. There is an inverse relationship between bonds' quality ratings 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.

a.

True

b.

False


(5.13) Interest rate risk

FG

Answer:

. A bond that had a 20-year original maturity with 1 year left to maturity has more interest rate price risk than a 10-year original maturity bond with 1 year left to maturity. (Assume that the bonds have equal default risk and equal coupon rates, and they cannot be called.)

a.

True

b.

False

(5.13) Interest rate risk

FG

Answer:

. 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 interest rate price risk if you purchased a 30-day bond than if you bought a 30-year bond.

a.

True

b.

False

(5.15) Junk bond

FG

Answer:

. 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.

a.

True


b.

False

:

(5.2) Callable bonds

FG

Answer:

. A bond that is callable has a chance of being retired earlier than its stated term to maturity. Therefore, if the yield curve is upward sloping, an outstanding callable bond should have a lower yield to maturity than an otherwise identical noncallable bond.

a.

True

b.

False

(5.2) Income bond

FG

Answer:

. 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.

a.

True

b.

False

(5.2) Sinking fund

FG

Answer:

. You are considering 2 bonds that will be issued tomorrow. Both are rated triple B (BBB, the lowest investment-grade rating), both mature in 20 years, both have a 10% coupon, neither can be called except for sinking fund purposes, and both are offered to you at their $1,000 par values. However, Bond SF has a sinking fund while Bond NSF does not. Under the sinking fund, the company must call and pay off 5% of the bonds at par each year. The yield curve at the time is upward sloping. The bond's prices, being equal, are probably not in equilibrium, as Bond SF, which has the sinking fund, would generally be expected to have a higher yield than Bond NSF.


a.

True

b.

False

(5.2) Floating-rate debt

FG

Answer:

. Floating-rate debt is advantageous to investors because the interest rate moves up if market rates rise. Since floating-rate debt shifts interest rate risk to companies, it offers no advantages to issuers.

a.

True

b.

False

(5.3) Bond premiums and discounts

FG

Answer:

. 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 interest rates are below 10% and at a discount if interest rates are greater than 10%.

a.

True

b.

False

(5.3) Bond value--annual payment

FG

Answer:

. You have funds that you want to invest in bonds, and you just noticed in the financial pages of the local newspaper that you can buy a $1,000 par value bond for $800. The coupon rate is 10% (with annual payments), and there are 10 years before the bond will mature and pay off its $1,000 par value. You should buy the bond if your required return on bonds with this risk is 12%.

a.

True

b.

False


(5.4) Bond value

FG

Answer:

. If the required rate of return on a bond (rd) is greater than its coupon interest rate and will remain above that rate, then the market value of the bond will always be below its par value until the bond matures, at which time its market value will equal its par value. (Accrued interest between interest payment dates should not be considered when answering this question.)

a.

True

b.

False

(5.11) Restrictive covenants

FG

Answer:

. "Restrictive covenants" are designed primarily to protect bondholders by constraining the actions of managers. Such covenants are spelled out in bond indentures.

a.

True

b.

False


(5.13) Prices and interest rates F G

Answer:

. The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds, other things held constant.

a.

True

b.

False

Multiple Choice: Conceptual

Many of these questions can be answered either by thinking about relationships and reasoning out which answer is correct, or by working out some numbers to see which answer is correct. Sometimes data are provided in the question, but sometimes students must make up their own examples to take the numerical approach.

Most students will have to think carefully to answer the and questions, and that will take some time. Therefore, the more time they have to do the test or quiz, the better their scores will be.

Finally, note that we provide answers only to selected questions. We see no need to answer relatively , obvious questions, so we limited answers to questions that students might have trouble (after the exam) understanding why the correct answer is right. Obviously, that would vary from student to student, so there is no one right answer to the issue of how many questions need answers.

:

(5.4) Interest rates

CG

Answer:


.

Which of the following statements is CORRECT?

a. You hold two bonds. One is a 10-year, zero coupon, issue 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 larger percentage decline. b. The time to maturity does not affect the change in the value of a bond in response to a given change in interest rates. c. 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. 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. e. 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.

(5.4) Callable bond

CG

Answer:

. Which of the following events would make it more likely that a company would choose to call its outstanding callable bonds?

a.

The company’s bonds are downgraded.

b.

Market interest rates rise sharply.

c.

Market interest rates decline sharply.

d.

The company's financial situation deteriorates significantly.

e.

Inflation increases significantly.

(Comp: 5.3,5.6) Bond concepts

CG

Answer:


. A 10-year bond with a 9% annual coupon has a yield to maturity 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 higher than its current price. b.

The bond is selling below its par value.

c.

The bond is selling at a discount.

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

The bond’s current yield is greater than 9%.

(Comp: 5.6,5.11,5.16) Bonds, default risk .

CG

Answer:

Which of the following statements is CORRECT?

a.

All else equal, senior debt generally has a lower yield to maturity than subordinated

b.

An indenture is a bond that is less risky than a mortgage bond.

debt.

c. maturity.

The expected return on a corporate bond will generally exceed the bond's yield to

d. If a bond’s coupon rate exceeds its yield to maturity, then its expected return to investors exceeds the yield to maturity. e. Under our bankruptcy laws, any firm that is in financial distress will be forced to declare bankruptcy and then be liquidated.

/:


(5.2) Call provision

CG

Answer:

/

. Tucker Corporation is planning to issue new 20-year bonds. Initially, the plan was to make the bonds non-callable. If the bonds were made callable after 5 years at a 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.

(5.3) Bond coupon rate

CG

Answer:

/

. Under normal conditions, which of the following would be most likely to increase the coupon rate required to enable a bond to be issued at par?

a.

Adding additional restrictive covenants that limit management's actions.

b.

Adding a call provision.

c.

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

d.

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

e.

Adding a sinking fund.

(5.13) Interest rate risk

CG

Answer:

/

. Which of the following bonds would have the greatest percentage increase in value if all interest rates fall by 1%?


a.

10-year, zero coupon bond.

b.

20-year, 10% coupon bond.

c.

20-year, 5% coupon bond.

d.

1-year, 10% coupon bond.

e.

20-year, zero coupon bond.

(5.13) Interest rate risk

CG

Answer:

/

. Assume that all interest rates in the economy decline from 10% to 9%. Which of the following bonds would have the largest percentage increase in price?

a.

An 8-year bond with a 9% coupon.

b.

A 1-year bond with a 15% coupon.

c.

A 3-year bond with a 10% coupon.

d.

A 10-year zero coupon bond.

e.

A 10-year bond with a 10% coupon.

(5.13) Interest rate risk .

CG

Answer:

/

Which of the following bonds has the greatest interest rate price risk?

a.

A 10-year $100 annuity.

b.

A 10-year, $1,000 face value, zero coupon bond.

c.

A 10-year, $1,000 face value, 10% coupon bond with annual interest payments.

d.

All 10-year bonds have the same price risk since they have the same maturity.

e.

A 10-year, $1,000 face value, 10% coupon bond with semiannual interest payments.

(5.13) Interest rate risk

CG

Answer:

/


. If its yield to maturity declined by 1%, which of the following bonds would have the largest percentage increase in value?

:

a.

A 1-year zero coupon bond.

b.

A 1-year bond with an 8% coupon.

c.

A 10-year bond with an 8% coupon.

d.

A 10-year bond with a 12% coupon.

e.

A 10-year zero coupon bond.


(5.2) Sinking funds .

CG

Answer:

Which of the following statements is CORRECT?

a. Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond has been issued. b. Most sinking funds require the issuer to provide funds to a trustee, who saves 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. Sinking fund provisions never require companies to retire their debt; they only establish “targets� for the company to reduce its debt over time. e. If interest rates have increased since a company issued bonds with a sinking fund, the company is less likely to retire the bonds by buying them back in the open market, as opposed to calling them in at the sinking fund call price.

(5.2) Convertible, callable bondsC G

Answer:

. Amram Inc. can issue a 20-year bond with a 6% annual coupon. This bond is not convertible, is not callable, and has no sinking fund. Alternatively, Amram 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 Amram would have to pay on the convertible, callable bond?

a.

Exactly equal to 6%.

b.

It could be less than, equal to, or greater than 6%.

c.

Greater than 6%.

d.

Exactly equal to 8%.

e.

Less than 6%.


(5.3) Bond concepts

CG

Answer:

. Three $1,000 face value bonds that mature in 10 years have the same level of risk, hence their YTMs are equal. Bond A has an 8% annual coupon, Bond B has a 10% annual coupon, and Bond C has a 12% annual coupon. Bond B sells at par. Assuming interest rates remain constant for the next 10 years, which of the following statements is CORRECT?

a.

Bond A’s current yield will increase each year.

b. 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. c. Bond C sells at a premium (its price is greater than par), and its price is expected to increase over the next year.


d. Bond A sells at a discount (its price is less than par), and its price is expected to increase over the next year. e. Over the next year, Bond A’s price is expected to decrease, Bond B’s price is expected to stay the same, and Bond C’s price is expected to increase. (5.6) Bond yields

CG

Answer:

. 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 NOT CORRECT?

a.

The bond’s expected capital gains yield is positive.

b.

The bond’s yield to maturity is 9%.

c.

The bond’s current yield is 9%.

d.

If the bond’s yield to maturity remains constant, the bond will continue to sell at par.

e.

The bond’s current yield exceeds its capital gains yield.

(5.6) Bond yields .

CG

Answer:

Which of the following statements is CORRECT?

a.

A zero coupon bond's current yield is equal to its yield to maturity.

b.

If a bond’s yield to maturity exceeds its coupon rate, the bond will sell at par.

c.

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

d. over par. e.

If a bond’s yield to maturity exceeds its coupon rate, the bond will sell at a premium All else equal, if a bond’s yield to maturity increases, its current yield will fall.


(5.6) Bond yields

CG

Answer:

. 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 coupon rate exceeds its current yield.

b.

The bond’s current yield exceeds its yield to maturity.

c.

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

d.

The bond’s current yield is equal to its coupon rate.

e. If the yield to maturity stays constant until the bond matures, the bond’s price will remain at $850.

(5.6) Bond yields

CG

Answer:

. 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.

The bond’s current yield is less than 8%.

b.

If the yield to maturity remains at 8%, then the bond’s price will decline over the next

c.

The bond’s coupon rate is less than 8%.

d.

If the yield to maturity increases, then the bond’s price will increase.

year.

e. If the yield to maturity remains at 8%, then the bond’s price will remain constant over the next year.


(5.6) Bond yields .

CG

Answer:

Which of the following statements is CORRECT?

a. If a bond is selling at a discount, the yield to call is a better measure of return than the yield to maturity. b. 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. c. 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. d.

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

e. 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.

(5.4) Interest rates and bond prices

CG

Answer:


. 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.

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

The bond should currently be selling at its par value.

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

(5.4) Interest rates and bond prices

CG

Answer:

. A 10-year Treasury bond has an 8% coupon, and an 8-year Treasury bond has a 10% coupon. Both bonds have the same yield to maturity. If the yield to maturity 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.


(5.4) Bond yields and prices

CG

Answer:

. You are considering two bonds. Bond A has a 9% annual coupon while Bond B has a 6% annual coupon. Both bonds have a 7% yield to maturity, and the YTM is expected to remain constant. Which of the following statements is CORRECT?

a.

The price of Bond B will decrease over time, but the price of Bond A will increase over

b.

The prices of both bonds will remain unchanged.

c.

The price of Bond A will decrease over time, but the price of Bond B will increase over

d.

The prices of both bonds will increase by 7% per year.

e.

The prices of both bonds will increase over time, but the price of Bond A will increase by

time.

time.

more.

(5.7) Interest rates

CG

Answer:

. Assume that interest rates on 20-year Treasury and corporate bonds with different ratings, all of which are noncallable, are as follows:

T-bond = 7.72% A = 9.64% AAA = 8.72%

BBB = 10.18%

The differences in rates among these issues were most probably caused primarily by:

a.

Real risk-free rate differences.

b.

Tax effects.


c.

Default risk differences.

d.

Maturity risk differences.

e.

Inflation differences.

(5.13) Interest vs. reinvestment rate riskC G .

Answer:

Which of the following statements is CORRECT?

a.

All else equal, high-coupon bonds have less reinvestment rate risk than low-coupon

b.

All else equal, long-term bonds have less interest rate price risk than short-term bonds.

c.

All else equal, low-coupon bonds have less interest rate price risk than high-coupon

d.

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

e.

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

bonds.

bonds.

(5.13) Interest vs. reinvestment rate riskC G .

Answer:

Which of the following statements is CORRECT?

a. One advantage of a zero coupon Treasury bond is that no one who owns the bond has to pay any taxes on it until it matures or is sold.


b. Long-term bonds have less interest rate price risk but more reinvestment rate risk than short-term bonds. c. If interest rates increase, all bond prices will increase, but the increase will be greater for bonds that have less interest rate risk. d. Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has more interest rate price risk but less reinvestment rate risk. e. Long-term bonds have less interest rate price risk and also less reinvestment rate risk than short-term bonds.

(5.14) Term structure of interest rates C G .

Answer:

Which of the following statements is CORRECT?

a. If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope. b.

Liquidity premiums are generally higher on Treasury than corporate bonds.

c. The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds. d. e. term bonds.

Default risk premiums are generally lower on corporate than on Treasury bonds. Reinvestment rate risk is lower, other things held constant, on long-term than on short-

(Comp: 5.3-5.6) Bond concepts .

CG

Answer:

Which of the following statements is CORRECT?

a.

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

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 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. d. premium.

If a bond’s yield to maturity exceeds its annual coupon, then the bond will trade at a

e.

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

(Comp: 5.3,5.6) Bond concepts

CG

Answer:

. 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 has a current yield greater than 8%.

c.

The bond sells at a discount.

d.

The bond’s required rate of return is less than 7.5%.

e.

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

(Comp: 5.4,5.6) Bond concepts

CG

Answer:

. An investor is considering buying one of two 10-year, $1,000 face value bonds: Bond A has a 7% annual coupon, while Bond B has a 9% annual coupon. Both bonds have a yield to maturity of 8%, which is expected to remain constant for the next 10 years. Which of the following statements is CORRECT?


a. Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price. b.

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

c.

Bond A’s current yield is greater than 8%.

d. Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price. e. Both bonds have the same price today, and the price of each bond is expected to remain constant until the bonds mature.

(Comp: 5.3,5.6,5.13) Bond concepts .

CG

Answer:

Which of the following statements is NOT CORRECT?

a. maturity.

If a bond is selling at a discount to par, its current yield will be less than its yield to

b. All else equal, bonds with longer maturities have more interest rate (price) risk than bonds with shorter maturities. c. d. maturity.

If a bond is selling at its par value, its current yield equals its yield to maturity. If a bond is selling at a premium, its current yield will be greater than its yield to

e. All else equal, bonds with larger coupons have greater interest rate (price) risk than bonds with smaller coupons.


(Comp: 5.2,5.3,5.6,5.13) Bond concepts C G .

Answer:

Which of the following statements is CORRECT?

a. If a 10-year, $1,000 par, zero coupon bond were issued at a price that gave investors a 10% yield to maturity, and if interest rates then dropped to the point where rd = YTM = 5%, the bond would sell at a premium over its $1,000 par value. b. If a 10-year, $1,000 par, 10% coupon bond were issued at par, and if interest rates then dropped to the point where rd = YTM = 5%, we could be sure that the bond would sell at a premium above its $1,000 par value. c. Other things held constant, a corporation would rather issue noncallable bonds than callable bonds. d. Other things held constant, a callable bond would have a lower required rate of return than a noncallable bond. e. Reinvestment rate risk is worse from an investor’s standpoint than interest rate price risk if the investor has a short investment time horizon.

(Comp: 5.4,5.6) Bond concepts .

CG

Answer:

Which of the following statements is CORRECT?

a. If the Federal Reserve unexpectedly announces that it expects inflation to increase, then we would probably observe an immediate increase in bond prices. b.

The total yield on a bond is derived from dividends plus changes in the price of the

c.

Bonds are riskier than common stocks and therefore have higher required returns.

bond.

d. Bonds issued by larger companies always have lower yields to maturity (less risk) than bonds issued by smaller companies. e. The market value of a bond will always approach its par value as its maturity date approaches, provided the bond’s required return remains constant.


(Comp: 5.3-5.6) Bond concepts .

CG

Answer:

Which of the following statements is CORRECT?

a.

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

b.

If rates fall after its issue, a zero coupon bond could trade at a price above its par value.

c.

If rates fall rapidly, a zero coupon bond’s expected appreciation could become negative.

d. If a firm moves from a position of strength toward financial distress, its bonds’ yield to maturity would probably decline. e. coupon rate.

If a bond is selling at a premium, this implies that its yield to maturity exceeds its

(Comp: 5.4,5.13) Bond concepts C G

Answer:

. Bond X has an 8% annual coupon, Bond Y has a 10% annual coupon, and Bond Z has a 12% annual coupon. Each of the bonds has a maturity of 10 years and a yield to maturity of 10%. Which of the following statements is CORRECT?


a. If the bonds' market interest rate remain at 10%, Bond Z’s price will be lower one year from now than it is today. b.

Bond X has the greatest reinvestment rate risk.

c. If market interest rates decline, all of the bonds will have an increase in price, and Bond Z will have the largest percentage increase in price. d.

If market interest rates remain at 10%, Bond Z’s price will be 10% higher one year from

today. e. If market interest rates increase, Bond X’s price will increase, Bond Z’s price will decline, and Bond Y’s price will remain the same.

(Comp: 5.3-5.6,5.13) Bond concepts

CG

Answer:

. Bonds A, B, and C all have a maturity of 10 years and a yield to maturity 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 its par value. 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 interest rate 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

e.

Bond C sells at a premium over its par value.

decline.


(Comp: 5.2,5.4,5.6,5.13) Bond concepts C G .

Answer:

Which of the following statements is CORRECT?

a. 10-year, zero coupon bonds have higher reinvestment rate risk than 10-year, 10% coupon bonds. b. A 10-year, 10% coupon bond has less reinvestment rate risk than a 10-year, 5% coupon bond (assuming all else equal). c. The total return on a bond during a given year is the sum of the coupon interest payments received during the year and the change in the value of the bond from the beginning to the end of the year. d. The price of a 20-year, 10% bond is less sensitive to changes in interest rates than the price of a 5-year, 10% bond. e. A $1,000 bond with $100 annual interest payments that has 5 years to maturity and is not expected to default would sell at a discount if interest rates were below 9% and at a premium if interest rates were greater than 11%.

(Comp: 5.3,5.6) Bond yields .

CG

Which of the following statements is CORRECT?

Answer:


a. The yield to maturity for a coupon bond that sells at a premium consists entirely of a positive capital gains yield; it has a zero current interest yield. b. The market value of a bond will always approach its par value as its maturity date approaches. This holds true even if the firm has filed for bankruptcy. c. Rising inflation makes the actual yield to maturity on a bond greater than a quoted yield to maturity that is based on market prices. d. The yield to maturity on a coupon bond that sells at its par value consists entirely of a current interest yield; it has a zero expected capital gains yield. e. 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.

(Comp: 5.3,5.6) Bond yields .

CG

Answer:

Which of the following statements is CORRECT?

a. b. negative.

If a coupon bond is selling at a premium, then the bond's current yield is zero. If a coupon bond is selling at a discount, then the bond's expected capital gains yield is

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. 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. e.

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

(Comp: 5.7,5.9,5.13,5.14) Yield curve .

CG

Answer:

Which of the following statements is CORRECT?

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


b. If the maturity risk premium (MRP) is greater than zero, then the yield curve must 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) equals zero, the yield curve must be flat.

e.

The yield curve can never be downward sloping.

(Comp: 5.7,5.9,5.13,5.14) Yield curve

CG

Answer:

. Assume that the current corporate bond yield curve is upward sloping. Under this condition, then we could be sure that

a.

Inflation is expected to decline in the future.

b.

The economy is not in a recession.

c.

Long-term bonds are a better buy than short-term bonds.

d.

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

e.

Long-term interest rates are more volatile than short-term rates.

(Comp: 5.7,5.9,5.11,5.13,5.14) Yield curve .

CG

Answer:

Which of the following statements is CORRECT?

a. be inverted.

The higher the maturity risk premium, the higher the probability that the yield curve will


b. to increase.

The most likely explanation for an inverted yield curve is that investors expect inflation

c. to decrease.

The most likely explanation for an inverted yield curve is that investors expect inflation

d.

If the yield curve is inverted, short-term bonds have lower yields than long-term bonds.

e. Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve can never be inverted.

(Comp: 5.7,5.9,5.11,5.13,5.14) Corporate yield curve C G

Answer:

. Short Corp. just issued bonds that will mature in 10 years, and Long Corp. issued bonds that will mature in 20 years. Both bonds promise to pay a semiannual coupon, they are not callable or convertible, and they are equally liquid. Further, assume that the Treasury yield curve is based only on expectations about future inflation, i.e., that the maturity risk premium is zero for T-bonds. Under these conditions, which of the following statements is correct?

a. If the Treasury yield curve is upward sloping and Short has less default risk than Long, then Short’s bonds must under all conditions have the lower yield. b. If the Treasury yield curve is downward sloping, Long’s bonds must under all conditions have the lower yield. c. If the yield curve for Treasury securities is upward sloping, Long’s bonds must under all conditions have a higher yield than Short’s bonds. d. If the yield curve for Treasury securities is flat, Short’s bond must under all conditions have the same yield as Long’s bonds. e. If Long’s and Short’s bonds have the same default risk, their yields must under all conditions be equal.


(Comp: 5.3-5.6) Bond rates and prices

CG

Answer:

. 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, and an 8% yield to maturity. Which of the following statements is CORRECT?

a.

Bond A’s capital gains yield is greater than Bond B’s capital gains yield.

b.

Bond A trades at a discount, whereas Bond B trades at a premium.

c. 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. d. If the yield to maturity for both bonds immediately decreases to 6%, Bond A’s bond will have a larger percentage increase in value. e.

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


(Comp: 5.2,5.4,5.6) Callable bond .

CG

Answer:

Which of the following statements is CORRECT?

a. Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is below the coupon rate than if it is above the coupon rate. b. A callable 10-year, 10% bond should sell at a higher price than an otherwise similar noncallable bond. c. Corporate treasurers dislike issuing callable bonds because these bonds may require the company to raise additional funds earlier than would be true if noncallable bonds with the same maturity were used. d. Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is above the coupon rate than if it is below the coupon rate. e. The actual life of a callable bond will always be equal to or less than the actual life of a noncallable bond with the same maturity. Therefore, if the yield curve is upward sloping, the required rate of return will be lower on the callable bond.


(Comp: 5.2,5.11) Costs of types of debt C G

Answer:

. A company is planning to raise $1,000,000 to finance a new plant. Which of the following statements is CORRECT?

a. The company would be especially eager to have a call provision included in the indenture if its management thinks that interest rates are almost certain to rise in the foreseeable future.


b. If debt is used to raise the million dollars, but $500,000 is raised as first mortgage bonds on the new plant and $500,000 as debentures, the interest rate on the first mortgage bonds would be lower than it would be if the entire $1 million were raised by selling first mortgage bonds. c. If two tiers of debt are used (with one senior and one subordinated debt class), the subordinated debt will carry a lower interest rate. d. If debt is used to raise the million dollars, the cost of the debt would be lower if the debt were in the form of a fixed-rate bond rather than a floating-rate bond. e. If debt is used to raise the million dollars, the cost of the debt would be higher if the debt were in the form of a mortgage bond rather than an unsecured term loan.

(Comp: 5.2,5.11,5.15) Types of debt .

CG

Answer:

Which of the following statements is CORRECT?

a. Junior debt is debt that has been more recently issued, and in bankruptcy it is paid off after senior debt because the senior debt was issued first. b.

Subordinated debt has less default risk than senior debt.

c. Convertible bonds have lower coupon rates than non-convertible bonds of similar default risk because they offer the possibility of capital gains. d.

Junk bonds typically provide a lower yield to maturity than investment-grade bonds.

e.

A debenture is a secured bond that is backed by some or all of the firm’s fixed assets.


(Comp: 5.2,5.6,5.16) Miscellaneous concepts .

CG

Answer:

Which of the following statements is CORRECT?

a. One disadvantage of zero coupon bonds is that the issuing firm cannot realize any tax savings from the debt until the bonds mature. b. Other things held constant, a callable bond should have a lower yield to maturity than a noncallable bond. c. Once a firm declares bankruptcy, it must then be liquidated by the trustee, who uses the proceeds to pay bondholders, unpaid wages, taxes, and lawyer fees. d. Income bonds must pay interest only if the company earns the interest. Thus, these securities cannot bankrupt a company prior to their maturity, and this makes them safer to the issuing corporation than "regular" bonds. e. A firm with a sinking fund that gave it the choice of calling the required bonds at par or buying the bonds in the open market would generally choose the open market purchase if the coupon rate exceeded the going interest rate.

(Comp: 5.3-5.6,5.16) Miscellaneous concepts .

Which of the following statements is CORRECT?

CG

Answer:


a. The total return on a bond during a given year consists only of the coupon interest payments received. b. All else equal, a bond that has a coupon rate of 10% will sell at a discount if the required return for bonds of similar risk is 8%. c. The price of a discount bond will increase over time, assuming that the bond’s yield to maturity remains constant. d. For a given firm, its debentures are likely to have a lower yield to maturity than its mortgage bonds. e. When large firms are in financial distress, they are almost always liquidated, whereas smaller firms are generally reorganized.

(Comp: 5.6,5.11,5.16) Default and bankruptcy .

CG

Answer:

Which of the following statements is NOT CORRECT?

a.

All else equal, secured debt is less risky than unsecured debt.

b. The expected return on a corporate bond must be less than its promised return if the probability of default is greater than zero. c.

All else equal, senior debt has less default risk than subordinated debt.

d.

A company’s bond rating is affected by its financial ratios and provisions in its indenture.

e. Under Chapter 11 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 its debt according to the seniority of the debt as spelled out in the Act.

/:

(Comp: 5.3,5.6) Call provision .

CG

Answer:

Which of the following statements is CORRECT?

/


a.

A bond is likely to be called if its coupon rate is below its YTM.

b.

A bond is likely to be called if its market price is below its par value.

c. Even if a bond's YTC exceeds its YTM, an investor with an investment horizon longer than the bond's maturity would be worse off if the bond were called. d.

A bond is likely to be called if its market price is equal to its par value.

e.

A bond is likely to be called if it sells at a discount below par.

:

(5.6) Current yield and yield to maturity .

CG

Answer:

Which of the following statements is CORRECT?

a. Assume that two bonds have equal maturities and are of equal risk, but one bond sells at par while the other sells at a premium above par. The premium bond must have a lower current yield and a higher capital gains yield than the par bond. b. 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.

value.

c.

If a bond sells at par, then its current yield will be less than its yield to maturity.

d.

If a bond sells for less than par, then its yield to maturity is less than its coupon rate.

e.

A discount bond’s price declines each year until it matures, when its value equals its par


(5.4) Effect of interest rate on bond prices

CG

Answer:

. Assume that a 10-year Treasury bond has a 12% annual coupon, while a 15-year T-bond has an 8% annual coupon. Assume also that the yield curve is flat, and all Treasury securities have a 10% yield to maturity. Which of the following statements is CORRECT?

a. If interest rates decline, the prices of both bonds will increase, but the 15-year bond would have a larger percentage increase in price. b. If interest rates decline, the prices of both bonds will increase, but the 10-year bond would have a larger percentage increase in price. c. premium. d.

The 10-year bond would sell at a discount, while the 15-year bond would sell at a The 10-year bond would sell at a premium, while the 15-year bond would sell at par.

e. If the yield to maturity on both bonds remains at 10% over the next year, the price of the 10-year bond would increase, but the price of the 15-year bond would fall.


(5.11) Bond indenture

CG

Answer:

. Listed below are some provisions that are often contained in bond indentures. Which of these provisions, viewed alone, would tend to reduce the yield to maturity that investors would otherwise require on a newly issued bond?

1.

Fixed assets are used as security for a bond.

2.

A given bond is subordinated to other classes of debt.

3.

The bond can be converted into the firm's common stock.

4.

The bond has a sinking fund.

5.

The bond has a call provision.

6.

The indenture contains covenants that prevent the use of additional debt.

a.

1, 3, 4, 6

b.

1, 4, 6

c.

1, 2, 3, 4, 6

d.

1, 2, 3, 4, 5, 6

e.

1, 3, 4, 5, 6


(5.11) Types of debt and their relative costs

CG

Answer:

. Suppose a new company decides to raise a total of $200 million, with $100 million as common equity and $100 million as long-term debt. The debt can be mortgage bonds or debentures, but by an iron-clad provision in its charter, the company can never raise any additional debt beyond the original $100 million. Given these conditions, which of the following statements is CORRECT?

a. The higher the percentage of debt represented by mortgage bonds, the riskier both types of bonds will be and, consequently, the higher the firm’s total dollar interest charges will be. b. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds, we could be certain that the firm’s total interest expense would be lower than if the debt were raised by issuing $100 million of debentures. c. In this situation, we cannot tell for sure how, or whether, the firm’s total interest expense on the $100 million of debt would be affected by the mix of debentures versus first mortgage bonds. The interest rate on each of the two types of bonds would increase as the percentage of mortgage bonds used was increased, but the result might well be such that the firm’s total interest charges would not be affected materially by the mix between the two. d. The higher the percentage of debentures, the greater the risk borne by each debenture, and thus the higher the required rate of return on the debentures. e. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds, we could be certain that the firm’s total interest expense would be lower than if the debt were raised by issuing $100 million of first mortgage bonds.

(5.13) Interest rate and reinvestment rate risk .

Which of the following statements is CORRECT?

CG

Answer:


a. A zero coupon bond of any maturity will have more interest rate price risk than any coupon bond, even a perpetuity. b. If their maturities and other characteristics were the same, a 5% coupon bond would have more interest rate price risk than a 10% coupon bond. c. A 10-year coupon bond would have more reinvestment rate risk than a 5-year coupon bond, but all 10-year coupon bonds have the same amount of reinvestment rate risk. d. A 10-year coupon bond would have more interest rate price risk than a 5-year coupon bond, but all 10-year coupon bonds have the same amount of interest rate price risk. e. If their maturities and other characteristics were the same, a 5% coupon bond would have less interest rate price risk than a 10% coupon bond.

(Comp: 5.4,5.6) Bond yields and prices .

CG

Answer:

Which of the following statements is CORRECT?

a. If two bonds have the same maturity, the same yield to maturity, and the same level of risk, the bonds should sell for the same price regardless of the bond’s coupon rates. b. All else equal, an increase in interest rates will have a greater effect on the prices of short-term than long-term bonds. c. All else equal, an increase in interest rates will have a greater effect on higher-coupon bonds than it will have on lower-coupon bonds. d. If a bond’s yield to maturity exceeds its coupon rate, the bond’s price must be less than its maturity value. e. If a bond’s yield to maturity exceeds its coupon rate, the bond’s current yield must be less than its coupon rate.

(Comp: 5.2,5.4,5.13) Bond concepts .

CG

Answer:

Assuming all else is constant, which of the following statements is CORRECT?


a.

A 20-year zero coupon bond has more reinvestment rate risk than a 20-year coupon

bond. b. For any given maturity, a 1.0 percentage point decrease in the market interest rate would cause a smaller dollar capital gain than the capital loss stemming from a 1.0 percentage point increase in the interest rate. c.

From a corporate borrower’s point of view, interest paid on bonds is not tax-deductible.

d. Price sensitivity as measured by the percentage change in price due to a given change in the required rate of return decreases as a bond’s maturity increases. e. For a bond of any maturity, a 1.0 percentage point increase in the market interest rate (rd) causes a larger dollar capital loss than the capital gain stemming from a 1.0 percentage point decrease in the interest rate.

Multiple Choice: Problems

:

(5.3) Bond valuation

CG

Answer:

. The Morrissey Company's bonds mature in 7 years, have a par value of $1,000, and make an annual coupon payment of $70. The market interest rate for the bonds is 8.5%. What is the bond's price?

a.

$923.22

b.

$946.30

c.

$969.96

d.

$994.21

e.

$1,019.06


(5.3) Bond valuation

CG

Answer:

. D. J. Masson Inc. recently issued noncallable bonds that mature in 10 years. They have a par value of $1,000 and an annual coupon of 5.5%. If the current market interest rate is 7.0%, at what price should the bonds sell?

a.

$829.21

b.

$850.47

c.

$872.28

d.

$894.65

e.

$917.01

(5.6) Yield to maturity

CG

Answer:

. Ezzell Enterprises’ noncallable bonds currently sell for $1,165. They have a 15-year maturity, an annual coupon of $95, and a par value of $1,000. What is their yield to maturity?

a.

6.20%

b.

6.53%

c.

6.87%

d.

7.24%

e.

7.62%

(5.6) Yield to maturity

CG

Answer:

. Quigley Inc.'s bonds currently sell for $1,080 and have a par value of $1,000. They pay a $100 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,125. What is their yield to maturity (YTM)?

a.

8.56%


b.

9.01%

c.

9.46%

d.

9.93%

e.

10.43%

(5.6) Yield to maturity

CG

Answer:

. Consider some bonds with one annual coupon payment of 7.25%. The bonds have a par value of $1,000, a current price of $1,125, and they will mature in 13 years. What is the yield to maturity on these bonds?

a.

5.56%

b.

5.85%

c.

6.14%

d.

6.45%

e.

6.77%

(5.6) Yield to call

CG

Answer:

. Sadik Inc.'s bonds currently sell for $1,280 and have a par value of $1,000. They pay a $135 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,050. What is their yield to call (YTC)?

a.

6.39%

b.

6.72%

c.

7.08%

d.

7.45%


e.

7.82%

(5.6) Current yield

CG

Answer:

. Garvin Enterprises’ bonds currently sell for $1,150. They have a 6-year maturity, an annual coupon of $85, and a par value of $1,000. What is their current yield?

a.

7.39%

b.

7.76%

c.

8.15%

d.

8.56%

e.

8.98%

(5.5) Bond valuation: semiannual coupons

CG

Answer:

. Assume that you are considering the purchase of a 15-year bond with an annual coupon rate of 9.5%. The bond has face value of $1,000 and makes semiannual interest payments. If you require an 11.0% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond?

a.

$891.00

b.

$913.27

c.

$936.10

d.

$959.51

e.

$983.49


(5.11) Default risk premium (DRP)

CG

Answer:

. If 10-year T-bonds have a yield of 6.2%, 10-year corporate bonds yield 8.5%, the maturity risk premium on all 10-year bonds is 1.3%, and corporate bonds have a 0.4% liquidity premium versus a zero liquidity premium for T-bonds, what is the default risk premium on the corporate bond?

a.

1.90%

b.

2.09%

c.

2.30%

d.

2.53%

e.

2.78%

:

(5.3) Bond valuation: annual coupons

CG

Answer:

. Wachowicz Corporation issued 15-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 14 years to maturity?

a.

$1,077.01

b.

$1,104.62

c.

$1,132.95

d.

$1,162.00

e.

$1,191.79


(5.6) Yields to maturity and call

CG

Answer:

. McCue Inc.'s bonds currently sell for $1,250. They pay a $120 annual coupon, have a 15-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.)

a.

2.11%

b.

2.32%

c.

2.55%

d.

2.80%

e.

3.09%

(5.6) Yields to maturity and call

CG

Answer:

. Taussig Corp.'s bonds currently sell for $1,150. They have a 6.75% annual coupon rate and a 15year maturity, but they can be called in 6 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, the YTC or the YTM?

a.

3.92%

b.

4.12%

c.

4.34%

d.

4.57%

e.

4.81%

(5.5) Bond valuation: semiannual coupons

CG

Answer:

. Moerdyk Corporation's bonds have a 10-year maturity, a 6.25% semiannual coupon, and a par value of $1,000. The going interest rate (rd) is 4.75%, based on semiannual compounding. What is the bond’s price?

a.

1,063.09

b.

1,090.35

c.

1,118.31

d.

1,146.27

e.

1,174.93


(5.5) Market value of semiannual bonds C G

Answer:

. In order to accurately assess the capital structure of a firm, it is necessary to convert its balance sheet figures to a market value basis. KJM Corporation's balance sheet as of today is as follows:

Long-term debt (bonds, at par) $10,000,000 Preferred stock 2,000,000 Common stock ($10 par) Retained earnings Total debt and equity

10,000,000 4,000,000

$26,000,000


The bonds have a 4.0% coupon rate, payable semiannually, and a par value of $1,000. They mature exactly 10 years from today. The yield to maturity is 12%, so the bonds now sell below par. What is the current market value of the firm's debt?

a.

$5,276,731

b.

$5,412,032

c.

$5,547,332

d.

$7,706,000

e.

$7,898,650

(5.8) Real risk-free rate, r*

CG

Answer:

. 5-year Treasury bonds yield 5.5%. The inflation premium (IP) is 1.9%, and the maturity risk premium (MRP) on 5-year bonds is 0.4%. What is the real risk-free rate, r*?

a.

2.59%

b.

2.88%

c.

3.20%

d.

3.52%

e.

3.87%

(5.9) Inflation premium (IP)

CG

Answer:

. Crockett Corporation's 5-year bonds yield 6.85%, and 5-year T-bonds yield 4.75%. The real riskfree rate is r* = 2.80%, the default risk premium for Crockett's bonds is DRP = 0.85% versus zero for Tbonds, the liquidity premium on Crockett's bonds is LP = 1.25%, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1)  0.1%, where t = number of years to maturity. What is the inflation premium (IP) on 5-year bonds?


a.

1.40%

b.

1.55%

c.

1.71%

d.

1.88%

e.

2.06%

(5.11) Default risk premium (DRP)

CG

Answer:

. Keys Corporation's 5-year bonds yield 7.00%, and 5-year T-bonds yield 5.15%. The real risk-free rate is r* = 3.0%, the inflation premium for 5-year bonds is IP = 1.75%, the liquidity premium for Keys' bonds is LP = 0.75% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1)  0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Keys' bonds?

a.

0.99%

b.

1.10%

c.

1.21%

d.

1.33%

e.

1.46%


(5.12) Liquidity premium (LP)

CG

Answer:

. Niendorf Corporation's 5-year bonds yield 6.75%, and 5-year T-bonds yield 4.80%. The real riskfree rate is r* = 2.75%, the inflation premium for 5-year bonds is IP = 1.65%, the default risk premium for Niendorf's bonds is DRP = 1.20% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1)  0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Niendorf's bonds?

a.

0.49%

b.

0.55%

c.

0.61%

d.

0.68%

e.

0.75%


/:

(5.6) Determining the coupon rate

CG

Answer:

/

. O'Brien Ltd.'s outstanding bonds have a $1,000 par value, and they mature in 25 years. Their nominal yield to maturity is 9.25%, they pay interest semiannually, and they sell at a price of $850. What is the bond's nominal (annual) coupon interest rate?

a.

6.27%

b.

6.60%

c.

6.95%

d.

7.32%

e.

7.70%

(5.6) Yields to maturity and call C G

Answer:

/

. Keenan Industries has a bond outstanding with 15 years to maturity, an 8.75% coupon paid semiannually, 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 $1,050. What is the bond’s nominal yield to call?

a.

5.01%

b.

5.27%

c.

5.54%

d.

5.81%

e.

6.10%

(5.4) Bond value in future time periods C G

Answer:

/


. A 25-year, $1,000 par value bond has an 8.5% annual coupon. The bond currently sells for $875. If the yield to maturity remains at its current rate, what will the price be 5 years from now?

a.

$839.31

b.

$860.83

c.

$882.90

d.

$904.97

e.

$927.60

(5.5) Bond valuation: effective rates

CG

Answer:

/

. Zumwalt Corporation's Class S bonds have a 12-year maturity, $1,000 par value, and a 5.75% coupon paid semiannually (2.875% each 6 months), and those bonds sell at their par value. Zumwalt's Class A bonds have the same risk, maturity, and par value, but the A bonds pay a 5.75% annual coupon. Neither bond is callable. At what price should the annual payment bond sell?

a.

$943.98

b.

$968.18

c.

$993.01

d.

$1,017.83

e.

$1,043.28

:

(5.5) Bond valuation: original issue discount bonds

CG

Answer:

. Cosmic Communications Inc. is planning two new issues of 25-year bonds. Bond Par will be sold at its $1,000 par value, and it will have a 10% semiannual coupon. Bond OID will be an Original Issue Discount bond, and it will also have a 25-year maturity and a $1,000 par value, but its semiannual


coupon will be only 6.25%. If both bonds are to provide investors with the same effective yield, how many of the OID bonds must Cosmic issue to raise $3,000,000? Disregard flotation costs, and round your final answer up to a whole number of bonds.

a.

4,228

b.

4,337

c.

4,448

d.

4,562

e.

4,676

Fin 534 week 4 quiz 3 chapter 4 and 5  
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