Exam 5: The Cost of Money

Suppose financial institutions,such as savings and loans,were required by law to make long-term,fixed interest rate mortgages,but,at the same time,were largely restricted,in terms of their capital sources,to deposits that could be withdrawn on demand.Under these conditions,these financial institutions should prefer a "normal" yield curve to an inverted curve.

Solarcell Corporation has $20,000 which it plans to invest in marketable securities.It is choosing between AT&T bonds which yield 11%,State of Florida municipal bonds which yield 8%,and AT&T preferred stock with a dividend yield of 9%.Solarcell's corporate tax rate is 40%,and 70% of the preferred stock dividends it receives are tax exempt.Assuming that the investments are equally risky and that Solarcell chooses strictly on the basis of after-tax returns,which security should be selected? Answer by giving the after-tax rate of return on the highest yielding security.

Which of the following statements is most correct? Other things held constant.

Which of the following statements is correct?

The term structure is defined as the relationship between interest rates and maturities of similar securities.

The normal yield curve is upward sloping implying that

Your uncle would like to restrict his interest rate risk and his default risk,but he still would like to invest in corporate bonds.Which of the possible bonds listed below best satisfies your uncle's criteria?

You are given the following data: Assume that a highly liquid market does not exist for long-term T-bonds,and the expected rate of inflation is a constant.Given these conditions,the nominal risk-free rate for T-bills is __________,and the rate on long-term Treasury bonds is __________.

Your corporation has the following cash flows: If the applicable income tax rate is 40 percent,and if 70 percent of dividends received are exempt from taxes,what is the corporation's tax liability?

Assume that a 3-year Treasury note has no maturity premium,and that the real,risk-free rate of interest is 3 percent.If the T-note carries a yield to maturity of 13 percent,and if the expected average inflation rate over the next 2 years is 11 percent,what is the implied expected inflation rate during Year 3?

In 2000,Craig and Kathy Koehler owned a small business which was held as a proprietorship in Kathy's name.They were thinking of incorporating if that would lower their total tax liability.The Koehlers expected the company to earn $100,000 before taxes next year.They planned to take out a salary of $45,000,and to reinvest the rest in the business.Their personal deductions total $10,750 and if they choose not to incorporate they will file a joint return.(1)What is their expected total tax liability as a proprietorship? (2)As a corporation? (3)Should they incorporate?

Investors with a higher time preference for consumption will demand a lower rate of return to forego current consumption and save than investors with a lower time preference for consumption.

As a corporate investor paying a marginal tax rate of 34 percent,if 70 percent of dividends are excludable,what would be your after-tax dividend yield on preferred stock with a 16 percent before-tax dividend yield?

The two reasons most experts give for the existence of a positive maturity risk premium are (1)because investors are assumed to be risk averse,and (2)because investors prefer to lend long while firms prefer to borrow short.

Assume that r* = 1.0%; the maturity risk premium is found as MRP = 0.2%(t - 1)where t = years to maturity; the default risk premium for AT&T bonds is found as DRP = 0.07%(t - 1); the liquidity premium is 0.50% for AT&T bonds but zero for Treasury bonds; and inflation is expected to be 7%,6%,and 5% during the next three years and then 4% thereafter.What is the difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds?

Bonds with higher liquidity will demand higher interest rates in the market since they can be easily converted into cash on short notice at or near the fair market value for that bond.

Assume that the current interest rate on a 1-year bond is 8 percent,the current rate on a 2-year bond is 10 percent,and the current rate on a 3-year bond is 12 percent.If the expectations theory of the term structure is correct,what is the 1-year interest rate expected during Year 3? (Base your answer on an arithmetic rather than geometric average.)

Assume that expected rates of inflation over the next 5 years are 4 percent,7 percent,10 percent,8 percent,and 6 percent,respectively.What is the average expected inflation rate over this 5-year period?

The yield curve is downward sloping,or inverted,if the long-term rates are higher than the short-term rates.

The existence of an upward sloping yield curve proves that the liquidity preference theory is correct,because an upward sloping curve necessarily implies that firms must offer a maturity risk premium in order to induce investors to lend for longer periods.