Deck 5: The Cost of Money

Question 1

If the tax laws stated that R0.50 out of every R1.00 of interest paid by a corporation was allowed as a tax-deductible expense, it would probably encourage companies to use more debt financing than they presently do, other things held constant.

Answer 1

False

Question 2

Firms with the most profitable investment opportunities are willing and able to pay the most for capital, so they tend to attract it away from less efficient firms or from those whose products are not in demand.

Answer 2

True

Question 3

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?

A) AAA bond with 10 years to maturity.
B) BBB perpetual bond.
C) BBB bond with 10 years to maturity.
D) AAA bond with 5 years to maturity.
E) BBB bond with 5 years to maturity.

Answer 3

AAA bond with 5 years to maturity.

Question 4

An investor with a six-year investment horizon believes that interest rates are determined only by expectations about future interest rates, (i.e., this investor believes in the expectations theory).This investor should expect to earn the same rate of return over the 6-year time horizon if he or she buys a 6-year bond or a 3-year bond now and another 3-year bond three years from now (ignore transaction costs).

Question 5

The real rate of interest is composed of a risk-free rate of interest plus a premium that reflects the riskiness of the security.

Question 6

If you have information that a recession is ending, and the economy is about to enter a boom, and your firm needs to borrow money, it should probably issue long-term rather than short-term debt.

Question 7

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.

Question 8

The nominal rate of interest is defined as the sum of the nominal risk-free rate of return and the expected inflation rate.

Question 9

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mortgages, but, at the same time, were largely restricted, in terms of their capital sources, to deposits that could be withdrawn on demand.Under these conditions, these financial institutions should prefer a "normal" yield curve to an inverted curve.

Question 10

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.

Question 11

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.

Question 12

The fact that a percentage of the interest income received by a corporation is excluded from taxable income, has encouraged firms to use more debt financing relative to equity financing.

Question 13

The liquidity preference theory states that each borrower and lender has a preferred maturity and that the slope of the yield curve depends on supply and demand for funds in the long-term market relative to the short-term market.

Question 14

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

A) the "liquidity preference theory" would generally lead to an upward sloping yield curve.
B) the "market segmentation theory" would generally lead to an upward sloping yield curve.
C) the "expectations theory" would generally lead to an upward sloping yield curve.
D) the yield curve under "normal" conditions would be horizontal (i.e., flat).
E) a downward sloping yield curve would suggest that investors expect interest rates to increase in the future.

Question 15

The expectations theory postulates that the term structure of interest rates is based on expectations regarding future inflation rates.

Question 16

During or near peaks of business activity, yield curves that are flat or downward sloping (possibly with humps) often are prevalent.

Question 17

If the South African Reserve Bank tightens the money supply, other things held constant, short-term interest rates will be pushed upward, and this increase probably will be greater than the increase in rates in the long-term market.

Question 18

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

Question 19

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

Question 20

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.

Question 21

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?

A) R74,000
B) R88,400
C) R91,600
D) R100,000
E) R106,500

Question 22

Which of the following statements is correct?

A) The maturity premiums embedded in the interest rates on S.A.Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds.
B) Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds.
C) According to the market segmentation theory of the term structure of interest rates, we should normally expect the yield curve to slope downward.
D) The expectations theory of the term structure of interest rates states that borrowers generally prefer to borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and that as a result, the yield curve normally is upward sloping.
E) If the maturity risk premium was zero and the rate of inflation was expected to decrease in the future, then the yield curve for S.A.Treasury securities would, other things held constant, have an upward slope.

Question 23

If the expectations theory of the term structure of interest rates is correct, and if the other term structure theories are invalid, and we observe a downward sloping yield curve, which of the following is a true statement?

A) Investors expect short-term rates to be constant over time.
B) Investors expect short-term rates to increase in the future.
C) Investors expect short-term rates to decrease in the future.
D) It is impossible to say unless we know whether investors require a positive or negative maturity risk premium.
E) The maturity risk premium must be positive.

Question 24

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?

A) 7%
B) 8%
C) 9%
D) 17%
E) 18%

Question 25

If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury coupon bond, relative to that on a 1-year T-bond?

A) The yield on the 10-year bond is less than the yield on a 1-year bond.
B) The yield on a 10-year bond will always be higher than the yield on a 1-year bond because of maturity premiums.
C) It is impossible to tell without knowing the coupon rates of the bonds.
D) The yields on the two bonds are equal.
E) It is impossible to tell without knowing the relative risks of the two bonds.

Question 26

Amandla Corporation can (1) build a new plant which should generate a before-tax return of 11 percent, or (2) invest the same funds in the preferred shares of FPL, which should provide Amandla with a before-tax return of 9%, all in the form of dividends.Assume that Amandla's marginal tax rate is 25 percent, and that 70 percent of dividends received are excluded from taxable income.If the plant project is divisible into small increments, and if the two investments are equally risky, what combination of these two possibilities will maximise Amandla's effective return on the money invested?

A) All in the plant project.
B) All in FPL preferred shares.
C) 60% in the project; 40% in FPL.
D) 60% in FPL; 40% in the project.
E) 50% in each.

Question 27

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?

A) 6.5%
B) 7.5%
C) 8.0%
D) 6.0%
E) 7.0%

Question 28

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 shares with a 16 percent before-tax dividend yield?

A) 6.36%
B) 7.36%
C) 12.19%
D) 13.01%
E) 14.37%

Question 29

The normal yield curve is upward sloping implying that

A) the return on short-term securities are higher than the return on long-term securities of similar risk.
B) the return on long-term securities are equal to the return on short-term securities of similar risk.
C) the return on short-term securities are lower than the return on long-term securities of similar risk.
D) the return on bonds with a higher default risk is higher than the returns on bonds with lower default risk.
E) the return on bonds with a lower default risk is higher than the returns on bonds with higher default risk.

Question 30

Assume that the current yield curve is upward sloping, or normal.This implies that

A) Short-term interest rates are more volatile than long-term rates.
B) Inflation is expected to subside in the future.
C) The economy is at the peak of a business cycle.
D) Long-term bonds are a better buy than short-term bonds.
E) None of the above statements is necessarily implied by the yield curve given.

Question 31

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?

A) 0.25%
B) 0.50%
C) 0.63%
D) 1.00%
E) 1.13%

Question 32

Which of the following statements is correct?

A) For the most part, our national tax rates are progressive, because higher incomes are taxed at higher average rates.
B) Bonds issued by a municipality such as the city of Tshwane would carry a lower interest rate than bonds with the same risk and maturity issued by a private corporation such as Tshwane Retailers.
C) Our national tax laws tend to encourage corporations to finance with debt rather than with equity securities.
D) Our national tax laws encourage the managers of corporations with surplus cash to invest it in shares rather than in bonds.However, other factors may offset tax considerations.
E) All of the above statements are true.

Question 33

You read in The Financial Mail that 30-day T-bills currently are yielding 8 percent.Your brother-in-law, a broker at Khumalo Securities, has given you the following estimates of current interest rate premiums: Based on these data, the real risk-free rate of return is

A) 0%
B) 1%
C) 2%
D) 3%
E) 4%

Question 34

Treasury securities that mature in 6 years currently have an interest rate of 8.5%.Inflation is expected to be 5% each of the next three years and 6% each year after the third year.The maturity risk premium is estimated to be 0.1%(t - 1), where it is equal to the maturity of the bond (i.e., the maturity risk premium of a one-year bond is zero).The real risk-free rate is assumed to be constant over time.What is the real risk-free rate of interest?

A) 0.25%
B) 0.50%
C) 1.00%
D) 1.75%
E) 2.50%

Question 35

Which of the following is not one of the four fundamental factors that affect the cost of money?

A) production opportunities
B) time preferences for consumption
C) risk
D) liquidity
E) inflation

Question 36

Interest rates on 1-year, 2-year, and 3-year Treasury bills are 5%, 6%, and 7% respectively.Assume that the pure expectations theory holds and that the market is in equilibrium.Which of the following statements is most correct?

A) The maturity risk premium is positive.
B) Interest rates are expected to rise over the next two years.
C) The market expects one-year rates to be 5.5% one year from today.
D) Answers a, b, and c are all correct.
E) Only answers b and c are correct.

Question 37

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 __________.

A) 4%; 14%
B) 4%; 15%
C) 11%; 14%
D) 11%; 15%
E) 11%; 17%

Question 38

Assume that the expectations theory holds, and that liquidity and maturity risk premiums are zero.If the annual rate of interest on a 2-year Treasury bond is 10.5 percent and the rate on a 1-year Treasury bond is 12 percent, what rate of interest should you expect on a 1-year Treasury bond one year from now?

A) 9.0%
B) 9.5%
C) 10.0%
D) 10.5%
E) 11.0%

Question 39

Carter Corporation has some money to invest, and its treasurer is choosing between City of Tshwane municipal bonds and S.A.Treasury bonds.Both have the same maturity, and they are equally risky and liquid.If Treasury bonds yield 6 percent, and Carter's marginal income tax rate is 40 percent, what yield on the Tshwane municipal bonds would make Carter's treasurer indifferent between the two?

A) 2.40%
B) 3.60%
C) 4.50%
D) 5.25%
E) 6.00%

Question 40

If the South African Reserve Bank sells R50 billion worth of short-term S.A.Treasury securities to the public, other things held constant, what will this tend to do to short-term security prices and interest rates?

A) Prices and interest rates will both rise.
B) Prices will rise and interest rates will decline.
C) Prices and interest rates will both decline.
D) Prices will decline and interest rates will rise.
E) There will be no changes in either prices or interest rates.

Question 41

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.)

A) 12.0%
B) 16.0%
C) 13.5%
D) 10.5%
E) 14.0%

Question 42

In 2000, Craig and Kathy Khumalo 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 Khumalos expected the company to earn R100,000 before taxes next year.They planned to take out a salary of R45,000, and to reinvest the rest in the business.Their personal deductions total R10,750 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?

A) R19,393.50; R22,250.00; No
B) R19,393.50; R13,887.50; Yes
C) R6,793.50; R6,637.50; Yes
D) R22,403.50; R15,753.50; Yes
E) R20,777.50; R22,250.00; No

Question 43

A 9 percent coupon bond issued by the State of Pennsylvania sells for R1,000 and thus provides a 9 percent yield to maturity.What yield on a Synthetic Chemical Company bond would cause the two bonds to provide the same after-tax rate of return to an investor in the 28 percent tax bracket?

A) 12.50%
B) 17.50%
C) 7.00%
D) 14.00%
E) 9.00%

Question 44

Suncell Corporation has R20,000 which it plans to invest in marketable securities.It is choosing between AT&T bonds which yield 11%, City of Tshwane municipal bonds which yield 8%, and AT&T preference shares with a dividend yield of 9%.Suncell's corporate tax rate is 40%, and 70% of the preference share dividends it receives are tax exempt.Assuming that the investments are equally risky and that Suncell 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.

A) 8.46%
B) 8.00%
C) 7.92%
D) 9.00%
E) 9.16%

Question 45

Assume that the real risk-free rate, r*, is 4 percent, and that inflation is expected to be 9% in Year 1, 6% in Year 2, and 4% thereafter.Assume also that all Treasury bonds are highly liquid and free of default risk.If 2-year and 5-year Treasury bonds both yield 12%, what is the difference in the maturity risk premiums (MRPs) on the two bonds, i.e., what is MRP5 - MRP2?

A) 2.1%
B) 1.8%
C) 5.0%
D) 3.0%
E) 2.5%