BUS 335 Mid Term Exam
Multiple Choice Questions (25*2=50 and the last one is bonus question)
1. Money markets are markets for
a. Common stocks.
b. Long-term bonds.
c. Short-term debt securities such as Treasury bills and commercial paper.
2. Which of the following statements is CORRECT?
a. Hedge funds have more in common with investment banks than with any other type of financial institution.
b. Hedge funds have more in common with commercial banks than with any other type of financial institution.
c. Hedge funds are not as highly regulated as most other types of financial institutions. The justification for this light regulation is that only “sophisticated investors” (i.e., those with high net worths and high incomes) are permitted to invest in these funds, and these investors supposedly can do any necessary “due diligence” on their own rather than have it done by the SEC or some other regulator.
3. Which of the following statements is CORRECT?
a. While the distinctions are becoming blurred, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise capital from other parties.
b. The NYSE operates as an auction market, whereas Nasdaq is an example of a dealer market.
c. Money markets are markets for long-term debt and common stocks.
4. Which of the following statements is NOT CORRECT?
a. When a corporation’s shares are owned by a few individuals, we say that the firm is “closely, or privately, held.”
b. The stock of publicly owned companies do not need to register with a regulatory agency such as the SEC.
c. When stock in a closely held corporation is offered to the public for the first time, the transaction is called “going public, or an IPO,” and the market for such stock is called the new issue or IPO market.
5. A share of common stock is not a derivative, but an option to buy the stock is a derivative because the value of the option is derived from the value of the stock.
6. Hedge funds are somewhat similar to mutual funds. The primary differences are that hedge funds are less highly regulated, have more flexibility regarding what they can buy, and restrict their investors to wealthy, sophisticated individuals and institutions.
7. Austin Financial recently announced that its net income increased sharply from the previous year, yet its net cash provided from operations declined. Which of the following could explain this performance?
a. The company’s dividend payment to common stockholders declined.
b. The company’s cost of goods sold increased.
c. The company’s depreciation expense declined.
8. Which of the following statements is CORRECT?
a. The primary reason the annual report is important in finance is that it is used by investors when they form expectations about the firm’s future earnings and dividends, and the riskiness of those cash flows.
b. The annual report is an internal document prepared by a firm’s managers solely for the use of its creditors/lenders.
c. Prior to the Enron scandal in the early 2000s, companies would put verbal information in their annual reports, along with the financial statements. That verbal information was often misleading, so today annual reports can contain only quantitative information–audited financial statements.
9. Analysts who follow Howe Industries recently noted that, relative to the previous year, the company’s net cash provided from operations increased, yet cash as reported on the balance sheet decreased. Which of the following factors could explain this situation?
a. The company cut its dividend.
b. The company made large investments in fixed assets.
c. The company issued new common stock.
10. Austin Financial recently announced that its net income increased sharply from the previous year, yet its net cash provided from operations declined. Which of the following could explain this performance?
a. The company’s dividend payment to common stockholders declined.
b. The company’s cost of goods sold increased.
c. The company’s depreciation expense declined.
11. Assume that inflation is expected to decline steadily in the future, but that the real risk-free rate, r*, will remain constant. Which of the following statements is CORRECT, other things held constant?
a. If the pure expectations theory holds, the Treasury yield curve must be downward sloping.
b. If the pure expectations theory holds, the corporate yield curve must be downward sloping.
c. If there is a positive maturity risk premium, the Treasury yield curve must be upward sloping.
12. Assume that interest rates on 20-year Treasury and corporate bonds are as follows:
T-bond = 7.72% AAA = 8.72% A = 9.64% BBB = 10.18%
The differences in these rates were probably caused primarily by:
a. Default and liquidity risk differences.
b. Maturity risk differences.
c. Inflation differences.
13. In the foreseeable future, the real risk-free rate of interest, r*, is expected to remain at 3%, inflation is expected to steadily increase, and the maturity risk premium is expected to be 0.1(t − 1)%, where t is the number of years until the bond matures. Given this information, which of the following statements is CORRECT?
a. The yield on 2-year Treasury securities must exceed the yield on 5 year Treasury securities.
b. The yield on 5-year corporate bonds must exceed the yield on 8-year Treasury bonds.
c. The yield curve must be upward sloping.
14. If the Treasury yield curve is downward sloping, how should the yield to maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-bill?
a. The yield on a 10-year bond would be less than that on a 1-year bill.
b. The yield on a 10-year bond would have to be higher than that on a 1 year bill because of the maturity risk premium.
c. It is impossible to tell without knowing the coupon rates of the bonds.
15. A bond trader observes the following information:
• The Treasury yield curve is downward sloping.
• Empirical data indicate that a positive maturity risk premium applies to both Treasury and corporate bonds.
• Empirical data also indicate that there is no liquidity premium for Treasury securities but that a positive liquidity premium is built into corporate bond yields.
On the basis of this information, which of the following statements is most CORRECT?
a. A 10-year corporate bond must have a higher yield than a 5-year Treasury bond.
b. A 10-year Treasury bond must have a higher yield than a 10-year corporate bond.
c. A 5-year corporate bond must have a higher yield than a 10-year Treasury bond.
16. Which of the following statements is CORRECT?
a. The yield on a 3-year Treasury bond cannot exceed the yield on a 10 year Treasury bond.
b. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.
c. The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond.
17. Assume that the rate on a 1-year bond is now 6%, but all investors expect 1-year rates to be 7% one year from now and then to rise to 8% two years from now. Assume also that the pure expectations theory holds, hence the maturity risk premium equals zero. Which of the following statements is CORRECT?
a. The interest rate today on a 2-year bond should be approximately 7%.
b. The interest rate today on a 3-year bond should be approximately 7%.
c. The interest rate today on a 3-year bond should be approximately 8%.
18. Assuming the pure expectations theory is correct, which of the following statements is CORRECT?
a. If 2-year Treasury bond rates exceed 1-year rates, then the market must expect interest rates to rise.
b. If both 2-year and 3-year Treasury rates are 7%, then 5-year rates must also be 7%.
c. If 1-year rates are 6% and 2-year rates are 7%, then the market expects 1-year rates to be 6.5% in one year.
19. Which of the following events would make it more likely that a company would call its outstanding callable bonds?
a. The company’s bonds are downgraded.
b. Market interest rates rise sharply.
c. Market interest rates decline sharply.
20. A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000). Which of the following statements is CORRECT?
a. The bond’s expected capital gains yield is zero.
b. The bond’s yield to maturity is above 9%.
c. The bond’s current yield is above 9%.
21. 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.
22. Three $1,000 face value, 10-year, noncallable, bonds have the same amount of risk, hence their YTMs are equal. Bond 8 has an 8% annual coupon, Bond 10 has a 10% annual coupon, and Bond 12 has a 12% annual coupon. Bond 10 sells at par. Assuming that interest rates remain constant for the next 10 years, which of the following statements is CORRECT?
a. 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.
b. Bond 12 sells at a premium (its price is greater than par), and its price is expected to increase over the next year.
c. Bond 8 sells at a discount (its price is less than par), and its price is expected to increase over the next year.
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 year.
c. If the yield to maturity increases, then the bond’s price will increase.
24. Which of the following bonds would have the greatest percentage increase in value if all interest rates in the economy fall by 1%?
a. 20-year, 10% coupon bond.
b. 1-year, 10% coupon bond.
c. 20-year, zero coupon bond.
25. 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 a bond’s yield to maturity exceeds its annual coupon, then the bond will trade at a premium.
26. Which of the following statements is CORRECT? (bonus question)
a. Bonds are generally regarded as being riskier than common stocks, and therefore bonds have higher required returns.
b. Bonds issued by larger companies always have lower yields to maturity (due to less risk) than bonds issued by smaller companies.
c. The market price of a bond will always approach its par value as its maturity date approaches, provided the bond’s required return remains constant.
Mid Term Exam Part II – Calculation
Multiple Choice (17*2.5=42.5) plus three bonus questions
1. Morin Company’s bonds mature in 8 years, have a par value of $1,000, and make an annual coupon interest payment of $65. The market requires an interest rate of 8.2% on these bonds. What is the bond’s price?
2. Adams Enterprises’ noncallable bonds currently sell for $1,120. They have a 15-year maturity, an annual coupon of $85, and a par value of $1,000. What is their yield to maturity?
3. Sadik Inc.’s bonds currently sell for $1,180 and have a par value of $1,000. They pay a $105 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,100. What is their yield to call (YTC)?
4. Malko Enterprises’ bonds currently sell for $1,050. They have a 6-year maturity, an annual coupon of $75, and a par value of $1,000. What is their current yield?
5. McCue Inc.’s bonds currently sell for $1,250. They pay a $90 annual coupon, have a 25-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; it is possible to get a negative answer.)
6. Assume that you are considering the purchase of a 20-year, noncallable bond with an annual coupon rate of 9.5%. The bond has a face value of $1,000, and it makes semiannual interest payments. If you require an 8.4% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond?
7. Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 2.25%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.
8. Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds yield 6.75%. Also, corporate bonds have a 0.25% liquidity premium versus a zero liquidity premium for T-bonds, and the maturity risk premium on both Treasury and corporate 10-year bonds is 1.15%. What is the default risk premium on corporate bonds?
9. 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?
10. Kelly Inc’s 5-year bonds yield 7.50% and 5-year T-bonds yield 4.90%. The real risk-free rate is r* = 2.5%, the default risk premium for Kelly’s bonds is DRP = 0.40%, the liquidity premium on Kelly’s bonds is LP = 2.2% versus zero on T-bonds, and the inflation premium (IP) is 1.5%. What is the maturity risk premium (MRP) on all 5-year bonds? (hint: just look at 5 year t-bond).
11. Suppose the interest rate on a 1-year T-bond is 5.0% and that on a 2 year T-bond is 7.0%. Assuming the pure expectations theory is correct, what is the market’s forecast for 1-year rates 1 year from now?
12. Suppose the real risk-free rate is 3.25%, the average future inflation rate is 4.35%, and a maturity risk premium of 0.07% per year to maturity applies to both corporate and T-bonds, i.e., MRP = 0.07%(t), where t is the years to maturity. Suppose also that a liquidity premium of 0.50% and a default risk premium of 0.90% apply to A-rated corporate bonds but not to T-bonds. How much higher would the rate of return be on a 10-year A-rated corporate bond than on a 5-year Treasury bond? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. (bonus question)
13. 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?
14. 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?
= rate(5, 0, -747.25, 1000)=6%
15. 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?
16. 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
17. 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? (bonus question)
18. Vasudevan Inc. recently reported operating income of $2.75 million, depreciation of $1.20 million, and had a tax rate of 40%. The firm’s expenditures on fixed assets and net operating working capital totaled $0.6 million. How much was its free cash flow, in millions?
19. Hartzell Inc. had the following data for 2011, in millions: Net income = $600; after-tax operating income [EBIT(1 - T)] = $700; and Total assets = $2,000. Information for 2012 is as follows: Net income = $825; after-tax operating income [EBIT(1 - T)] = $925; and Total assets = $2,500. How much free cash flow did the firm generate during 2012?
20. Last year, Stewart-Stern Inc. reported $11,250 of sales, $4,500 of operating costs other than depreciation, and $1,250 of depreciation. The company had $3,500 of bonds outstanding that carry a 6.5% interest rate, and its federal-plus-state income tax rate was 35%. During last year, the firm had expenditures on fixed assets and net operating working capital that totaled $2,000. These expenditures were necessary for it to sustain operations and generate future sales and cash flows. This year’s data are expected to remain unchanged except for one item, depreciation, which is expected to increase by $725. By how much will the depreciation change cause (1) the firm’s net income and (2) its free cash flow to change? Note that the company uses the same depreciation for tax and stockholder reporting purposes (bonus question)
a. -$383.84; $206.68
b. -$404.04; $217.56
c. -$425.30; $229.01
d. -$447.69; $241.06
e. -$471.25; $253.75
Here’s the SOLUTION