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Fin 221 Fall 2012 Exam 1

Multiple Choice
Identify the choice that best completes the statement or answers the question.
1. 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) Maturity risk differences.
B) Tax effects.
C) Default and liquidity risk differences.
D) Real risk-free rate differences.
E) Inflation differences.

2. A Whole Lotta Dough Pizza (AWLD) trades on the NASDAQ stock market. Below is the current stock price
information. What price would you sell this stock at now if you already own stock in A Whole Lotta Dough
Stock Ticker


3. Astro Investors is interested in purchasing the bonds of the Jetson Company. Jetsons bonds are currently priced at
$1,100.00 and have 14.5 years to maturity. If the bonds have a 6% coupon rate what is the yield-to-maturity of
these SEMIANNUAL coupon paying bonds?
A) 2.51%
B) 2.50%
C) 5.02%
D) 5.00%

4. Chief Wiggums plans to make 11 semi-annual deposits of $2000 beginning today and ending 5 years from now
into an account that will pay a 5% nominal annual rate compounded semi-annually. How much will Chief
Wiggums have in this account 5 years from today after he makes his last deposit?


5. You found your dream house. It will cost you $175,000 and you will put down $35,000 as a down payment. For
the rest you get a 30-year 6.25% mortgage. What will be your monthly mortgage payment (assume no early
A) $729
B) $605
C) $389
D) $862

6. Which of the following statements are TRUE?

Statement I:
Statement II:
Statement III:


As you increase the interest rate, the future value of an investment

As you increase the length of the investment (to receive some lump sum),
the present value of the investment increases.
The present value of an ordinary annuity is larger than the present value of
an annuity due. (all else equal)

Statements I and II
Statement II only
Statements I and III only
Statement I only

7. After graduating from college with a finance degree, you begin an ambitious plan to retire in 25 years. To build up
your retirement fund, you will make quarterly payments into a mutual fund that on average will pay 12% APR
compounded quarterly. To get you started, a relative gives you a graduation gift of $5,000. Once retired, you plan
on moving your investment to a money market fund that will pay 6% APR with monthly compounding. As a
young retiree, you believe you will live for 30 more years and will make monthly withdrawals of $10,000. To meet
your retirement needs, what quarterly payment should you make?
A) $2,746.50
B) $2,904.73
C) $2,221.45
D) $2,588.27

8. A two-year bond offers a yield of 6% and a three year bond offers a yield of 7.5%. Under the expectations theory
what should be the yield on a one year bond in two years?
A) 3.06%
B) 12.49%
C) 5.95%
D) 10.56%

9. The Springfield Crusaders just signed their quarterback to a 10 year $50 million contract. Is this contract really
worth $50 million? (assume r >0)
A) No, it would only be worth $50 million if it were all paid out today.
B) Yes, because the payments over time add up to $50 million.
C) Yes, because his agent told him so.
D) No, it is worth more because he can invest the money.

10. 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) 9%
B) 7%
C) 18%
D) 8%
E) 17%

11. As a young graduate, you have plans on buying your dream car in three years. You believe the car will cost
$50,000. You have two sources of money to reach your goal of $50,000. First, you will save money for the next
three years in a money market fund that will return 8% annually. You plan on making $5,000 annual payments to
this fund. You will make yearly investments at the BEGINNING of the year. The second source of money will be a
car loan that you will take out on the day you buy the car. You anticipate the car dealer to offer you a 6% APR loan
with monthly compounding for a term of 60 months. To buy your dream car, what monthly car payment will you
A) $540.15
B) $627.73
C) $483.99
D) $652.83

12. Which of the following transactions takes place in secondary markets?

A) Stock sold in a seasoned equity offering.
B) New stock sold in an initial public offering.
C) Treasury securities auctioned off by the government.
D) Stock sold by an insurance company to adjust its portfolio of assets'.
E) None of the above.

13. You want to buy a new car. The car you picked will cost you $32,000 and you decide to go with the dealers
financing offer of 5.9% compounded monthly for 60 months. Unfortunately, you can only afford monthly loan
payments of $300. However, the dealer allows you to pay off the rest of the loan in a one time lump sum payment
at the end of the loan. How much do you have to pay to the dealer when the lump sum is due?
A) $25,455.37
B) $14,000.00
C) $21,890.43
D) $22,071.75

14. The primary operating goal of a publicly-owned firm interested in serving its stockholders should be to
A) Maximize the stock price on a specific target date.
B) Maximize the stock price per share over the long run, which is the stock's intrinsic value.
C) Maximize its expected total corporate income.
D) Minimize the chances of losses.
E) Maximize its expected EPS.

15. MAD Inc.'s bond rating is downgraded by Standard and Poor's from AAA to BBB. Which of the following would
occur in light of this news?
A) MAD Inc.'s bond price would fall.
B) MAD Inc.'s bond price would increase.
C) MAD Inc.'s bond price would remain the same.
D) MAD Inc.s default risk premium would increase.
E) Both A and D would occur.

16. 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) 8.41%
B) 7.59%
C) 7.99%
D) 6.85%
E) 7.21%

17. What is the future value of cash flows 1-5 AT THE END YEAR 5, assuming a 6% interest rate (compounded
End of year
Cash flow


18. Other things held constant, if a bond indenture contains a call provision, the yield to maturity that would exist
without such a call provision will generally be ____ the YTM with it.
A) The same as
B) Either higher or lower, depending on the level of call premium, than
C) Unrelated to
D) Lower than
E) Higher than

19. Which answer is FALSE regarding bond prices and interest rates?
A) Interest rate risk can be described as the risk that changes in market interest rates will
cause fluctuations in the bonds price.
B) The price of a bond is the present value of the coupon payments and the face value.
C) Bond prices and interest rates move in opposite directions.
D) The prices of short-term bonds display greater price sensitivity to interest rate changes
than do the prices of long-term bonds.

20. Relaxant Inc. operates as a partnership. Now the partners have decided to convert the business into a corporation.
Which of the following statements is CORRECT?
A) The firm's investors will be exposed to less liability, but they will find it more difficult to
transfer their ownership.
B) The firm will find it more difficult to raise additional capital to support its growth.
C) The company will probably be subject to fewer regulations and required disclosures.
D) Assuming the firm is profitable, none of its income will be subject to federal income taxes.
E) Relaxant's shareholders (the ex-partners) will now be exposed to less liability.

21. Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders
and managers?
A) Change the corporation's formal documents to make it easier for outside investors to
acquire a controlling interest in the firm through a hostile takeover.
B) Beef up the restrictive covenants in the firm's debt agreements.
C) Pay managers large cash salaries and give them no stock options.
D) For a firm that compensates managers with stock options, reduce the time before options
are vested, i.e., the time before options can be exercised and the shares that are received
can be sold.
E) Eliminate a requirement that members of the board of directors must hold a high
percentage of their personal wealth in the firm's stock.

22. 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 increase in the future.
B) Investors expect short-term rates to be constant over time.
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.

23. Bavarian Sausage just issued a 10-year 12% coupon bond. The face value of the bond is $1,000 and the bond
makes ANNUAL coupon payments. If the bond is trading at $967.25, what is the bonds yield to maturity?
A) 11.26%
B) 12.00%
C) 13.27%
D) 12.59%

24. You want to buy your dream car, but you are $5,000 short. If you could invest your entire savings of $2,350 at an
annual interest of 12%, how long would you have to wait until you have accumulated enough money to buy the
A) 9.40 years
B) 3.48 years
C) 6.66 years
D) 7.24 years

25. You are planning your retirement and you come to the conclusion that you need to have saved $1,250,000 in 30
years. You can invest into an retirement account that guarantees you a 5% annual return. How much do you have
to put into your account at the end of each year to reach your retirement goal?
A) $81,314.29
B) $12,382.37
C) $18,814.30
D) $23,346.59

26. If interest rates fall from 8 percent to 7 percent, which of the following bonds will have the largest percentage
increase in its value?
A) A 10-year zero-coupon bond.
B) A 10-year bond with a 10 percent semiannual coupon.
C) A 10-year bond with a 10 percent annual coupon.
D) A 5-year zero-coupon bond.
E) A 5-year bond with a 12 percent annual coupon.

27. The normal yield curve is upward sloping implying that

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

28. Which of the following would be most likely to lead to a higher level of interest rates in the economy?
A) The level of inflation begins to decline.
B) The Federal Reserve decides to try to stimulate the economy.
C) The economy moves from a boom to a recession.
D) Corporations step up their expansion plans and thus increase their demand for capital.
E) Households start saving a larger percentage of their income.

29. Steaks Galore needs to arrange financing for its expansion program. One bank offers to lend the required
$1,000,000 on a loan which requires interest to be paid at the end of each quarter. The quoted rate is 10 percent,
and the principal must be repaid at the end of the year. A second lender offers 9 percent, daily compounding
(365-day year), with interest and principal due at the end of the year. What is the difference in the effective annual
rates (EFF%) charged by the two banks?
A) 0.96%
B) 0.75%
C) 0.31%
D) 1.25%
E) 0.53%

30. Cold Boxes Ltd. has 100 bonds outstanding (maturity value = $1,000). The required rate of return on these bonds is
currently 10 percent, and interest is paid semiannually. The bonds mature in 5 years, and their current market value
is $768 per bond. What is the annual coupon interest rate?
A) 6%
B) 4%
C) 2%
D) 0%
E) 8%

31. Keenan Industries has a bond outstanding with 15 years to maturity, an 8.25% nominal coupon, semiannual
payments, 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 $1,120. What is the bond's nominal yield to call?
A) 6.85%
B) 6.53%
C) 6.20%
D) 7.55%
E) 7.20%

32. Kern Corporation's 5-year bonds yield 7.30% and 5-year T-bonds yield 4.10%. The real risk-free rate is r* = 2.5%,
the default risk premium for Kern's bonds is DRP = 1.90% versus zero for T-bonds, the liquidity premium on
Kern's bonds is LP = 1.3%, 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 all 5-year bonds?
A) 1.68%
B) 1.20%
C) 1.60%
D) 1.45%
E) 1.32%

33. When you retire you expect to live for another 30 years. During those 30 years you want to be able to withdraw
$45,000 at the BEGINNING of each year for living expenses. How much money do you have to have in your
retirement account to make this happen. Assume that you can earn 8% on your investments.
A) $547,128.27
B) $506,600.25
C) $723,745.49
D) $1,350,000.00

34. Bonds issued by BB&C Communications that have a coupon rate of interest equal to 10.65 percent currently have
a yield to maturity (YTM) equal to 15.25 percent. Based on this information, BB&C's bonds must currently be
selling at ____ in the financial markets.
A) par value
B) a premium
C) a discount
D) Not enough information is given to answer this question.
E) None of the above is a correct answer.

35. If you buy a bond that is selling for less than its face, or maturity, value what will happen to the price (value) of the
bond as the maturity date nears if market interest rates do not change during the life of the bond?
A) The price of the bond should decrease even further below the bond's face value because
the rates in the market are too high.
B) The price of the bond will increase as the bond gets closer to its maturity because the
bond's value has to equal its face value at maturity.
C) Because interest rates remain constant, nothing happens to the market value of the bond.
D) This question cannot be answered without additional information.
E) None of the above is a correct answer.

36. Which of the following would be considered a primary market transaction?

A) The Federal Reserves purchase of mortgage bonds
B) The purchase of the Water Fund, an ETF traded on NASDAQ
C) The purchase of Fidelitys Total Market Fund, an open-ended mutual fund.
D) The purchase of Out of The Rough Fund, a closed-end mutual fund investing in companies
that sponsor golf tournaments and pro golfers.
E) None of the above

37. Bavarian Sausage just issued a 10-year 12% coupon bond. The face value of the bond is $1,000 and the bond
makes SEMIANNUAL coupon payments. If the required return on the bond is 10%, what is the bonds price?
A) $1,122.89
B) $1,000.00
C) $1,124.62
D) $815.26

38. You want to buy a house in 4 years and expect to need $25,000 for a down payment. If you have $15,000 to invest,
how much interest do you have to earn (compounded annually) to reach your goal?
A) 25.74%
B) 13.62%
C) 16.67%
D) 21.53%

39. If you hold the annual percentage rate constant while increasing the number of compounding periods per year, then
A) the effective interest rate will decrease.
B) the effective interest rate will increase.
C) the effective interest rate will not change.
D) none of the above.

40. 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) 13.64%
B) 12.96%
C) 15.08%
D) 12.31%
E) 14.36%

Fin 221 Fall 2012 Exam 1

Answer Section