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Solved Questions for Assignment - Honors: Financial Management | FIN 201, Study notes of Financial Management

Chapter 6 homework/review Material Type: Notes; Professor: McCarthy; Class: Honors: Financial Management; Subject: Finance; University: Bryant University;

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2011/2012

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FIN201e Homework Assignment – Chapter 6
Questions:
6-2 Which fluctuate more – long-term or short-term interest rates? Why?
Short-term rates fluctuate more, because they rise and fall rapidly during booms and
recessions, which shows that they’re more volatile on the graph when compare to long-term.
6-3 Suppose you believe that the economy is just entering a recession. Your firm must raise capital
immediately, and debt will be used. Should you borrow on a long-term or a short-term basis? Why?
Short-term. Because a decreased demand for credit usually occurs during recession, which
lead to an increase in the monetary supply and a decline in interest rates.
6-5 Suppose a new process was developed that could be used to make oil out of seawater. The
equipment required is quite expensive; but it would, in time, lead to low prices for gasoline,
electricity, and other types of energy. What effect would this have on interest rates?
Initially the expensive equipment would lead to an increase of demand in capital which
pushes rates up. But in the long-run the interest rates would fall because of dropping prices.
6-6 Suppose a new and more liberal Congress and administration are elected. Their first order of
business is to take away the independence of the Federal Reserve System and to force the Fed to
greatly expand the money supply. (increase in expected inflation) What effect will this have:
a. On the level and slope of the yield curve immediately after the announcement?
By greatly expand the money supply, long-term rates will rise and short-term rates will fall.
Yield Curve for short-term rates is downward sloping.
b. On the level and slope of the yield curve that would exist 2 or 3 years in the future?
Lowered short-term rates will hopefully motivate businesses to borrow more capital; this
increased demand for capital pushes rates back up. YC is upward sloping again.
6-8 Suppose interest rates on Treasury bonds rose from 5% to 9% as a result of higher interest
rates in Europe. What effect would this have on the price of an average company’s common stock?
Higher interest rates translate to drop in demand for loans and an average company will be
less likely to expand their capital to invest, the price of their stock should decrease.
6-9 What does it mean when it is said that the United States is running a trade deficit? What impact
will a trade deficit have on interest rates?
Trade deficit is when U.S. export < import, they must be financed (borrowing from nations
with export surpluses) It hinders the Fed’s ability to combat a recession by lowering rates.
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FIN201e Homework Assignment – Chapter 6 Questions: 6-2 Which fluctuate more – long-term or short-term interest rates? Why? Short-term rates fluctuate more, because they rise and fall rapidly during booms and recessions, which shows that they’re more volatile on the graph when compare to long-term. 6-3 Suppose you believe that the economy is just entering a recession. Your firm must raise capital immediately, and debt will be used. Should you borrow on a long-term or a short-term basis? Why? Short-term. Because a decreased demand for credit usually occurs during recession, which lead to an increase in the monetary supply and a decline in interest rates. 6-5 Suppose a new process was developed that could be used to make oil out of seawater. The equipment required is quite expensive; but it would, in time, lead to low prices for gasoline, electricity, and other types of energy. What effect would this have on interest rates? Initially the expensive equipment would lead to an increase of demand in capital which pushes rates up. But in the long-run the interest rates would fall because of dropping prices. 6-6 Suppose a new and more liberal Congress and administration are elected. Their first order of business is to take away the independence of the Federal Reserve System and to force the Fed to greatly expand the money supply. (increase in expected inflation) What effect will this have: a. On the level and slope of the yield curve immediately after the announcement? By greatly expand the money supply, long-term rates will rise and short-term rates will fall. Yield Curve for short-term rates is downward sloping. b. On the level and slope of the yield curve that would exist 2 or 3 years in the future? Lowered short-term rates will hopefully motivate businesses to borrow more capital; this increased demand for capital pushes rates back up. YC is upward sloping again. 6-8 Suppose interest rates on Treasury bonds rose from 5% to 9% as a result of higher interest rates in Europe. What effect would this have on the price of an average company’s common stock? Higher interest rates translate to drop in demand for loans and an average company will be less likely to expand their capital to invest, the price of their stock should decrease. 6-9 What does it mean when it is said that the United States is running a trade deficit? What impact will a trade deficit have on interest rates? Trade deficit is when U.S. export < import, they must be financed (borrowing from nations with export surpluses) It hinders the Fed’s ability to combat a recession by lowering rates.

Problem: 6-1 YIELD CURVES The following yields on U.S. Treasury securities were taken from a recent financial publication: Term 6m 1yr 2yr 3yr 4yr 5yr 10yr 20yr 30yr Rate 5.1% 5.5 5.6 5.7 5.8 6.0 6.1 6.5 6. a. Plot a yield curve based on these data. b. What type of yield curve is shown? Normal, humped. c. What information does this graph tell you? Interest rates on medium-term maturities were higher than rates on both short- and long- term maturities. It’s probably because of expectations of future inflation. d. Based on this yield curve, if you needed to borrow for longer than 1 year, would it make sense for you to borrow short-term and renew the loan or borrow long-term? Explain. Long-term. The yield curve suggests expected future inflation to increase, so by borrowing long-term my interest costs would remain constant and an increase in interest rates in the economy won’t affect my payments. 6-2 REAL RISK-FREE RATE You read in the Wall Street Journal that 30-day T-bills are currently yielding 5.5%. Your brother-in-law, a broker at Safe and Sound Securities, has given you the following estimate of current interest rate premiums:  Inflation premium = 3.25%  Liquidity premium = 0.6%  Maturity risk premium = 1.8%  Default risk premium = 2.15% On the basis of these data, what is the real risk-free rate return? T-bond rate = r + IP + MRP 5.5% = r + 3.25% +1.8% r=0.45%*

6-8 EXPECTATIONS THEORY Interest rates on 4-year Treasury securities are currently 7%, while 6-year Treasury securities yield 7.5%. If the pure expectations theory is correct, what does the market believe that 2-year securities will be yielding 4 years from now? 8.5% 6-9 EXPECTED INTEREST RATE The real risk-free rate is 3%. Inflation is expected to be 3% this year, 4% next year, and 3.5% thereafter. The maturity risk premium is estimated to be 0.05(t- 1)%, where t = number of years to maturity. What is the yield on a 7-year Treasury note? 6-10 INFLATION Due to a recession, expected inflation this year is only 3%. However, the inflation rate in Year 2 and thereafter is expected to be constant at some level above 3%. Assume that the expectations theory holds and the real risk-free rate is r = 2%. If the yield on 3-year Treasury bonds equals the 1-year yield plus 2%, what inflation rate is expected after Year 1? 6% 6-11 DEFAULT RISK PREMIUM A company’s 5-year bonds are yielding 7.75% per year. Treasury bonds with the same maturity are yielding 5.2% per year, and the real risk-free rate (r) is 2.3%. The average inflation premium is 2.5%; and the maturity risk premium is estimated to be 0.1(t-1)%, where t=number of years to maturity. If the liquidity premium is 1%, what is the default risk premium on the corporate bonds?

6-14 EXPECTATIONS THEORY AND INFLATION Suppose 2-year Treasury bonds yield 4.5%, while 1-year bonds yield 3%. (r) is 1%, and the maturity risk premium is zero. a. Using the expectations theory, what is the yield on a 1-year bond 1 year from now? 6% b. What is the expected inflation rate in Year 1? Year 2? 5% 6-17 INTEREST RATE PREMIUMS A 5-year Treasury bond has 5.2% yield. A 10-year Treasury bond yields 6.4%, and a 10-year corporate bond yields 8.4%. The market expects that inflation will average 2.5% over the next 10 years (IP 0 =2.5%). Assume that there is no maturity risk premium (MRP=0) and that the annual real risk-free rate, r, will remain constant over the next 10 years. (Hint: Remember that the default risk premium and the liquidity premium are zero for Treasury securities: DRP=LP=0.) A 5-year corporate bond has the same default risk premium and liquidity premium as the 10-year corporate bond described. What is the yield on this 5-year corporate bond?