Chapter 1 Multiple Choice Questions 1.

This book is mainly about A) financial decisions made by households B) financial decisions made by corporations C) financial decisions made by governments D) none of the above Answer B Type !asy "age #

$. %inance& generally& deals with A) money B) markets C) people D) all of the above Answer D Type !asy "age #

#. The following are e'amples of the (nited )tates*based corporations e'cept A) +eneral ,otors B) ,icrosoft C) Bank of America D) (nilever Answer D Type !asy "age #

-. The following are e'amples of foreign*based corporations e'cept A) British "etroleum B) .olkswagen C) +eneral !lectric D) )ony Answer C Type !asy "age #

/. Businesses can be organi0ed as A) sole proprietorships B) partnerships C) corporations D) any of the above Answer D Type !asy "age #

1. +enerally& a corporation is owned by the A) ,anagers B) Board of Directors C) )hareholders D) All of the above. Answer C Type !asy "age #

2. 3imited liability is an important feature of A) )ole proprietorships B) "artnerships C) Corporations D) All of the above Answer C Type !asy "age -

4. Corporations& potentially& have infinite life because A) of limited liability B) of separation of ownership and management C) it is a legal entity D) none of the above Answer C Type ,edium "age -

5. The main disadvantage of organi0ing a business as a corporation in the (nited )tates is A) 3imited liability B) )eparation of ownership and management C) Double ta'ation. D) 6one of the above Answer C Type ,edium "age -

17. A large number of (nited )tates corporations are incorporated in A) 6ew 8ork B) California C) Delaware D) 6one of the above Answer C Type !asy "age -

11. The following are e'amples of real assets e'cept A) ,achinery B) Common stock C) 9ffice buildings D) :nventory Answer B Type ,edium "age /

1$. The following are e'amples of intangible assets e'cept A) ,achinery B) Trade marks C) "atents D) Technical e'pertise Answer A Type ,edium "age /

1#. The following are e'amples of financial assets e'cept A) Common stocks B) Bonds C) "atents D) "referred stocks Answer C Type ,edium "age /

1-. A firm;s investment decision is also called the A) %inancing decision B) Capital budgeting decision C) 3i<uidity decision D) 6one of the above Answer B Type ,edium "age /

1/. :n finance& =short*term= means A) less than three months B) less than si' months C) less than one year D) less than five years Answer C Type !asy "age /

11. The following cities are also important financial centers of the world A) 6ew 8ork B) 3ondon C) Tokyo D) All of the above Answer D Type !asy "age 1

12. The treasurer usually oversees the following functions of a corporation e'cept A) "reparation of financial statements B) :nvestor relationships C) Cash management D) 9btaining finances Answer A Type Difficult "age 1

14. The treasurer is usually responsible the following functions of a corporation e'cept A) >aising new capital B) Cash management C) Banking relationships D) :nternal accounting Answer D Type Difficult "age 1

15. The controller is usually responsible for the following functions of a corporation e'cept A) "reparation of financial statements B) :nternal accounting C) >aising new capital D) Ta'es Answer C Type Difficult "age 1

$7. The controller usually oversees the following functions of a corporation e'cept A) Cash management B) Ta' management C) :nternal accounting D) "reparation of financial statements Answer A Type Difficult "age 1

$1. The Chief %inancial 9fficer ?C%9) of a corporation oversees A) Treasurer;s functions B) Controller;s functions C) Both A and B D) 6one of the above Answer C Type !asy "age 2

$$. The following are advantages of separation of ownership and management of corporations e'cept A) Corporations can e'ist forever. B) %acilitate transfer of ownership without affecting the operations of the firm. C) @ire professional managers D) :ncur agency costs Answer D Type ,edium "age 2

$#. Conflicts of interest between shareholders and managers of a firm result in A) "rincipal*agent problem B) :ncreased agency costs C) Both A and B D) 6one of the above Answer C Type ,edium "age 4

$-. The financial goal of a corporation is to A) ,a'imi0e sales B) ,a'imi0e profits C) ,a'imi0e the value of the firm for the shareholders D) ,a'imi0e managers; benefits Answer C Type Difficult "age 4

$/. Agency costs are incurred by a corporation because A) managers may not attempt to ma'imi0e the value of the firm to shareholders B) shareholders incur monitoring cost C) separation of ownership and management D) all of the above Answer D Type ,edium "age 4

$1. :n the principal*agent framework A) )hareholders are the principals B) ,anagers are the agents C) )hareholders are the agents D) ,anagers are the principals !) A and B Answer ! Type ,edium "age 4

$2. Costs associated with the conflicts of interest between the bondholders and a shareholders of a corporation is called A) 3egal costs B) Agency costs C) Administrative costs D) Bankruptcy costs Answer B Type Difficult "age 4

$4. The following groups are some of the claimants to a firm;s income stream A) )hareholders B) Bondholders C) +overnment D) !mployees !) All of the above Answer ! Type ,edium "age 4

$5. :nformational asymmetry refers to the differences in information regarding the value of a firm among A) )hareholders B) ,anagers C) Bondholders D) All of the above. Answer D Type ,edium "age 4

True/False Questions T % #7. A corporation has a legal e'istence of its own and is based on =articles of incorporation.= Answer True Type !asy "age -

% #1. The board of directors is ultimately responsible for all large investment decisions. Answer True Type ,edium "age /

% #$. :n large firms& there is usually a Chief %inancial 9fficer ?C%9) who oversees both the treasurer;s and controller;s work. Answer True Type !asy "age 1

% ##. The controller;s responsibilities include banking relations and cash management. Answer %alse Type ,edium "age 1

% #-. The treasurer;s responsibilities include preparation of financial statements. Answer %alse Type ,edium "age 1

% #/. 9ne distinctive feature of a corporation is that there is no separation of ownership and control. Answer %alse Type ,edium "age 2

% #1. :n a sole proprietorship& the owner is also the manager& and hence& agency costs are at a minimum. Answer True Type ,edium "age 4

Short Answer Questions #2. !'plain the term =corporation.= Answer A corporation is a legal entity and has an e'istence of its own. +enerally& large businesses are organi0ed as corporations. Type !asy "age -

#4. Briefly e'plain the advantages of a corporation as a form of business organi0ation. Answer Corporations have infinite life. Corporations have very many owners called shareholders and therefore corporations can raise funds more easily than other forms of business. There is a separation of ownership and management that is helpful in running the corporation on a day*to*day basis. :t is very easy to transfer ownership in a corporation. Corporations have limited liability. Type ,edium "age -

#5. Briefly e'plain the term limited liability. Answer The shareholders of a corporation cannot be held personally responsible for the debt of the corporation. This is called limited liability. @ence a shareholder;s loss is limited to the amount he or she has invested in a corporation. This is an attractive feature for the investors. Type ,edium "age -

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-7. Briefly e'plain why a large number of corporations are incorporated in the state of Delaware Answer Delaware has a well*developed system of corporate law. :t is very supportive of corporations. Type ,edium "age -

-1. Briefly e'plain the se<uence flow of cash between financial markets and the firm. Answer Cash is raised by selling financial assets to investors. Cash is invested in the firm;s operation and used to purchase real assets. Cash is generated by the firm;s operations. Cash is reinvested or returned to investors. Type ,edium "age 1

-$. Briefly discuss the role of the financial manager. Answer Chief %inancial 9fficer ?C%9) )upervises the treasurer and the controller in a large corporation. C%9 is involved in corporate planning and financial policy. Treasurer :s responsible for obtaining funds& managing cash& banking relationships and investor relationships. Controller :s responsible for accounting functions& payroll and ta'es. Type ,edium "age 2

-#. Briefly discuss principal * agent problems as related to a corporation Answer "rincipal*agent problems arise in a corporation as a result of the separation of ownership and management. ,anagers may not act in the best interests of the shareholders while making decisions. @ence the shareholders incur monitoring and bonding costs which are a part of agency costs. :t also arises as result of informational asymmetry between managers and other stakeholders of a firm. Agency costs tend to reduce the value of a firm. Type ,edium "age 4

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--. Briefly e'plain the term =web of contracts= in the conte't of a corporation Answer A corporation is a comple' organi0ation. All the claimants to the value of a corporation are called stakeholders of a corporation. They areA shareholders& bondholders& employees& managers& suppliers& customers& government and the community. A comple' set interrelated contracts governs their relationships. These contracts could be formal or informal. This comple' set of contracts can be thought of as =web of contracts.= Type ,edium "age 4

-/. Briefly e'plain the term =Agency costs= as related to a corporation Answer Agency costs arise in a corporation as a result of principal*agent problems. %or e'ampleA managers may not act in the best interests of the shareholders while making decisions. @ence the shareholders incur monitoring costs that are called agency costs. :t also arises as result of informational asymmetry between managers and other stakeholders of a firm. Agency costs tend to reduce the value of a firm. Type ,edium "age 4 Chapter 2 Multiple Choice Questions 1. The following are e'amples of tangible assets e'cept A) ,achinery B) Barehouse C) 9ffice buildings D) "atents Answer D Type !asy "age 1#

$. The following are e'amples of intangible assets e'cept A) ,achinery B) Trade marks C) "atents D) Technical e'pertise Answer A Type !asy "age 1#

#. The following are e'amples of real assets e'cept A) ,achinery

1$

B) Common stock C) :nventory D) Barehouse Answer B Type !asy "age 1#

1#

-. "resent value of C117&777 e'pected to be received one year from today at an interest rate ?discount rate) of 17D per year is A) C1$1&777 B) C177&777 C) C117&777 D) 6one of the above Answer B Type !asy "age 1>esponse ". E ?117&777) F ?1.1) E 177&777 /. 9ne year discount factor at a discount rate of 17D per year is A) 1.1 B) 1.7 C) 7.575 D) 6one of the above Answer C Type !asy "age 1>esponse Discount %actor E 1F1.1 E 7.575 1. "resent .alue of C177&777 e'pected to be received at the end of one year at a discount rate of 177D per year is A) C/7&777 B) C$77&777 C) C177&777 D) 6one of the above Answer A Type !asy "age 1>esponse ". E ?177&777) F ?1G1) E /7&777 2. The one*year discount factor at an interest rate of $/D per year is A) 1.$/ B) 7.4 C) 7.$/ D) 6one of the above Answer B Type !asy "age 1>esponse Discount factor E 1F?1.$/) E 7.4

1-

4. :f the one*year discount factor is 7.215$& what is the discount rate ?interest rate) per yearH A) 17D B) $7D C) #7D D) 6one of the above Answer C Type ,edium "age 1>esponse 1Gr E 1F?7.215$) E 1.#7A r E #7D 5. :f the present value of C--- to be paid at the end of one year is C-77& what is the one*year discount factorH A) 7.571 B) 1.11 C) 7.11 D) 6one of the above Answer A Type ,edium "age 1>esponse Discount factor is E -77F--- E 7.571 17. :f the one*year discount factor is 7.4/& what is the present value of C1$7 to be received one year from todayH A) C177 B) C17$ C) C1-1.14 D) 6one of the above Answer B Type ,edium "age 1>esponse ". E ?1$7)?7.4/) E 17$ 11. :f the present value of C-47 e'pected to be received one year from today is C-77& what is the discount rateH A) 17D B) $7D C) #7D D) 6one of the above Answer B Type ,edium "age 1>esponse 1Gr E -47 F-77 E 1.$A r E $7D

1/

1$. :f the present value of C#77 e'pected to be received one year from today is C$-7& what is the one year discount rateH A) 1/D B) $7D C) $/D D) #7D Answer C Type ,edium "age 1>esponse 1Gr E ?#77)F?$-7) E 1.$/A r E $/ D 1#. The rate of return is also called A) Discount rate B) @urdle rate C) 9pportunity cost of capital D) All of the above. Answer D Type !asy "age 1/

1-. The present value formula for one period cash flow is A) ". E C1?1 G r) B) ". E C1Fr C) ". E C1F?1 G r) D) 6one of the above Answer C Type ,edium "age 1/

1/. The net present value formula for one period is A) 6". E ". cash flowsFinitial investment B) 6". E C7FC1 C) 6". E C7GIC1F?1 G r)J D) 6one of the above Answer C Type ,edium "age 1/

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11. :f the present value of a cash flow generated by an initial investment of C177&777 is C1$7&777& what is the 6". of the proKectH A) C1$7&777 B) C$7&777 C) C177&777 D) 6one of the above Answer B Type !asy "age 1/ >esponse 6".E *177&777 G 1$7&777 E $7&777 12. An initial investment of C-77&777 will produce an end of year cash flow of C-/7&777. Bhat is the 6". of the proKect at a discount rate of 17DH A) C5757.57 B) C-75&757.57 C) C7 ?0ero) D) 6one of the above Answer A Type ,edium "age 1/ >esponse 6".E *-77&777 G ?-/7&777F1.1) E 5757.57 14. An initial investment of C-77 produces a cash flow C/77 one year from today. Calculate the rate of return on the proKect A) 17D B) $7D C) $/D D) none of the above Answer C Type !asy "age 11 >esponse >ate of return E ?/77 -77)F-77 E $/D 15. The following statements regarding the 6". rule and the rate of return rule are true e'cept A) Accept a proKect if its 6". L 7 B) >eKect a proKect if its 6". M 7 C) Accept a proKect if its rate of return L 7 D) Accept a proKect if its rate of return L opportunity cost of capital Answer C Type Difficult "age 12

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$7. :f the probability of a recession is 7.#& normal growth is 7.- and a boom is 7.#& and the payoff in the event of a recession is C177& normal growth is C#77 and boom is C/77& what is the e'pected payoffH A) C$77 B) C#77 C) C-77 D) 6one of the above Answer B Type ,edium "age 12 >esponse !'pected payoff E 177N7.# G #77N7.- G /77N7.# E #77 $1. The payoffs of an investment are dependent on the state of the economy. The economy can have two states& recession or growth& with e<ual probability. :f the payoff in the event of growth is C1-7 and in the event of recession is C47& what is the e'pected payoff for the investmentH A) C177 B) C117 C) C1$7 D) 6one of the above Answer B Type ,edium "age 12 >esponse !'pected payoff E 7./N1-7 G 7./N47 E 117 $$. Current price of Company O;s stock is C177. The table below gives the data on end of the year prices and probabilities dependent on the state of the economy. Calculate the e'pected return for the stock.
! conom y + ro w th > e c e s s io n " ro b a b ility ./ ./ ! n d o f th e y e a r p ric e C1#7 C 57

A) B) C) D)

17D 1/D $7D 6one of the above

Answer A Type ,edium "age 12 >esponse !'pected "rice E 7./N1#7 G 7./N57 E 117A !'pected return E ?117 177)F177 E 17D

14

$#. The opportunity cost of capital for a risky proKect is A) The e'pected rate of return on a government security having the same maturity as the proKect B) The e'pected rate of return on a well diversified portfolio of common stocks C) The e'pected rate of return on a portfolio of securities of similar risks as the proKect D) 6one of the above Answer C Type Difficult "age 14

$-. ,r. %ree has C177 dollars income this year and 0ero income ne't year. The market interest rate is 17D per year. :f ,r. %ree consumes C$7 this year& and invests the rest in the market& what will be his consumption ne't yearH A) C/7 B) C177 C) C44 D) C// Answer C Type ,edium "age $7 >esponse Consumption ne't year E ?177 E 44 ?)ee %igure*1)

%:+(>!*1 6e't 8ear C44

C177 This 8ear C47

15

$/. ,r. Thomas has C177 income this year and 0ero income ne't year. The market interest rate is 17D per year. ,r. Thomas also has an investment opportunity in which he can invest C/7 this year and receive C27 ne't year. )uppose ,r. Thomas consumes C/7 this year and invests in the proKect. Bhat will be his consumption ne't yearH A) C// B) C27 C) C/7 D) 6one of the above Answer B Type ,edium "age $7 >esponse ,r. Thomas; investment this year E 177 /7 E /7. @is income ne't year by taking the investment opportunity is e<ual to 27 $1. ,r. Dell has C177 income this year and 0ero income ne't year. The market interest rate is 17D per year. ,r. Dell also has an investment opportunity in which he can invest C/7 this year and receive C27 ne't year. )uppose ,r. Dell consumes C/7 this year and invests in the proKect. Bhat is the 6". of the investment opportunityH A) C/ B) C1#.1C) C7 ?0ero) D) 6one of the above. Answer B Type Difficult "age $7 >esponse 6". E ?27F1.1) /7 E 1#.1$2. ,r. Crow has C177 income this year and 0ero income ne't year. The market interest rate is 17D per year. ,r. Crow also has an investment opportunity in which he can invest C/7 today and receive C27 ne't year. )uppose ,r. Crow consumes C$7 this year and invests in the proKect. Bhat will be his consumption ne't yearH A) C44 B) C17# C) C47 D) C177 Answer B Type Difficult "age $7 >esponse Consumption ne't year E ?177*$7*/7)N1.1 G27 E 17#

$7

$4. ,s. .enus has C177 income this year and C1$7 ne't year. The market interest rate is 17D per year. )uppose ,s. .enus consumes C/7 this year. Bhat will be her consumption ne't yearH A) C12/ B) C127 C) C1$7 D) 6one of the above Answer A Type Difficult "age $7 >esponse Consumption ne't year E ?177 * /7)N1.1 G 1$7 E12/ $5. ,s. 6ewcastle has C17&777 income this year and C#7&777 ne't year. The market interest rate is 17D per year. )uppose ,s. 6ewcastle consumes C27&777 this year. Bhat will be her consumption ne't yearH A) C17&777 B) C#7&777 C) C27&777 D) C15&777 Answer D Type Difficult "age $7 >esponse Borrow C17&777 this year to consume 17&777G17&777 E 27&777 Consumption ne't year E #7&777 ?17&777N1.1) E 15&777 #7. ,s. 6ewcastle has C17&777 income this year and C#7&777 ne't year. The market interest rate is 17D per year. )uppose ,s. 6ewcastle wishes to consume C1#&777 ne't year. Bhat will be her consumption this yearH A) C17&777 B) C#7&777 C) C27&777 D) C15&777 Answer B Type Difficult "age $7 >esponse Consumption this year E 17&777 ?##&777F1.1) E #7&777

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#1. The line that connects the ma'imum that one can consume this year ?now) and the ma'imum one can consume ne't year A) @as a slope of ?1Gr) B) @as a slope of *?1Gr) C) @as a slope of r D) @as a slope of 1Fr Answer B Type Difficult "age $7

#$. ,r. @opper has an income of C-7&777 this year and C17&777 ne't year. @e can invest in a proKect that costs C$7&777 this year& which generates an income of C$#&777 ne't year. The market interest rate is 17D. Bhat will be his consumption ne't year& if ,r. @opper invests in the proKect and consumes C/7&777 this year H A) C-7&777 B) C/7&777 C) C17&777 D) 6one of the above Answer B Type Difficult "age $7 >esponse Consumption ne't year E I-7&777 $7&777 /7&777JN1.1 G ?17&777 G $#&777) E /7&777 ##. According to the net present value rule& an investment in a proKect should be made if the A) 6et present value is greater than the cost of investment B) 6et present value is greater than the present value of cash flows C) 6et present value is positive D) 6et present value is negative Answer C Type Difficult "age $1

#-. Bhich of the following statements regarding the net present value rule and the rate of return rule is not trueH A) Accept a proKect if 6". L cost of investment B) Accept a proKect if 6". is positive C) Accept a proKect if return on investment e'ceeds the rate of return on an e<uivalent investment in the financial market D) All of the above statements are true Answer A Type Difficult "age $1

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#/. According to the rate of return rule an investment in a risky proKect should be made if A) The return on investment e'ceeds the risk*free rate B) The return on investment is positive C) The return on investments e'ceeds the rate of return on an e<uivalent investment in the financial market D) 6one of the above statements are true Answer C Type Difficult "age $1 #1. Bhich of the following statements regarding the net present value rule and the rate of return rule is trueH A) Accept a proKect if the rate of return is positive B) Accept a proKect the rate of return on a risky proKect e'ceeds the risk*free rate C) Accept a proKect if the net present value is positive D) 6one of the above statements are true Answer C Type Difficult "age $1

#2. There are two reasons for discounting future cash flow. They are A) A dollar today is worth more than a dollar tomorrow ?for positive interest rates) B) A safe dollar is worth more than a risky one C) The value of a dollar is changing all the time D) A and B above Answer D Type ,edium "age $1

#4. The discount rate is used for calculating the 6". is A) Determined by the financial market B) %ound by the government C) %ound by the C!9 D) 6one of the above Answer A Type !asy "age $1

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#5. The financial goal of a corporation is to A) ,inimi0e stockholder wealth B) ,a'imi0e profit C) ,a'imi0e value of the corporation to the stockholders D) 6one of the above Answer C Type !asy "age $$

-7. The managers of a firm can ma'imi0e stockholder wealth by A) Taking all proKects with positive 6".s B) Taking all proKects with 6".s greater than the cost of investment C) Taking all proKects with 6".s greater than present value of cash flow D) All of the above Answer A Type ,edium "age $$

-1. The following are some of the actions shareholders can take if the corporation is not performing well A) >eplace the board of directors in an election. B) %orce the board of directors to change the management team. C) )ell their shares of stock in the corporation. D) Any of the above Answer D Type ,edium "age $#

-$. ,anagers; actions are monitored by A) The board of directors B) Commercial banks that have loaned funds to the firm C) The Ball )treet analysts D) All of the above Answer D Type ,edium "age $#

$-

True/False Questions T % -#. A dollar today is worth more than a dollar tomorrow if the interest rate is positive. Answer True Type !asy "age 1-

% --. The present value of a future cash flow can be found by dividing it by an appropriate discount factor. Answer %alse Type ,edium "age 1-

% -/. The discount rate& hurdle rate or opportunity cost of capital all mean the same. Answer True Type ,edium "age 1/

% -1. 6et present value is found by subtracting the re<uired investment from the present value of future cash flows. Answer True Type ,edium "age 1/

% -2. A safe dollar is always worth less than a risky dollar because the rate of return on a safe investment is generally low and the rate of return on a risky investment is generally high. Answer %alse Type Difficult "age 1/

% -4. The opportunity cost of capital is higher for safe investments than for risky ones. Answer %alse Type ,edium "age 1/

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% -5. =Accept investments that have positive net present values= is called the net present value rule. Answer True Type ,edium "age 12

% /7. Capital markets are perfectly competitive in theory and practice. Answer %alse Type ,edium "age 15

% /1. The goal of a corporation should be to ma'imi0e profits. Answer %alse Type ,edium "age $$

Short Answer Questions /$. :ntuitively e'plain the concept of the present value. Answer :f you have C177 today& you can invest it and start earning interest on it. 9n the other hand& if you have to make a payment of C177 one year from today& you do not need to invest C177 today but a lesser amount. The lesser amount invested today plus the interest earned on it should add up to C177. The present value of C177 one year from today at an interest rate of 17D is C57.51. I". E 177F1.1 E 57.51J Type Difficult "age 1-

/#. Briefly e'plain the term =discount rate.= Answer Discount rate is the rate of return used for discounting future cash flows to obtain the present value. The discount rate can be obtained by looking at the rate of return& an e<uivalent investment opportunity in the capital market. Type Difficult "age 1-

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/-. Briefly e'plain the concept of risk. Answer :f the future cash flows from an investment are not certain then we call it a risky cash flow. That means there is an uncertainty about the future cash flows or future cash flows could be different from e'pected cash flows. The degree of uncertainty varies from investment to investment. +enerally& uncertain cash flows are discounted using a higher discount rate than certain cash flows. This is only one method of dealing with risk. There are many ways to take risk into consideration while making financial decisions. Type Difficult "age 1/

//. )tate the =net present value rule.= Answer :nvest in proKects with positive net present values. 6et present value is the difference between the present value of future cash flows from the proKect and the initial investment. Type ,edium "age 12

/1. )tate the = rate of return rule.= Answer :nvest as long as the rate of return on the investment e'ceeds the rate of return on e<uivalent investments in the capital market. Type ,edium "age 12 /2. Briefly e'plain how individuals can adKust their preferences for current and future consumption Answer :ndividuals can adKust their preferences for consumption by borrowing or lending in the financial market. The appropriate balance between present and future consumption that each individual will choose depends on personal preferences. But individuals with different preferences can adKust their preferences using financial market. Type Difficult "age 15

/4. !'plain why =ma'imi0ation of shareholders; wealth= is the appropriate goal of the firm. Answer (nder perfect market conditions& everyone can borrow or lend at the same interest rate. This implies that differences in consumption patterns can be adKusted in the capital markets. +iven this& all investors will agree that they are better off if the firm ma'imi0es their current wealth& i.e. ma'imi0e shareholders; wealth. Type Difficult "age $$

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/5. Briefly e'plain how a financial manager;s task is simplified by the presence of a well functioning financial market. Answer :n the presence a well*functioning financial market& shareholders can adKust their preferences by borrowing and lending. )hareholders prefer more consumption to less. Therefore managers need not worry about shareholders; preferences but concentrate on increasing the market value of the firm by taking all proKects with positive net present value. Type Difficult "age $$

17. Briefly e'plain how the concept of net present value allows for efficient separation of ownership and management. Answer A manager who invests in proKects with positive net present value serves the best interests of each and every shareholder by increasing the value of the firm. This is true regardless of individual preferences of shareholders. %or e'ample& there is no need for mangers to follow a specific investment policy to match the time preferences of shareholders; consumption. )hareholders can always use the financial market for that. Thus there is an efficient separation of ownership and management. :t is important to note that the net present values are meaningful only in the presence of a well*functioning financial market. Type Difficult "age $$

11. Briefly e'plain some of the institutional arrangements that ensure that managers work toward increasing the value of a firm. Answer The board of directors who are elected by the shareholders scrutini0es managers; actions. Competition among managers The threat of takeover that brings a new management team. :ncentive schemes that are tied to the value of the firm like stock options. Type ,edium "age $/ Chapter 3 Multiple Choice Questions 1. "resent .alue is defined as A) %uture cash flows discounted to the present at an appropriate discount rate B) :nverse of future cash flows C) "resent cash flow compounded into the future D) 6one of the above Answer A Type !asy "age ##

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$. The present value of C177 e'pected in two years from today at a discount rate of 17D is A) C57.51 B) C117.77 C) C177.77 D) C4$.1!) 6one of the above Answer D Type !asy "age ## >esponse ". E 177 F ?1.1P$) E 4$.1#. :f the interest rate is 1/D& what is the $* year discount factorH A) 7.2/11 B) 7.4152 C) 1.#$$/ D) 6one of the above Answer A Type !asy "age ## >esponse D% E 1 F ?1.1/P$) E .2/11 -. The absence of money machines means there are A) 6o opportunities for arbitrage B) 6o opportunities for investment C) 6o opportunities for borrowing D) All of the above Answer A Type ,edium "age #-

$5

/. :f the $*year discount factor is 7./17$& what is the rate of interest ?in A">)H A) 17D B) $/D C) -7D D) 6one of the above. Answer C Type ,edium "age #>esponse 7./17$ E 1F?1Gr)P$A ?1Gr)P$ E 1.51A 1Gr E 1.-7A r E -7D 1. :f the present value of the cash flow O is C$77& and the present value cash flow 8 C1/7& than the present value of the combined cash flow is A) C$77 B) C1/7 C) C/7 D) C#/7 !) 6one of the above Answer D Type !asy "age #>esponse ". ?' G y) E ". ?') G ". ?y) E $77 G 1/7 E #/7 2. Bhat is the present value of the following cash flow at a 1$D discount rateH
8ear 1 C 1 7 7 &7 7 7 8ear $ C 1 / 7 &7 7 7 8 ear # C $ 7 7 &7 7 7

A) B) C) D)

C#/1&$$1 C-/7&777 C-5#&--7 6one of the above

Answer A Type ,edium "age #>esponse ". E ?177&777F1.1$) G ?1/7&777F?1.1$P$)) G $77&777F?1.1$P#) E #/1&$$1

#7

4. Bhat is the net present value of the following cash flows at a discount rate on 1$DH
t E 7 * $ / 7 &7 7 7 t E 1 1 7 7 &7 7 7 tE $ 1 / 7 &7 7 7 tE # $ 7 7 &7 7 7

A) B) C) D)

C171&$$1 C$77&777 C1-$&$74 6one of the above

Answer A Type ,edium "age #>esponse 6". E *$/7&777 G ?177&777F1.1$) G ?1/7&777F?1.1$P$)) G $77&777F?1.1$P#) E 171&$$1 5. Bhat is the present value of the following cash flow at a discount rate of 1$D A">H
tE 1 * 1 7 7 &7 7 7 tE $ # 7 7 &7 7 7

A) B) C) D)

C14/&777 C$77&777 C1-5&42$ 6one of the above

Answer C Type ,edium "age #>esponse ". E ?*177&777F1.1$) G ?#77&777F?1.1$P$)) E 1-5&42$ 17. Bhat is the net present value of the following cash flow at a discount rate of 1/DH
tE 7 * 1 $ 7 &7 7 7 tE 1 # 7 7 &7 7 7 tE $ * 1 7 7 &7 7 7

A) B) C) D)

C1/&$// C47&777 C$1&#77 6one of the above

Answer A Type ,edium "age #>esponse 6". E *1$7&777 G ?#77&777F1.1/) * ?177&777F?1.1/P$)) E 1/&$//

#1

11. A perpetuity is defined as A) !<ual cash flows at e<ual intervals of time forever B) !<ual cash flows at e<ual intervals of time for a specific period C) (ne<ual cash flows at e<ual intervals of time forever D) 6one of the above Answer A Type !asy "age #2

1$. Bhat is the present value of C17&777 per year perpetuity at an interest rate of /DH A) C17&777 B) C177&777 C) C$77&777 D) 6one of the above Answer C Type !asy "age #2 >esponse ". E ?17&777F7.7/) E $77&777 1#. 8ou would like to have enough money saved to receive a C17&777 per year perpetuity after retirement so that you and your family can lead a good life. @ow much would you need to save in your retirement fund to achieve this goal ?assume that the perpetuity payments start one year from the date of your retirement. The interest rate is 17D)H A) C2&/77&777 B) C2/7&777 C) C177&777 D) 6one of the above Answer C Type ,edium "age #2 >esponse ". E ?17&777F7.1) E 177&777

#$

1-. 8ou would like to have enough money saved to receive a C177&777 per year perpetuity after retirement so that you and your family can lead a good life. @ow much would you need to save in your retirement fund to achieve this goal ?assume that the perpetuity payments start one year from the date of your retirement. The interest rate is 17D)H A) C1&777&777 B) C17&777&777 C) C177&777 D) 6one of the above Answer A Type ,edium "age #2 >esponse ". E ?177&777F7.1) E 1&777&777 1/. 8ou would like to have enough money saved to receive a growing perpetuity& growing at a rate of -D per year& the first payment being C17&777& after retirement so that you and your family can lead a good life. @ow much would you need to save in your retirement fund to achieve this goal ?assume that the growing perpetuity payments start one year from the date of your retirement. The interest rate is 4D)H A) C2&/77&777 B) C1&/77&777 C) C177&777 D) 6one of the above Answer B Type Difficult "age #2 >esponse ". E ?17&777F?7.74*7.7-)) E 1&/77&777 11. 8ou would like to have enough money saved to receive a growing perpetuity& growing at a rate of /D per year& the first payment being C177&777& after retirement so that you and your family can lead a good life. @ow much would you need to save in your retirement fund to achieve this goal ?assume that the growing perpetuity payments start one year from the date of your retirement. The interest rate is 17D)H A) C1&777&777 B) C17&777&777 C) C$&777&777 D) 6one of the above Answer C Type Difficult "age #2 >esponse ". E ?177&777F?7.1*7.7/)) E $&777&777

##

12. 8ou would like to have enough money saved to receive a C17&777 per year perpetuity after retirement so that you and your family can lead a good life. @ow much would you need to save in your retirement fund to achieve this goal ?assume that the perpetuity payments starts on the day of retirement. The interest rate is 4D)H A) C2&/77&777 B) C417&777 C) C177&777 D) 6one of the above Answer B Type Difficult "age #2 >esponse ". E ?17&777F7.74)?1.74) E 417&777 14. 8ou would like to have enough money saved to receive a C177&777 per year perpetuity after retirement so that you and your family can lead a good life. @ow much would you need to save in your retirement fund to achieve this goal ?assume that the perpetuity payments starts on the day of retirement. The interest rate is 17D)H A) C1&777&777 B) C1&177&777 C) C$&777&777 D) 6one of the above Answer B Type Difficult "age #2 >esponse ". E ?177&777F7.1)?1.1) E 1&177&777 15. An annuity is defined as A) !<ual cash flows at e<ual intervals of time forever B) !<ual cash flows at e<ual intervals of time for a specific period C) (ne<ual cash flows at e<ual intervals of time forever D) 6one of the above Answer B Type !asy "age #4

#-

$7. :f the five*year present value annuity factor is #.251 and four*year present value annuity factor is #.127& what is the present value at the C1 received at the end of five yearsH A) C7.1$1 B) C1.11 C) C7.#1/ D) 6one of the above Answer A Type Difficult "age #5 >esponse ". E ?#.251 #.127)N?1) E 7.1$1 $1. :f the three*year present value annuity factor is $.2$# and two*year present value annuity factor is 1.4/5& what is the present value of C1 received at the end of the # yearsH A) C7.1/2 B) C7.41C) C1.77 D) 6one of the above Answer B Type Difficult "age #5 >esponse ". E ?$.2$#*1.4/5) N?1) E 7.41$$. Bhat is the present value annuity factor at a discount rate of 1#D for 17 yearsH A) C/.-$1$ B) C4./1C) C4.1# D) 6one of the above Answer A Type ,edium "age #5 >esponse ". annuity factor E ?1F7.1#) ?1F??7.1#)?1.1#P17))) E /.-$1$ $#. Bhat is the present value annuity factor at an interest rate of 11D for / yearsH A) 4./1B) 1.1-/ C) #.15/5 D) 6one of the above Answer C Type ,edium "age #5 >esponse ". annuity factor E ?1F7.11) ?1F??7.11)?1.11P/))) E #.15/5

#/

$-. Bhat is the present value of C1777 per year annuity for ten years at an interest rate of 17DH A) C11-/ B) C4/1C) C$/5D) 6one of the above Answer A Type ,edium "age #5 >esponse ". annuity factor E I?1F7.17) ?1F??7.17)?1.17P 17)))JN1777 E 11-/ $/. Bhat is the present value of C$777 per year annuity at a discount rate of 1/D for 1/ yearsH A) C4&1#2 B) C11&15/ C) C12&7$4 D) 6one of the above Answer B Type ,edium "age #5 >esponse ". E I?1F7.1/) ?1F??7.1/)?1.1/P1/)))JN$777 E 11&15/ $1. After retirement& you e'pect to live for $7 years. 8ou would like to have C47&777 income each year. @ow much should you have saved in the retirement to receive this income& if the interest is 17D per year ?assume that the payments start one years after the retirement)H A) C141&74/ B) C1&177&#77 C) C/#4&$77 D) 6one of the above Answer A Type Difficult "age #5 >esponse ". E I?1F7.17) ?1F??7.17)?1.17P$7)))JN47&777 E 141&74/ $2. After retirement& you e'pect to live for $7 years. 8ou would like to have C47&777 income each year. @ow much should you have saved in the retirement to receive this income& if the interest is 17D per year ?assume that the payments start on the day of retirement)H A) C141&74/ B) C2-5&15C) C/#4&$77 D) 6one of the above Answer B Type Difficult "age #5 >esponse ". E II?1F7.17) ?1F??7.17)?1.17P$7)))JN47&777JN?1.1) E 2-5&15-.

#1

$4. :f the present annuity factor is #.45& what is the present value annuity factor for an e<uivalent annuity due if the interest rate is 5DH A) #./2 B) -.$C) #.45 D) 6one of the above. Answer B Type Difficult "age #5 >esponse annuity due factor E #.45 N 1.75 E -.$$5. :f the present value annuity factor for 17 years at 17D interest rate is 1.21& what is the present value annuity factor for an e<uivalent annuity dueH A) 2.#4 B) 1.17 C) 1.21 D) 6one of the above Answer A Type Difficult "age #5 >esponse Annuity due 1.21 N 1.1 E 2.#4 #7. Qohn @ouse has taken a C1/7&777 mortgage on his house at an interest rate of 2D per year. :f the mortgage calls for twenty e<ual annual payments& what is the amount of each paymentH A) C1-&1/4.5B) C17&/77.77 C) C11&44$.-# D) 6one of the above Answer A Type Difficult "age #5 >esponse ?(se a financial calculator) ". E 1/7&777A : *E 2DA 6 E $7A %. E 7A Compute ",T E C1-&1/4.5-

#2

#1. Qohn @ouse has taken a C1/7&777 mortgage on his house at an interest rate of 2D per year. Bhat is the value of the mortgage after the payment of the fifth annual installmentH A) C1$4&5/4.-1 B) C-25&$7/.#7 C) C52&/77.77 D) 6one of the above Answer A Type Difficult "age #5 >esponse 1/7&777F17./5- E 1-&1/4.5-A 1-&1/4.5-?5.1727) E C1$4&5/4.-1 #$. :f the present value of C1.77 received n years from today at an interest rate of r is 7.1$1& then what is the future value of C1.77 invested today at an interest rate of rD for n yearsH A) C1.77 B) C1.11 C) C1.27 D) 6ot enough information to solve the problem Answer B Type Difficult "age -7 >esponse %. E 1F?7.1$1) E 1.11 ##. :f the present value of C1.77 received n years from today at an interest rate of r is 7.$27& then what is the future value of C1.77 invested today at an interest rate of rD for n yearsH A) C1.77 B) C#.27 C) C1.27 D) 6ot enough information to solve the problem Answer B Type Difficult "age -7 >esponse %. E 1F?7.$27) E #.27 #-. :f the future value of C1 invested today at an interest rate of rD for n years is $./5#2& what is the present value of C1 to be received in n years at rD interest rateH A) C7.#4// B) C1.77 C) C7.1$1 D) 6one of the above Answer A Type Difficult "age -7 >esponse ". E 1F$./5#2 E 7.#4///

#4

#/. :f the present value annuity factor at 1$D A"> for / years is #.17/& what is the e<uivalent future value annuity factorH A) 1.#/# B) $.7-1 C) 1.21$ D) 6one of the above Answer A Type Difficult "age -7 >esponse %. annuity factor E #.17/N?1.1$P/) E 1.#/# #1. :f the future value annuity factor at 17D and / years is 1.17/1& calculate the e<uivalent present value annuity factor A) 1.17/1 B) #.2574 C) 5.4#$# D) none of the given ones Answer B Type Difficult "age -7 >esponse ". E 1.17/1F?1.1)P/ E #.2574 #2. :f the present value annuity factor at 4D A"> for 17 years is 1.21& what is the e<uivalent future value annuity factorH A) #.174 B) 1-.-41 C) $.1/5 D) 6one of the above Answer B Type Difficult "age -7 >esponse %. annuity factor E 1.$1N?1.74P/) E 1-.-41 #4. :f the present value annuity factor at 17D A"> for 17 years is 1.1--1& what is the e<uivalent future value annuity factorH A) #.174 B) 1/.5#2C) $.1/5 D) 6one of the above Answer B Type Difficult "age -7 >esponse %. annuity factor E 1.$1N?1.74P/) E 1-.-41

#5

#5. Bhich of the following statements is trueH A) "resent value of an annuity due is always less than the present value of an e<uivalent annuity factor for a given interest rate B) The present value of an annuity approaches the present value of a perpetuity as n goes to infinity for a given interest rate C) Both A and B are true D) Both A and B are false Answer B Type Difficult "age -7

-7. Bhich of the following statements is trueH A) "resent value of an annuity is always greater than the present value of e<uivalent annuity for a given interest rate. B) The future value of an annuity factor is always greater than the future value of an e<uivalent annuity at the same interest rate. C) Both A and B are true D) Both A and B are false Answer C Type Difficult "age -7

-1. ,r. @opper is e'pected to retire in #7 years and he wishes accumulate C1&777&777 in his retirement fund by that time. :f the interest rate is 1$D per year& how much should ,r. @opper put into the retirement fund each year in order to achieve this goalH A) C-&1-#.11 B) C4&$42.#$ C) C-&777 D) 6one of the above Answer A Type Difficult "age -7 >esponse %uture value annuity factor E I?1F7.1$) ?1F?7.1$N1.1$P#7)JN?1.1$P#7) E $-1.#4$2A payment E 1&777&777F$-1.##$2 E -1-#.11

-7

-$. ,r. @opper is e'pected to retire in #7 years and he wishes accumulate C2/7&777 in his retirement fund by that time. :f the interest rate is 17D per year& how much should ,r. @opper put into the retirement fund each year in order to achieve this goalH A) C-&//5.-B) C$&/77 C) C5&114.44 D) 6one of the above Answer A Type Difficult "age -7 >esponse %uture value annuity factor E I?1F7.17) ?1F?7.17N1.17P#7)JN?1.17P#7) E 11-.-5-A payment E 2/7&777F11-.-5- E -//5.--#. :f you invest C177 at 1$D A"> for three years& how much would you have at the end of # years using simple interestH A) C1#1 B) C1-7.-5 C) C$-7.14 D) 6one of the above Answer A Type ,edium "age -7 >esponse %. E 177 G ?177N7.1$N#) E C1#1 --. :f you invest C177 at 1$D A"> for three years& how much would you have at the end of # years using compound interestH A) C1#1 B) C1-7.-5 C) C$-7.14 D) 6one of the above Answer B Type ,edium "age -7 >esponse %. E 177N?1.1$P#) E C1-7.-5

-1

-/. Bhich of the following statements regarding simple interest and compound interest are trueH A) "roblems in finance generally use the simple interest concept B) "roblems in finance generally use the compound interest concept C) :t does not really matter whether you use simple interest or compound interest for solving problems in finance D) 6one of the above Answer B Type ,edium "age -7

-1. Bhich of the following statements is trueH A) The process of discounting is the inverse of the process of compounding B) !nding balances using simple interest is always greater than the ending balance using compound interest at positive interest rates. C) "resent value of an annuity due is always less than the present value of an e<uivalent annuity at positive interest rates D) All of the above are true Answer A Type Difficult "age -1

-2. Qohn @ouse has Kust taken out a C1/7&777 mortgage at an interest rate of 4D per year. :f the mortgage calls for e<ual monthly payments for twenty years& what is the amount of each paymentH ?Assume monthly compounding or discounting.) A) C1$/-.27 B) C11$/.77 C) C1$1#.71 D) 6one of the above are true Answer A Type Difficult "age -# >esponse ",T E 1/7&777FI?1F7.771112) 1F??7.771112N??1G.771112)P$-7)))J E C1$/-.27

-$

-4. ,r. Anton e'pects to retire in #7 years and would like to accumulate C1 million in the pension fund. :f the annual interest rate is 1$D per year& how much should ,r. Anton put into the pension fund each month in order to achieve his goalH Assume that ,r. Anton will deposit the same amount each month into his pension fund and also use monthly compounding. A) C$41.1# B) C221.17 C) C#-/.#7 D) 6one of the above Answer A Type Difficult "age -# >esponse ",T E 1&777&777F RI?1F7.71)*?1F?7.71N?1.71P#17)))JN?1.71P#17)SE C$41.1# -5. An investment at 1$D nominal rate compounded monthly is e<ual to an annual rate of A) 1$.14D B) 1$.#1D C) 1$D D) 6one of the above Answer A Type ,edium "age -# >esponse !A> E ??1.71)P1$)*1 E 7.1$141 E 1$.14D /7. An investment at 17.-2D effective rate compounded monthly is e<ual to a nominal ?annual) rate of A) 17.55D B) 5./2D C) 17D D) 6one of the above Answer C Type ,edium "age -# >esponse 69, E I??1.17-2)P?1F1$)*1JN1$ E 7.1 E 17.77D

-#

/1. An investment at 17D nominal rate compounded continuously is e<ual to an e<uivalent annual rate of A) 17.$/7D B) 17./12D C) 17.#41D D) 6one of the above Answer B Type Difficult "age -# >esponse ?eP?7.1))*1 E 7.17/12 E 17./12D /$. The present value of a C177 per year perpetuity at 17D per year interest rate is C1777. Bhat would be the present value if the payments were compounded continuouslyH A) C1777.77 B) C17-5.$1 C) C17$-.-7 D) 6one of the above Answer B Type Difficult "age -# >esponse ?ePr) E 1.1r E ln?1.1) E 7.75/#1A ". E 177F7.75/#1 E C17-5.$1 /#. :f the nominal interest rate per year is 17D and the inflation rate is -D& what is the real rate of interestH A) 17D B) -D C) /.4D D) 6one of the above Answer C Type !asy "age -1 >esponse 1Grreal E ?1Grnominal)F?1Grinflation) E 1.1F1.7- E1.7/4A rreal E /.4D /-. ,r. O invests C1777 at 17D nominal rate for one year. :f the inflation rate is -D& what is the real value of the investment at the end of one yearH A) C1177 B) C1777 C) C17/4 D) 6one of the above Answer C Type ,edium "age -1 >esponse >eal investment E ?1777N1.1)F?1.7-) E C17/4

--

//. A /*year treasury bond with a coupon rate of 4D has a face value of C1777. Bhat is the annual interest paymentH A) C47 B) C-7 C) C177 D) 6one of the above Answer A Type !asy "age -2 >esponse Annual interest payment E 1777?7.74) E C47 /1. A #*year bond with 17D coupon rate and C1777 face value yields 4D A">. Assuming annual coupon payment& calculate the price of the bond. A) C17/1./B) C5/1.51 C) C1777.77 D) C4/2.51 Answer A Type ,edium "age -2 >esponse ". E ?177F1.74) G ?177F?1.74P$)) G ?1177F?1.74P#)) E C17/1.//2. A three*year bond has 4.7D coupon rate and face value of C1777. :f the yield to maturity on the bond is 17D& calculate the price of the bond assuming that the bond makes semi*annual coupon interest payments. A) C5-5.$B) C4/2.51 C) C17/2./D) C1777.77 Answer A Type Difficult "age -2 >esponse ". E ?-7F1.7/) G ?-7F?1.7/P$)) G. . . G ?17-7F?1.7/P1)) E C5-5.$-

-/

/4. A four*year bond has an 4D coupon rate and a face value of C1777. :f the current price of the bond is C424.#1& calculate the yield to maturity of the bond ?assuming annual interest payments). A) 4D B) 1$D C) 17D D) 1D Answer B Type Difficult "age -4 >esponse (se trial and error method. ?47F1.1$) G ?47F?1.1$P$)) G ?47F?1.1$P#)) G ?1147F ?1.1$P-)) E C427./1. Therefore& yield to maturity is 1$D. 9r use a financial calculator ". E *424.#1A 6 E -A ",T E 47A %. E 1777A C9,"(T! : E 1$D True/False Questions T % /5. The two*year discount factor must be greater than the one*year discount factor for a given discount rate. Answer %alse Type !asy "age #-

% 17. %orward rate cannot be negative. Answer True Type ,edium "age #/

% 11. :f the term structure of interest rate is flat the nine*year interest rate is e<ual to the ten* year interest rate. Answer True Type ,edium "age #/

% 1$. The rate of return on a perpetuity is e<ual to the cash flow divided by the price. Answer True Type ,edium "age #2

-1

% 1#. :n the case of a growing perpetuity& the present value of the cash flow is given by IC1F?r*g)J where rLg. Answer True Type Difficult "age #4

% 1-. An e<ual*payment home mortgage is an e'ample of an annuity. Answer True Type ,edium "age #4

% 1/. The value of a five*year annuity is e<ual to the sum of two perpetuities. 9ne makes its first payment in year 1& and the other makes its first payment in year 1. Answer %alse Type Difficult "age #4

% 11. Compound interest assumes that you are reinvesting the interest payments at the rate of return. Answer True Type ,edium "age -7

% 12. The relationship between nominal interest rate and real interest rate is given by 1 G rnominal E ?1 G rreal)?1Ginflation rate) Answer True Type ,edium "age -1

% 14. :n the ()& most bonds make coupon payments annually. Answer %alse Type !asy "age -2

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Short Answer Questions 15. Discuss why a dollar tomorrow cannot be worth less than a dollar the day after tomorrow. Answer :f a dollar tomorrow is worth less than a dollar a day after tomorrow& it would be possible to earn a very large amount of money through =money machine= effect. This is only possible& if someone else is losing a very large amount of money. These conditions can only e'ist for a short period of time& and cannot e'ist in e<uilibrium as the source of money is <uickly e'hausted. Thus a dollar tomorrow cannot be worth less than a dollar the day after tomorrow. Type Difficult "age #-

27. Define the concept of the term structure of interest rates. Answer The relationship between the interest rates and maturity is called the term structure of interest rates. Type ,edium "age #/

21. Define the term =perpetuity.= Answer A perpetuity is defined as the same cash flow each year occurring forever. Type ,edium "age #2

2$. )tate the assumption re<uired for using the formula for the present value of a growing perpetuity. Answer Be have to assume that the growth rate is less than the discount rate. Then only we get reasonable values for the present value of a growing perpetuity. 9therwise the formula will not work. Type Difficult "age #2

2#. Bhat algebraic techni<ue is used to find the present value of a perpetuity and the present value of an annuityH Answer The techni<ue is called the sum of a geometric series. This is a standard algebraic techni<ue. Type Difficult "age #2

-4

2-. Bhat is the difference between simple interest and compound interestH Answer Bhen money is invested at compound interest& each interest payment is reinvested to earn more interest in subse<uent periods. :n the simple interest case& the interest is paid only on the initial investment. Type ,edium "age -7

2/. Briefly e'plain& =continuous compounding.= Answer As fre<uency of compounding is increases& the effective rate on an investment also increases. :n case of continuous compounding the fre<uency of compounding is infinity. :n this case& the nature of the function also changes. The effective interest rate is given by ?e r T1)& where the value of e E $.214. e is the base for natural logarithms. Type Difficult "age -#

21. Define the terms& =real interest rate.= Answer >eal interest rate is the inflation adKusted nominal interest rate. Be do not observe this directly. The relationship between the two is given by 1 G r nominal E ?1 G rreal rate)?1Ginflation rate). ?An appro'imate formula that works for low values is r nominal E rreal rate G :nflation rate) Type ,edium "age -/

22. Define the term =nominal interest rate.= Answer 6ominal interest rate is what we observe in the market. !'pected inflation rate is incorporated into the nominal interest rate. The relationship between the two is given by 1 G rnominal E ?1 G rreal rate)?1Ginflation rate). ?An appro'imate formula that works for low values is r nominal E rreal rate G :nflation rate) Type ,edium "age -/

24. Discuss the importance of taking inflation into consideration when making financial decisions. Answer %inancial decisions involve money& and inflation reduces the purchasing power of money. )o inflation is a critical element of financial decisions. Type ,edium "age -/

-5

25. Briefly e'plain the cash flows associated with a bond to the investor Answer Bonds provide two types of cash flows interest payments and the principal payment. :nterest payments occur each period& usually annually or semi*annually. "eriodic interest payments are also called coupon payments. Thus this forms an annuity. "rincipal payment occurs at the time of maturity of the bond and is a lump sum payment. Type !asy "age -2

47. Define the term =yield to maturity= of a bond. Answer 8ield to maturity is the effective interest rate on the bond. :t is the rate used for discounting the cash flows from a bond. As yield to maturity increases the price of a bond falls and vice*versa. Type ,edium "age -4

41. Bhat is the relationship between the price and the yield to maturity of a bondH Answer The relationship between the price and the yield to maturity of a bond is an inverse one. As yield to maturity increases the price of a bond falls and vice*versa. Type ,edium "age -4

/7