Here are the answers to the midterm exam. Note that the answers are highlighted
in blue.
1.
What should be the primary objective of a firm? Is this goal inconsistent with a
desire to advance society? How does meeting the objective that you listed above
help advance the welfare of all of society?
a.
The primary objective of the firm is to maximize the wealth of the
shareholders.
b.
Yes, for multiple reasons. First, the shareholders
are society
– that is, most
people own stock either directly or indirectly through pension plans. As a
result, maximizing stockholder wealth also maximizes societal wealth.
Second, in order to maximize shareholder wealth, firms must develop new
ideas and new technology, and this benefits society.
2.
Drongo Corporation’s 4year bonds currently yield 7.4 percent.
The real riskfree
rate of interest, r*, is 2.7 percent and is assumed to be constant.
The maturity risk
premium (MRP) is estimated to be 0.1%(t  1), where t is equal to the time to
maturity.
The default risk and liquidity premiums for this company’s bonds total
0.9 percent and are believed to be the same for all bonds issued by this company.
If the average inflation rate is expected to be 5 percent for years 5, 6, and 7, what
is the yield on a 7year bond for Drongo Corporation?
The MRP for the 4year bond is 0.1%(4  1) = 0.3%.
Find the 4year IP as 7.4% =
2.7% + 0.3% + 0.9% + IP
4
, or IP
4
= 3.5%.
Calculate the 7year IP as [3.5%(4) +
5%(3)]/7 = 4.14%.
The MRP for the 7year bond is 0.1%(7  1) = 0.6%.
Finally,
the yield on the 7year bond is 2.7% + 0.6% + 0.9% + 4.14% = 8.34%.
3.
You read in
The Wall Street Journal
that 30day Tbills are currently yielding 8
percent.
Your brotherinlaw, a broker at Kyoto Securities, has given you the
following estimates of current interest rate premiums:
Inflation premium
5%
Liquidity premium
1%
Maturity risk premium
2%
Default risk premium
2%
Based on these data, what would you estimate as the real riskfree rate of return?
Tbill rate = r* + IP
8% = r* + 5%
r* = 3%.
4.
You can earn 8 percent interest, compounded annually.
How much must you
deposit today to withdraw $10,000 in 6 years?
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Time Line:
0
1
2
3
4
5
6
Years
8%
├──────

───┼────

─────┼────────┼─────────┼─────────┼────────┤
PV = ?
FV = 10,000
Numerical solution:
PV = $10,000 /(1.08
6
) = $10,000 /(1.5869) = $6,301.70.
Financial calculator solution:
Inputs: N = 6; I = 8; PMT = 0; FV = 10,000.
Output: FV = $6,301.70.
5.
Suppose you invested $1,000 in stocks 10 years ago.
If your account is now
worth $2,839.42, what rate of return did your stocks earn?
Time Line:
0
i = ?
1
10
├──────────────┼────────
·· ·
─────────┤
1,000
2,839.42
Numerical solution:
$2,839.42 = $1,000(1+i)
10
(1+i)
10
=2,839.42/1,000=2.8394
(1+i)=2.8394
(1/10)
= 1.11
i
≈
11%.
Financial calculator solution:
Inputs: N = 10; PV = 1,000; PMT = 0; FV = 2,839.42.
Output: I =
11.0%.
6.
Assume that you will receive $2,000 a year in Years 1 through 5, $3,000 a year in
Years 6 through 8, and $4,000 in Year 9, with all cash flows to be received at the
end of the year.
If you require a 14 percent rate of return, what is the present
value of these cash flows?
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 Spring '09
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 Interest, Net Present Value, Risk premium

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