Answered Midterm Exam - Here are the answers to the...

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Here are the answers to the mid-term 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 4-year bonds currently yield 7.4 percent. The real risk-free 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 7-year bond for Drongo Corporation? The MRP for the 4-year bond is 0.1%(4 - 1) = 0.3%. Find the 4-year IP as 7.4% = 2.7% + 0.3% + 0.9% + IP 4 , or IP 4 = 3.5%. Calculate the 7-year IP as [3.5%(4) + 5%(3)]/7 = 4.14%. The MRP for the 7-year bond is 0.1%(7 - 1) = 0.6%. Finally, the yield on the 7-year bond is 2.7% + 0.6% + 0.9% + 4.14% = 8.34%. 3. You read in The Wall Street Journal that 30-day T-bills are currently yielding 8 percent. Your brother-in-law, 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 risk-free rate of return? T-bill 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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This note was uploaded on 11/22/2009 for the course HR GM600 taught by Professor Na during the Spring '09 term at Keller Graduate School of Management.

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Answered Midterm Exam - Here are the answers to the...

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