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mtexam1_f10_soln - Midterm Exam#1 Solutions Finance 325...

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1 Midterm Exam #1 – Solutions Finance 325 September 28, 2010 Name: Exam Instructions: This exam should have 6 pages (including this one) and 5 questions. The point value is given for each problem. The entire exam is worth 100 points. You may use a calculator and the provided formula sheet on this exam. You must show your work in order to receive credit for your answers. Partial credit will be given for partially correct answers. If a question asks “Why/Explain”, you should give an explanation that would convince a skeptic. You may use the back of a page if you need additional space to write an answer. Suggestions: Use your time wisely. Move on to another problem if you feel like you’re stuck. You may ask me questions if you are unclear about a problem. I may be able to clarify the problem for you. GOOD LUCK!!
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2 Throughout the exam, assume that inflation is 4.8% APR, compounded monthly. 1. Explain why the yield curve is usually upward-sloping. (12 pts) There are 3 reasons why interest rates differ depending on maturity: 1) Future interest rates may be expected to be higher or lower than current interest rates 2) Longer-term interest rates subject investors to more interest rate risk. Due to this risk, long-term interest rates are higher than short-term interest rates. This is called the term premium. 3) Investors prefer to invest in shorter-term (more liquid) investments, while borrowers prefer to borrow for longer-term periods. Thus, long-term rates are higher than short- term rates to entice investors to lend for longer periods. This is called the liquidity premium. The term premium and liquidity premium are always present and cause the yield curve to be upward-sloping most of the time. 2. Schweitzer Engineering is considering a perpetual sponsorship deal with WSU to advertize at every home Apple Cup (in other words, every other year and lasting forever.) The deal would start this year, and would involve Schweitzer paying $50,000 this year for the rights to paint their corporate logo on the field at Martin Stadium for the 2010 game. As part of the negotiations, the cost (per-game) will not increase in the future. Schweitzer’s cost of capital is a nominal rate of 6%, compounded annually. What is the PV of this deal to Schweitzer? (8 pts) The cash flows of this investment are: Today (2010) 2011 2012 2013 2014 2015 2016 50,000 50,000 50,000 50,000 This is a regular perpetuity, but the period between cash flows is 2 years. Thus, we need the discount rate that accrues over a 2 – year period: ࢘ ൌ ሺ૚ ൅ ૙. ૙૟ሻ
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mtexam1_f10_soln - Midterm Exam#1 Solutions Finance 325...

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