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 upwardsloping.
(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)
Longerterm interest rates subject investors to more interest rate risk.
Due to this risk,
longterm interest rates are higher than shortterm interest rates.
This is called the
term premium.
3)
Investors prefer to invest in shorterterm (more liquid) investments, while borrowers
prefer to borrow for longerterm periods.
Thus, longterm 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
upwardsloping 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 (pergame) 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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 Winter '09
 FREEDMAN
 Finance, Inflation, Time Value Of Money, college fund

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