978-0134476308 Test Bank Chapter 6 Part 1

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Principles of Managerial Finance, Brief Ed., 8e (Zutter/Smart)

Chapter 6 Interest Rates and Bond Valuation

6.1 Interest rates and required returns

1) An interest rate or a required rate of return represents the cost of money.

2) A real rate of interest is the compensation paid by the borrower of funds to the lender

measured in today’s dollars.

3) A nominal rate of interest is approximately equal to the sum of the real rate of interest plus the

risk free rate of interest.

4) The nominal interest rate on a risk-free investment is approximately equal to the sum of the

real rate of interest plus an inflation premium.

5) The nominal interest rate on a risky investment equals the risk-free rate plus a risk premium.

6) The nominal rate of interest on a bond is 8% and the expected inflation premium is 4%. This

results in an approximate real rate of interest of 4% on the bond.

7) Historically, the rate of return on U.S. Treasury bills is usually greater than the rate of

inflation.

8) The nominal rate of interest is the actual rate of interest charged by the supplier of funds and

paid by demander.

9) The term structure of interest rates is a graphical presentation of the relationship between the

maturity and rate of return.

10) An inverted yield curve is a downward-sloping yield curve that indicates that short-term

interest rates are generally higher than long-term interest rates.

11) A yield curve that reflects relatively similar borrowing costs for both short- and long-term

loans is called a normal yield curve.

12) Upward-sloping yield curves result from higher future inflation expectations, lender

preferences for shorter maturity loans, and greater supply of short-term as opposed to long-term

loans relative to their respective demand.

13) A flat yield curve means that the rates do not vary much at different maturities.

14) A normal yield curve is upward-sloping and indicates generally cheaper short-term

borrowing costs than long-term borrowing costs.

15) A flat yield curve indicates generally cheaper long-term borrowing costs than short-term

borrowing costs.

16) The market segmentation theory suggests that the shape of the yield curve is determined by

the supply and demand for funds within each maturity segment.

17) The liquidity preference theory suggests that the shape of the yield curve is determined by

the supply and demand for funds within each maturity segment.

18) The liquidity preference theory suggests that short-term interest rates should be lower than

long-term interest rates most of the time.

19) The expectations theory suggests that the shape of the yield curve reflects investors

expectations about future interest rates.

20) A downward-sloping yield curve indicates generally cheaper short-term borrowing costs than

long-term borrowing costs.

21) An inverted yield curve is an upward-sloping yield curve that indicates generally cheaper

short-term borrowing costs than long-term borrowing costs.

22) The liquidity preference theory suggests that long-term interest rates tend to be higher than

short-term rates (and therefore the yield curve slopes up) due to the lower liquidity and higher

responsiveness to general interest rate movements of longer-term securities.

23) The components of risk premium includes business risk, financial risk, interest rate risk,

liquidity risk, and tax risk.

24) The possibility that the issuer of a bond will not pay the contractual interest or principal

payments as scheduled is called maturity risk.

25) The possibility that the issuer of a bond will not pay the contractual interest or principal

payments as scheduled is called default risk.

26) The ________ rate of interest is the rate that balances the supply of savings and the demand

for investment funds.

A) Nominal

B) Real

C) Risk-free

D) Equilibrium

27) Generally, an increase in risk will result in ________.

A) a lower required return or interest rate

B) a higher required return or interest rate

C) a higher inflation premium

D) a lower real interest rate

28) Although no investment is truly risk free, ________ are generally viewed as the closest thing

we can come to in the real world to a risk-free investment.

A) U.S. Treasury securities

B) AAA-rated corporate bonds

C) secured bonds

D) zero-coupon bonds

29) Ai Lun, a management trainee at a large New York-based bank, is trying to estimate the real

rate of return expected by investors. He notes that the 3-month T-bill currently yields 3 percent,

and consumer prices have been rising steadily at a 2% rate for several years. What should Ai

Lun’s estimate of the real rate be?

A) 5%

B) 1%

C) 3%

D) 2%

30) Nico invested an amount a year ago and calculated his return on investment. He found that

his purchasing power had increased by 15 percent as a result of his investment. If inflation

during the year was 4 percent, then Nico’s ________.

A) real return on investment is more than 15 percent

B) nominal return on investment is more than 15 percent

C) nominal return on investment is less than 11 percent

D) real return on investment is equal to 4 percent

31) The ________ rate of interest is the actual rate charged by the supplier and paid by the

demander of funds.

A) Nominal

B) Real

C) Risk-free

D) Inflationary

32) The ________ is the compound annual rate of interest earned on a debt security purchased on

a given date and held to maturity.

A) risk premium

B) yield curve

C) risk-free rate

D) yield to maturity

33) A(n) ________ is a graphic depiction of the relation between the maturity and rate of return

for bonds with similar risks.

A) yield curve

B) supply function

C) risk-return profile

D) aggregate demand curve

34) According to the expectations hypothesis, a(n) ________ yield curve reflects higher expected

future rates of interest.

A) upward-sloping

B) flat

C) downward-sloping

D) linear

35) According to the expectations hypothesis, a(n) ________ yield curve reflects lower expected

future rates of interest.

A) upward-sloping

B) flat

C) downward-sloping

D) linear

36) The term structure of interest rates is the relationship between ________.

A) the present value of principal and coupon rate of the bonds

B) the general expectation of inflation and nominal rate of return for bonds

C) the general expectation of inflation and real rate of return for bonds

D) the maturity and rate of return for bonds with similar level of risk

37) A downward-sloping yield curve that indicates generally cheaper long-term borrowing costs

than short-term borrowing costs is called ________.

A) normal yield curve

B) inverted yield curve

C) flat yield curve

D) linear yield curve

38) An upward-sloping yield curve that indicates cheaper short-term borrowing costs than long-

term borrowing costs is called as ________.

A) normal yield curve

B) inverted yield curve

C) flat yield curve

D) lognormal yield curve

39) A yield curve that reflects relatively similar borrowing costs for both short-term and long-

term loans is called as ________.

A) normal yield curve

B) inverted yield curve

C) flat yield curve

D) lognormal curve

40) The theory suggesting that for any given issuer, long-term interest rates tends to be higher

than short-term rates is called ________.

A) expectation hypothesis

B) liquidity preference theory

C) market segmentation theory

D) interest parity theory

41) Which of the following explains the general shape of the yield curve?

A) Expectations theory

B) Perfect market theory

C) Capital asset pricing theory

D) Securities market theory

42) Assume the following returns and yields: U.S. T-bill = 8%, 5-year U.S. T-note = 7%, IBM

common stock = 15%, IBM AAA Corporate Bond = 12% and 10-year U.S. T-bond = 6%. Based

on this information, the shape of the yield curve is ________.

A) upward sloping

B) downward sloping

C) flat

D) normal

43) ________ mainly explains the tendency for the yield curve to be upward sloping.

A) Expectations theory

B) Liquidity preference theory

C) Market segmentation theory

D) Investor perception theory

44) Which of the following affects the slope of yield curve?

A) tax rates

B) dividend policy

C) selection of accounting standards

D) liquidity preferences

45) Which of the following is TRUE of the risk premium?

A) T-bills have a have a higher risk premium compared with Treasury bonds.

B) Government bonds have a higher risk premium compared with corporate bonds.

C) Junk bonds have a lower risk premium investment-grade bonds.

D) The lower-rated corporate issues have a higher risk premium than that of the higher rated

corporate issues.

46) Current interest rates on bonds of different maturities look like this:

Maturity Rate

1-year 2.50%

2-year 2.75%

3-year 3.00%

If the expectations hypothesis is true, what interest rate would you expect a 1-year bond to pay, 2

years from now?

Answer: The expectations hypothesis says that the equilibrium in the bond market is such that

investors earn the same expected return over a given time horizon whether they buy a single

long-term bond or a sequence of short-term bonds. In this example, suppose an investor buys a 3-

year bond. Their total return will be (1.03)3 – 1 = 9.2727%. Or to say this another way, $1

invested in the 3-year bond will grow to $1(1.03)3 = $1.092727 over 3 years.

Suppose instead that an investor buys a 2-year bond and then when that bond matures, the

investor buys a brand new 1-year bond. It is the rate on this second bond that the question is

asking about….what is the rate on a 1-year bond, 2 years from now? The expectations hypothesis

says that the investor who buys the 2-year bond today and then buys another 1-year bond should

earn the same return as an investor who buys the 3-year bond today. Both investors are investing

over a 3-year horizon, and they should earn the same return no matter what type of bonds they

hold over that horizon. So let E(r) be the expected return on the 1-year bond, two years from

now. The investor who buys the 2-year bond today and then the 1-year bond after that will earn

the following return:

(1.0275)2 × (1+E(r)) – 1

Or we could say that $1 invested in this way will grow to $1(1.0275)2(1+E(r)) over the 3 years.

But as already stated, this has to equal what the other investor earns, so equating the returns from

the two strategies we have

(1.0275)2(1+(E(r)) = 1.092727

Solve for E(r) and you obtain 3.50%.

Here’s an intuitive way to get this answer.

For simplicity, ignore compounding for a moment. “Investor A” buys the 3-year bond paying 3%

and earns 9% over 3 years. “Investor B” buys the 2-year bond and earns 5.5% over 2 years

(2.75% per year for 2 years). How much does Investor B need to earn in the 3rd year to get the

same return that Investor A earned? The answer is 3.5% because Investor B earns 2.75% +

2.75% + 3.5% = 9%, the same as Investor A. Because we have ignored compounding, the math

here should be considered as an approximate solution, but as you can see, the answer is nearly

the same (i.e., the same to two decimal places) as the answer we obtained by doing math that did

not ignore compounding.

Diff: 3

Topic: Term Structure of Interest Rates

Learning Obj.: LG 1

Learning Outcome: F-05

AACSB: Analytical Thinking

47) Draw a graph of a typical Treasury yield curve and discuss why it usually takes that shape.

48) Current interest rates on bonds of different maturities look like this:

Maturity Rate

1-year 2.50%

2-year 2.75%

3-year 3.00%

If the expectations hypothesis is true, what interest rate would you expect a 2-year bond to pay, 1

year from now?

Answer: The expectations hypothesis says that the equilibrium in the bond market is such that

investors earn the same expected return over a given time horizon whether they buy a single

long-term bond or a sequence of short-term bonds. In this example, suppose an investor buys a 3-

year bond. Their total return will be (1.03)3 – 1 = 9.2727%. Or to say this another way, $1

invested in the 3-year bond will grow to $1(1.03)3 = $1.092727 over 3 years.

Suppose instead that an investor buys a 1-year bond and then when that bond matures, the

investor buys a brand new 2-year bond. It is the rate on this second bond that the question is

asking about….what is the rate on a 2-year bond, 1 year from now? The expectations hypothesis

says that the investor who buys the 1-year bond today and then buys another 2-year bond should

earn the same return as an investor who buys the 3-year bond today. Both investors are investing

over a 3-year horizon, and they should earn the same return no matter what type of bonds they

hold over that horizon. So let E(r) be the annual expected return on the 2-year bond, two years

from now. The investor who buys the 1-year bond today and then the 2-year bond after that will

earn the following return:

(1.025) × (1+E(r))2 – 1

Or we could say that $1 invested in this way will grow to $1(1.025)(1+E(r))2 over the 3 years.

But as already stated, this has to equal what the other investor earns, so equating the returns from

the two strategies we have

(1.025)(1+(E(r))2 = 1.092727

Solve for E(r):

(1+E(r))2 = 1.0927/1.025

1 + E(r) = (1.092727/1.025)(0.5)

E(r) = 0.0325 = 3.25%

Here’s an intuitive way to get this answer.

For simplicity, ignore compounding for a moment. “Investor A” buys the 3-year bond paying 3%

and earns 9% over 3 years. “Investor B” buys the 1-year bond and earns 2.5%. How much does

Investor B need to earn in the next 2 years to get the same return that Investor A earned? The

answer is 3.25% because Investor B earns 2.5% + 3.25% + 3.25% = 9%, the same as Investor A.

Because we have ignored compounding, the math here should be considered as an approximate

solution, but as you can see, the answer is nearly the same (i.e., the same to two decimal places)

as the answer we obtained by doing math that did not ignore compounding.

Diff: 3

Topic: Term Structure of Interest Rates

Learning Obj.: LG 1

Learning Outcome: F-05

AACSB: Analytical Thinking

49) Suppose the expectations hypothesis is true. The interest rate on a bond maturing in one year

is 2%, and the interest rate on a bond maturing in two years is 3%. The interest rate that investors

expect next year on a one-year bond is ________.

A) 2%

B) 3%

C) 4%

D) 5%

50) Jeff is trying to forecast what the annual interest rate on a three-year bond will be two years

from now, and he believes that the expectations hypothesis is the basis upon which he should

build his forecast. Currently the rates of return on bonds of different maturities look like this:

Maturity Rate

1-year 3.00%

2-year 3.50%

3-year 3.75%

4-year 4.00%

5-year 4.00%

Based on the expectations hypothesis, what forecast should Jeff make for the return on a three-

year bond, two years in the future?

A) 4.0%

B) 4.25%

C) 4.33%

D) 13%

51) Suppose the expectations hypothesis is true. The current rate of return on a one-year bond is

3%, and the current rate of return on a 2-year bond is 2.5%. What is the expected rate of return

next year on a one-year bond?

A) 2%

B) 0.5%

C) 1.5%

D) 1%

52) Suppose the expectations hypothesis is true. If the yield curve is flat this means that

________.

A) investors do not expect interest rates to change in the future

B) investors expect interest rates to rise in the future

C) investors expect interest rates to fall in the future

D) investors do not require a premium for expected inflation

53) Explain liquidity risk, default risk, and interest rate risk.

6.2 Government and corporate bonds

1) The coupon rate on a bond represents the percentage of the bond’s par value that will be paid

annually, typically in two equal semiannual payments, as interest.

2) Restrictive covenants are contractual clauses in long-term debt agreements that place certain

operating and financial constraints on the borrower.

3) The reason for a difference in the yield between a Aaa corporate bond and an otherwise

identical Baa bond is the risk premium; other things being equal.

4) Standard debt provisions specify certain record keeping and general business practices that

must be followed by the bond issuer.

5) A trustee is a paid party representing the bond issuer in the bond indenture.