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CFIN4
Chapter 5 – The Cost of Money (Interest Rates)
1. The nominal rate of interest is defined as the sum of the nominal risk-free rate of return and the expected inflation
rate.
a. True
b. False
2. If the Federal Reserve tightens the money supply, other things held constant, short-term interest rates will be pushed
upward, and this increase probably will be greater than the increase in rates in the long-term market.
a. True
b. False
3. The term structure is defined as the relationship between interest rates and maturities of similar securities.
a. True
b. False
4. During or near peaks of business activity, yield curves that are flat or downward sloping (possibly with humps) often
are prevalent.
a. True
b. False
CFIN4
Chapter 5 – The Cost of Money (Interest Rates)
5. The expectations theory postulates that the term structure of interest rates is based on expectations regarding future
inflation rates.
a. True
b. False
6. The fact that a percentage of the interest income received by one corporation is excluded from taxable income has
encouraged firms to use more debt financing relative to equity financing.
a. True
b. False
7. If the tax laws stated that $0.50 out of every $1.00 of interest paid by a corporation was allowed as a tax-deductible
expense, it would probably encourage companies to use more debt financing than they presently do, other things held
constant.
a. True
b. False
8. The real rate of interest is composed of a risk-free rate of interest plus a premium that reflects the riskiness of the
security.
a. True
b. False
CFIN4
Chapter 5 – The Cost of Money (Interest Rates)
9. The yield curve is downward sloping, or inverted, if the long-term rates are higher than the short-term rates.
a. True
b. False
10. The liquidity preference theory states that each borrower and lender has a preferred maturity and that the slope of
the yield curve depends on supply and demand for funds in the long-term market relative to the short-term market.
a. True
b. False
11. If you have information that a recession is ending, and the economy is about to enter a boom, and your firm needs to
borrow money, it should probably issue long-term rather than short-term debt.
a. True
b. False
12. The two reasons most experts give for the existence of a positive maturity risk premium are (1) because investors
are assumed to be risk averse, and (2) because investors prefer to lend long while firms prefer to borrow short.
a. True
b. False
CFIN4
Chapter 5 – The Cost of Money (Interest Rates)
13. An investor with a six-year investment horizon believes that interest rates are determined only by expectations about
future interest rates, (i.e., this investor believes in the expectations theory). This investor should expect to earn the
same rate of return over the 6-year time horizon if he or she buys a 6-year bond or a 3-year bond now and another
3-year bond three years from now (ignore transaction costs).
a. True
b. False
14. The existence of an upward sloping yield curve proves that the liquidity preference theory is correct, because an
upward sloping curve necessarily implies that firms must offer a maturity risk premium in order to induce investors to
lend for longer periods.
a. True
b. False
15. Suppose financial institutions, such as savings and loans, were required by law to make long-term, fixed interest rate
mortgages, but, at the same time, were largely restricted, in terms of their capital sources, to deposits that could be
withdrawn on demand. Under these conditions, these financial institutions should prefer a "normal" yield curve to an
inverted curve.
a. True
b. False
16. Investors with a higher time preference for consumption will demand a lower rate of return to forego current
consumption and save than investors with a lower time preference for consumption.
a. True
b. False
CFIN4
Chapter 5 – The Cost of Money (Interest Rates)
17. Firms with the most profitable investment opportunities are willing and able to pay the most for capital, so they tend
to attract it away from less efficient firms or from those whose products are not in demand.
a. True
b. False
18. Bonds with higher liquidity will demand higher interest rates in the market since they can be easily converted into
cash on short notice at or near the fair market value for that bond.
a. True
b. False
19. Which of the following statements is most correct? Other things held constant.
a. the "liquidity preference theory" would generally lead to an upward sloping yield curve.
b. the "market segmentation theory" would generally lead to an upward sloping yield curve.
c. the "expectations theory" would generally lead to an upward sloping yield curve.
d. the yield curve under "normal" conditions would be horizontal (i.e., flat).
e. a downward sloping yield curve would suggest that investors expect interest rates to increase in the future.
CFIN4
Chapter 5 – The Cost of Money (Interest Rates)
20. Your uncle would like to restrict his interest rate risk and his default risk, but he still would like to invest in corporate
bonds. Which of the possible bonds listed below best satisfies your uncle's criteria?
a. AAA bond with 10 years to maturity.
b. BBB perpetual bond.
c. BBB bond with 10 years to maturity.
d. AAA bond with 5 years to maturity.
e. BBB bond with 5 years to maturity.
21. If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury coupon bond, relative to
that on a 1-year T-bond?
a. The yield on the 10-year bond is less than the yield on a 1-year bond.
b. The yield on a 10-year bond will always be higher than the yield on a 1-year bond because of maturity
premiums.
c. It is impossible to tell without knowing the coupon rates of the bonds.
d. The yields on the two bonds are equal.
e. It is impossible to tell without knowing the relative risks of the two bonds.
22. If the expectations theory of the term structure of interest rates is correct, and if the other term structure theories
are invalid, and we observe a downward sloping yield curve, which of the following is a true statement?
a. Investors expect short-term rates to be constant over time.
b. Investors expect short-term rates to increase in the future.
c. Investors expect short-term rates to decrease in the future.
d. It is impossible to say unless we know whether investors require a positive or negative maturity risk premium.
e. The maturity risk premium must be positive.
CFIN4
Chapter 5 – The Cost of Money (Interest Rates)
23. Which of the following statements is correct?
a. For the most part, our federal tax rates are progressive, because higher incomes are taxed at higher average
rates.
b. Bonds issued by a municipality such as the city of Miami would carry a lower interest rate than bonds with the
same risk and maturity issued by a private corporation such as Florida Power & Light.
c. Our federal tax laws tend to encourage corporations to finance with debt rather than with equity securities.
d. Our federal tax laws encourage the managers of corporations with surplus cash to invest it in stocks rather
than in bonds. However, other factors may offset tax considerations.
e. All of the above statements are true.
24. Which of the following is not one of the four fundamental factors that affect the cost of money?
a. production opportunities
b. time preferences for consumption
c. risk
d. liquidity
e. inflation
25. Interest rates on 1-year, 2-year, and 3-year Treasury bills are 5%, 6%, and 7% respectively. Assume that the pure
expectations theory holds and that the market is in equilibrium. Which of the following statements is most correct?
a. The maturity risk premium is positive.
b. Interest rates are expected to rise over the next two years.
c. The market expects one-year rates to be 5.5% one year from today.
d. Answers a, b, and c are all correct.
e. Only answers b and c are correct.
26. If the Federal Reserve sells $50 billion of short-term U.S. Treasury securities to the public, other things held
constant, what will this tend to do to short-term security prices and interest rates?
a. Prices and interest rates will both rise.
b. Prices will rise and interest rates will decline.
c. Prices and interest rates will both decline.
d. Prices will decline and interest rates will rise.
e. There will be no changes in either prices or interest rates.
CFIN4
Chapter 5 – The Cost of Money (Interest Rates)
27. Assume that the current yield curve is upward sloping, or normal. This implies that
a. Short-term interest rates are more volatile than long-term rates.
b. Inflation is expected to subside in the future.
c. The economy is at the peak of a business cycle.
d. Long-term bonds are a better buy than short-term bonds.
e. None of the above statements is necessarily implied by the yield curve given.
28. Which of the following statements is correct?
a. The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the
fact that the probability of default is higher on long-term bonds than on short-term bonds.
b. Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds.
c. According to the market segmentation theory of the term structure of interest rates, we should normally
expect the yield curve to slope downward.
d. The expectations theory of the term structure of interest rates states that borrowers generally prefer to
borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and that as a result,
the yield curve normally is upward sloping.
e. If the maturity risk premium was zero and the rate of inflation was expected to decrease in the future, then
the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope.
CFIN4
Chapter 5 – The Cost of Money (Interest Rates)
29. Allen Corporation can (1) build a new plant which should generate a before-tax return of 11 percent, or (2) invest
the same funds in the preferred stock of FPL, which should provide Allen with a before-tax return of 9%, all in the
form of dividends. Assume that Allen's marginal tax rate is 25 percent, and that 70 percent of dividends received are
excluded from taxable income. If the plant project is divisible into small increments, and if the two investments are
equally risky, what combination of these two possibilities will maximize Allen's effective return on the money
invested?
a. All in the plant project.
b. All in FPL preferred stock.
c. 60% in the project; 40% in FPL.
d. 60% in FPL; 40% in the project.
e. 50% in each.
30. The normal yield curve is upward sloping implying that
a. the return on short-term securities are higher than the return on long-term securities of similar risk.
b. the return on long-term securities are equal to the return on short-term securities of similar risk.
c. the return on short-term securities are lower than the return on long-term securities of similar risk.
d. the return on bonds with a higher default risk is higher than the returns on bonds with lower default risk.
e. the return on bonds with a lower default risk is higher than the returns on bonds with higher default risk.
CFIN4
Chapter 5 – The Cost of Money (Interest Rates)
31. Carter Corporation has some money to invest, and its treasurer is choosing between City of Chicago municipal bonds
and U.S. Treasury bonds. Both have the same maturity, and they are equally risky and liquid. If Treasury bonds yield
6 percent, and Carter's marginal income tax rate is 40 percent, what yield on the Chicago municipal bonds would
make Carter's treasurer indifferent between the two?
a. 2.40%
b. 3.60%
c. 4.50%
d. 5.25%
e. 6.00%
32. As a corporate investor paying a marginal tax rate of 34 percent, if 70 percent of dividends are excludable, what
would be your after-tax dividend yield on preferred stock with a 16 percent before-tax dividend yield?
a. 6.36%
b. 7.36%
c. 12.19%
d. 13.01%
e. 14.37%
