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Chapter 5 – The Cost of Money (Interest Rates)
33. Treasury securities that mature in 6 years currently have an interest rate of 8.5%. Inflation is expected to be 5%
each of the next three years and 6% each year after the third year. The maturity risk premium is estimated to be
0.1%(t − 1), where t is equal to the maturity of the bond (i.e., the maturity risk premium of a one–year bond is zero).
The real risk-free rate is assumed to be constant over time. What is the real risk-free rate of interest?
a. 0.25%
b. 0.50%
c. 1.00%
d. 1.75%
e. 2.50%
34. Assume that the expectations theory holds, and that liquidity and maturity risk premiums are zero. If the annual rate
of interest on a 2-year Treasury bond is 10.5 percent and the rate on a 1-year Treasury bond is 12 percent, what
rate of interest should you expect on a 1-year Treasury bond one year from now?
a. 9.0%
b. 9.5%
c. 10.0%
d. 10.5%
e. 11.0%
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Chapter 5 – The Cost of Money (Interest Rates)
35. Assume that expected rates of inflation over the next 5 years are 4 percent, 7 percent, 10 percent, 8 percent, and 6
percent, respectively. What is the average expected inflation rate over this 5-year period?
a. 6.5%
b. 7.5%
c. 8.0%
d. 6.0%
e. 7.0%
36. Your corporation has the following cash flows:
Operating income
$250,000
Interest received
10,000
Interest paid
45,000
Dividends received
20,000
Dividends paid
50,000
If the applicable income tax rate is 40 percent, and if 70 percent of dividends received are exempt from taxes, what
is the corporation’s tax liability?
a. $74,000
b. $88,400
c. $91,600
d. $100,000
e. $106,500
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Chapter 5 – The Cost of Money (Interest Rates)
37. Assume that r* = 1.0%; the maturity risk premium is found as MRP = 0.2%(t − 1) where t = years to maturity; the
default risk premium for AT&T bonds is found as DRP = 0.07%(t − 1); the liquidity premium is 0.50% for AT&T
bonds but zero for Treasury bonds; and inflation is expected to be 7%, 6%, and 5% during the next three years and
then 4% thereafter. What is the difference in interest rates between 10-year AT&T bonds and 10-year Treasury
bonds?
a. 0.25%
b. 0.50%
c. 0.63%
d. 1.00%
e. 1.13%
38. You are given the following data:
r* = real risk-free rate
4%
Constant inflation premium
7%
Maturity risk premium
1%
Default risk premium for AAA bonds
3%
Liquidity premium for long-term T-bonds
2%
Assume that a highly liquid market does not exist for long-term T-bonds, and the expected rate of inflation is a
constant. Given these conditions, the nominal risk-free rate for T-bills is , and the rate on long-term Treasury
bonds is .
a. 4%; 14%
b. 4%; 15%
c. 11%; 14%
d. 11%; 15%
e. 11%; 17%
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Chapter 5 – The Cost of Money (Interest Rates)
39. You read in The Wall Street Journal that 30–day T-bills currently are 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, the real risk-free rate of return is
a. 0%
b. 1%
c. 2%
d. 3%
e. 4%
40. Assume that a 3-year Treasury note has no maturity premium, and that the real, risk–free rate of interest is 3
percent. If the T-note carries a yield to maturity of 13 percent, and if the expected average inflation rate over the
next 2 years is 11 percent, what is the implied expected inflation rate during Year 3?
a. 7%
b. 8%
c. 9%
d. 17%
e. 18%
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Chapter 5 – The Cost of Money (Interest Rates)
41. Assume that the current interest rate on a 1-year bond is 8 percent, the current rate on a 2-year bond is 10 percent,
and the current rate on a 3-year bond is 12 percent. If the expectations theory of the term structure is correct, what
is the 1-year interest rate expected during Year 3? (Base your answer on an arithmetic rather than geometric
average.)
a. 12.0%
b. 16.0%
c. 13.5%
d. 10.5%
e. 14.0%
42. Assume that the real risk-free rate, r*, is 4 percent, and that inflation is expected to be 9% in Year 1, 6% in Year 2,
and 4% thereafter. Assume also that all Treasury bonds are highly liquid and free of default risk. If 2-year and 5-
year Treasury bonds both yield 12%, what is the difference in the maturity risk premiums (MRPs) on the two bonds,
i.e., what is MRP5 − MRP2?
a. 2.1%
b. 1.8%
c. 5.0%
d. 3.0%
e. 2.5%
43. Solarcell Corporation has $20,000 which it plans to invest in marketable securities. It is choosing between AT&T
bonds which yield 11%, State of Florida municipal bonds which yield 8%, and AT&T preferred stock with a dividend
yield of 9%. Solarcell’s corporate tax rate is 40%, and 70% of the preferred stock dividends it receives are tax
exempt. Assuming that the investments are equally risky and that Solarcell chooses strictly on the basis of after-tax
returns, which security should be selected? Answer by giving the after-tax rate of return on the highest yielding
security.
a. 8.46%
b. 8.00%
c. 7.92%
d. 9.00%
e. 9.16%
44. A 9 percent coupon bond issued by the State of Pennsylvania sells for $1,000 and thus provides a 9 percent yield to
maturity. What yield on a Synthetic Chemical Company bond would cause the two bonds to provide the same after-
tax rate of return to an investor in the 28 percent tax bracket?
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Chapter 5 – The Cost of Money (Interest Rates)
a. 12.50%
b. 17.50%
c. 7.00%
d. 14.00%
e. 9.00%
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Chapter 5 – The Cost of Money (Interest Rates)
45. In 2000, Craig and Kathy Koehler owned a small business which was held as a proprietorship in Kathy‘s name. They
were thinking of incorporating if that would lower their total tax liability. The Koehlers expected the company to earn
$100,000 before taxes next year. They planned to take out a salary of $45,000, and to reinvest the rest in the
business. Their personal deductions total $10,750 and if they choose not to incorporate they will file a joint return. (1)
What is their expected total tax liability as a proprietorship? (2) As a corporation? (3) Should they incorporate?
a. $19,393.50; $22,250.00; No
b. $19,393.50; $13,887.50; Yes
c. $6,793.50; $6,637.50; Yes
d. $22,403.50; $15,753.50; Yes
e. $20,777.50; $22,250.00; No