FIN 534/FIN534 WEEK 4 QUIZ 3 (Solution 30/30) Guarantee - 87638

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Question 1 You are considering two equally risky annuities, each of which pays $5,000 per year for 10 years. Investment ORD is an ordinary (or deferred) annuity, while Investment DUE is an annuity due. Which of the following statements is CORRECT? Answer The present value of ORD must exceed the present value of DUE, but the future value of ORD may be less than the future value of DUE. The present value of DUE exceeds the present value of ORD, while the future value of DUE is less than the future value of ORD. The present value of ORD exceeds the present value of DUE, and the future value of ORD also exceeds the future value of DUE. The present value of DUE exceeds the present value of ORD, and the future value of DUE also exceeds the future value of ORD. If the going rate of interest decreases from 10% to 0%, the difference between the present value of ORD and the present value of DUE would remain constant. 2 points Question 2 A U.S. Treasury bond will pay a lump sum of $1,000 exactly 3 years from today. The nominal interest rate is 6%, semiannual compounding. Which of the following statements is CORRECT? Answer The periodic interest rate is greater than 3%. The periodic rate is less than 3%. The present value would be greater if the lump sum were discounted back for more periods. The present value of the $1,000 would be larger if interest were compounded monthly rather than semiannually. The PV of the $1,000 lump sum has a smaller present value than the PV of a 3-year, $333.33 ordinary annuity. 2 points Question 3 Which of the following statements is CORRECT? Answer A time line is not meaningful unless all cash flows occur annually. Time lines are useful for visualizing complex problems prior to doing actual calculations. Time lines cannot be constructed in situations where some of the cash flows occur annually but others occur quarterly. Time lines cannot be constructed for annuities where the payments occur at the beginning of the periods. Some of the cash flows shown on a time line can be in the form of annuity payments, but none can be uneven amounts. 2 points Question 4 Which of the following statements is CORRECT? Answer The present value of a 3-year, $150 ordinary annuity will exceed the present value of a 3-year, $150 annuity due. If a loan has a nominal annual rate of 8%, then the effective rate will never be less than 8%. If a loan or investment has annual payments, then the effective, periodic, and nominal rates of interest will all be different. The proportion of the payment that goes toward interest on a fully amortized loan increases over time. An investment that has a nominal rate of 6% with semiannual payments will have an effective rate that is smaller than 6%. 2 points Question 5 Which of the following investments would have the highest future value at the end of 10 years? Assume that the effective annual rate for all investments is the same and is greater than zero. Answer Investment A pays $250 at the beginning of every year for the next 10 years (a total of 10 payments). Investment B pays $125 at the end of every 6-month period for the next 10 years (a total of 20 payments). Investment C pays $125 at the beginning of every 6-month period for the next 10 years (a total of 20 payments). Investment D pays $2,500 at the end of 10 years (just one payment). Investment E pays $250 at the end of every year for the next 10 years (a total of 10 payments). 2 points Question 6 Which of the following statements is CORRECT? Answer If you have a series of cash flows, each of which is positive, you can solve for I, where the solution value of I causes the PV of the cash flows to equal the cash flow at Time 0. If you have a series of cash flows, and CF0 is negative but each of the following CFs is positive, you can solve for I, but only if the sum of the undiscounted cash flows exceeds the cost. To solve for I, one must identify the value of I that causes the PV of the positive CFs to equal the absolute value of the FV of the negative CFs. It is impossible to find the value of I without a computer or financial calculator. If you solve for I and get a negative number, then you must have made a mistake. If CF0 is positive and all the other CFs are negative, then you can still solve for I. 2 points Question 7 Which of the following investments would have the lowest present value? Assume that the effective annual rate for all investments is the same and is greater than zero. Answer Investment A pays $250 at the end of every year for the next 10 years (a total of 10 payments). Investment B pays $125 at the end of every 6-month period for the next 10 years (a total of 20 payments). Investment C pays $125 at the beginning of every 6-month period for the next 10 years (a total of 20 payments). Investment D pays $2,500 at the end of 10 years (just one payment). Investment E pays $250 at the beginning of every year for the next 10 years (a total of 10 payments). 2 points Question 8 You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following would increase the calculated value of the investment? Answer The cash flows are in the form of a deferred annuity, and they total to $100,000. You learn that the annuity lasts for 10 years rather than 5 years, hence that each payment is for $10,000 rather than for $20,000. The discount rate decreases. The riskiness of the investment’s cash flows increases. The total amount of cash flows remains the same, but more of the cash flows are received in the later years and less are received in the earlier years. The discount rate increases. 2 points Question 9 Which of the following statements regarding a 15-year (180-month) $125,000, fixed-rate mortgage is CORRECT? (Ignore taxes and transactions costs.) Answer The remaining balance after three years will be $125,000 less one third of the interest paid during the first three years. Because the outstanding balance declines over time, the monthly payments will also decline over time. Interest payments on the mortgage will increase steadily over time, but the total amount of each payment will remain constant. The proportion of the monthly payment that goes towards repayment of principal will be lower 10 years from now than it will be the first year. The outstanding balance declines at a faster rate in the later years of the loan’s life. 2 points Question 10 Which of the following statements is CORRECT? Answer The present value of a 3-year, $150 annuity due will exceed the present value of a 3-year, $150 ordinary annuity. If a loan has a nominal annual rate of 8%, then the effective rate can never be greater than 8%. If a loan or investment has annual payments, then the effective, periodic, and nominal rates of interest will all be different. The proportion of the payment that goes toward interest on a fully amortized loan increases over time. An investment that has a nominal rate of 6% with semiannual payments will have an effective rate that is smaller than 6%. 2 points Question 11 Which of the following statements is CORRECT? Answer The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods. If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is by definition an annuity. The cash flows for an annuity due must all occur at the ends of the periods. The cash flows for an annuity must all be equal, and they must occur at regular intervals, such as once a year or once a month. If some cash flows occur at the beginning of the periods while others occur at the ends, then we have what the textbook defines as a variable annuity. 2 points Question 12 Your bank account pays an 8% nominal rate of interest. The interest is compounded quarterly. Which of the following statements is CORRECT? Answer The periodic rate of interest is 2% and the effective rate of interest is 4%. The periodic rate of interest is 8% and the effective rate of interest is greater than 8%. The periodic rate of interest is 4% and the effective rate of interest is less than 8%. The periodic rate of interest is 2% and the effective rate of interest is greater than 8%. The periodic rate of interest is 8% and the effective rate of interest is also 8%. 2 points Question 13 You plan to invest some money in a bank account. Which of the following banks provides you with the highest effective rate of interest? Answer Bank 1; 6.1% with annual compounding. Bank 2; 6.0% with monthly compounding. Bank 3; 6.0% with annual compounding. Bank 4; 6.0% with quarterly compounding. Bank 5; 6.0% with daily (365-day) compounding. 2 points Question 14 Which of the following statements regarding a 15-year (180-month) $125,000, fixed-rate mortgage is CORRECT? (Ignore taxes and transactions costs.) Answer The remaining balance after three years will be $125,000 less one third of the interest paid during the first three years. Because it is a fixed-rate mortgage, the monthly loan payments (which include both interest and principal payments) are constant. Interest payments on the mortgage will increase steadily over time, but the total amount of each payment will remain constant. The proportion of the monthly payment that goes towards repayment of principal will be lower 10 years from now than it will be the first year. The outstanding balance declines at a slower rate in the later years of the loan’s life. 2 points Question 15 Which of the following statements regarding a 30-year monthly payment amortized mortgage with a nominal interest rate of 10% is CORRECT? Answer The monthly payments will decline over time. A smaller proportion of the last monthly payment will be interest, and a larger proportion will be principal, than for the first monthly payment. The total dollar amount of principal being paid off each month gets smaller as the loan approaches maturity. The amount representing interest in the first payment would be higher if the nominal interest rate were 7% rather than 10%. Exactly 10% of the first monthly payment represents interest. 2 points Question 16 A 12-year bond has an annual coupon rate of 9%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 7%. Which of the following statements is CORRECT? Answer If market interest rates decline, the price of the bond will also decline. The bond is currently selling at a price below its par value. If market interest rates remain unchanged, the bond’s price one year from now will be lower than it is today. The bond should currently be selling at its par value. If market interest rates remain unchanged, the bond’s price one year from now will be higher than it is today. 2 points Question 17 Which of the following statements is NOT CORRECT? Answer If a bond is selling at a discount to par, its current yield will be less than its yield to maturity. All else equal, bonds with longer maturities have more interest rate (price) risk than bonds with shorter maturities. If a bond is selling at its par value, its current yield equals its yield to maturity. If a bond is selling at a premium, its current yield will be greater than its yield to maturity. All else equal, bonds with larger coupons have greater interest rate (price) risk than bonds with smaller coupons. 2 points Question 18 A 10-year Treasury bond has an 8% coupon, and an 8-year Treasury bond has a 10% coupon. Both bonds have the same yield to maturity. If the yield to maturity of both bonds increases by the same amount, which of the following statements would be CORRECT? Answer The prices of both bonds will decrease by the same amount. Both bonds would decline in price, but the 10-year bond would have the greater percentage decline in price. The prices of both bonds would increase by the same amount. One bond’s price would increase, while the other bond’s price would decrease. The prices of the two bonds would remain constant. 2 points Question 19 Which of the following statements is CORRECT? Answer All else equal, high-coupon bonds have less reinvestment rate risk than low-coupon bonds. All else equal, long-term bonds have less interest rate price risk than short-term bonds. All else equal, low-coupon bonds have less interest rate price risk than high-coupon bonds. All else equal, short-term bonds have less reinvestment rate risk than long-term bonds. All else equal, long-term bonds have less reinvestment rate risk than short-term bonds. 2 points Question 20 An investor is considering buying one of two 10-year, $1,000 face value bonds: Bond A has a 7% annual coupon, while Bond B has a 9% annual coupon. Both bonds have a yield to maturity of 8%, which is expected to remain constant for the next 10 years. Which of the following statements is CORRECT? Answer Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price. One year from now, Bond A’s price will be higher than it is today. Bond A’s current yield is greater than 8%. Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price. Both bonds have the same price today, and the price of each bond is expected to remain constant until the bonds mature. 2 points Question 21 Which of the following statements is CORRECT? Answer If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope. Liquidity premiums are generally higher on Treasury than corporate bonds. 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. Default risk premiums are generally lower on corporate than on Treasury bonds. Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds. 2 points Question 22 Which of the following statements is CORRECT? Answer A zero coupon bond’s current yield is equal to its yield to maturity. If a bond’s yield to maturity exceeds its coupon rate, the bond will sell at par. All else equal, if a bond’s yield to maturity increases, its price will fall. If a bond’s yield to maturity exceeds its coupon rate, the bond will sell at a premium over par. All else equal, if a bond’s yield to maturity increases, its current yield will fall. 2 points Question 23 Which of the following statements is CORRECT? Answer Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond has been issued. Most sinking funds require the issuer to provide funds to a trustee, who saves the money so that it will be available to pay off bondholders when the bonds mature. A sinking fund provision makes a bond more risky to investors at the time of issuance. Sinking fund provisions never require companies to retire their debt; they only establish “targets” for the company to reduce its debt over time. If interest rates have increased since a company issued bonds with a sinking fund, the company is less likely to retire the bonds by buying them back in the open market, as opposed to calling them in at the sinking fund call price. 2 points Question 24 A 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which of the following statements is CORRECT? Answer If the yield to maturity remains constant, the bond’s price one year from now will be higher than its current price. The bond is selling below its par value. The bond is selling at a discount. If the yield to maturity remains constant, the bond’s price one year from now will be lower than its current price. The bond’s current yield is greater than 9%. 2 points Question 25 You are considering two bonds. Bond A has a 9% annual coupon while Bond B has a 6% annual coupon. Both bonds have a 7% yield to maturity, and the YTM is expected to remain constant. Which of the following statements is CORRECT? Answer The price of Bond B will decrease over time, but the price of Bond A will increase over time. The prices of both bonds will remain unchanged. The price of Bond A will decrease over time, but the price of Bond B will increase over time. The prices of both bonds will increase by 7% per year. The prices of both bonds will increase over time, but the price of Bond A will increase by more. 2 points Question 26 If its yield to maturity declined by 1%, which of the following bonds would have the largest percentage increase in value? Answer A 1-year zero coupon bond. A 1-year bond with an 8% coupon. A 10-year bond with an 8% coupon. A 10-year bond with a 12% coupon. A 10-year zero coupon bond. 2 points Question 27 Under normal conditions, which of the following would be most likely to increase the coupon rate required to enable a bond to be issued at par? Answer Adding additional restrictive covenants that limit management’s actions. Adding a call provision. The rating agencies change the bond’s rating from Baa to Aaa. Making the bond a first mortgage bond rather than a debenture. Adding a sinking fund. 2 points Question 28 Which of the following statements is CORRECT? Answer If the Federal Reserve unexpectedly announces that it expects inflation to increase, then we would probably observe an immediate increase in bond prices. The total yield on a bond is derived from dividends plus changes in the price of the bond. Bonds are riskier than common stocks and therefore have higher required returns. Bonds issued by larger companies always have lower yields to maturity (less risk) than bonds issued by smaller companies. The market value of a bond will always approach its par value as its maturity date approaches, provided the bond’s required return remains constant. 2 points Question 29 Which of the following statements is CORRECT? Answer All else equal, senior debt generally has a lower yield to maturity than subordinated debt. An indenture is a bond that is less risky than a mortgage bond. The expected return on a corporate bond will generally exceed the bond’s yield to maturity. If a bond’s coupon rate exceeds its yield to maturity, then its expected return to investors exceeds the yield to maturity. Under our bankruptcy laws, any firm that is in financial distress will be forced to declare bankruptcy and then be liquidated. 2 points Question 30 Which of the following statements is CORRECT? Answer If a coupon bond is selling at par, its current yield equals its yield to maturity. If a coupon bond is selling at a discount, its price will continue to decline until it reaches its par value at maturity. If interest rates increase, the price of a 10-year coupon bond will decline by a greater percentage than the price of a 10-year zero coupon bond. If a bond’s yield to maturity exceeds its annual coupon, then the bond will trade at a premium. If a coupon bond is selling at a premium, its current yield equals its yield to maturity. This quiz consist of 30 multiple choice questions. The first 15 questions cover the material in Chapter 4. The second 15 questions cover the material in Chapter 5. Be sure you are in the correct Chapter when you take the quiz.
Solution Description

Question 1

You are considering two equally risky annuities, each of which pays $5,000 per year for 10 years. Investment ORD is an ordinary (or deferred) annuity, while Investment DUE is an annuity due. Which of the following statements is CORRECT?

Answer

The present value of ORD must exceed the present value of DUE, but the future value of ORD may be less than the future value of DUE.

The present value of DUE exceeds the present value of ORD, while the future value of DUE is less than the future value of ORD.

The present value of ORD exceeds the present value of DUE, and the future value of ORD also exceeds the future value of DUE.

The present value of DUE exceeds the present value of ORD, and the future value of DUE also exceeds the future value of ORD.

If the going rate of interest decreases from 10% to 0%, the difference between the present value of ORD and the present value of DUE would remain constant.

2 points

Question 2

A U.S. Treasury bond will pay a lump sum of $1,000 exactly 3 years from today. The nominal interest rate is 6%, semiannual compounding. Which of the following statements is CORRECT?

Answer

The periodic interest rate is greater than 3%.

The periodic rate is less than 3%.

The present value would be greater if the lump sum were discounted back for more periods.

The present value of the $1,000 would be larger if interest were compounded monthly rather than semiannually.

The PV of the $1,000 lump sum has a smaller present value than the PV of a 3-year, $333.33 ordinary annuity.

2 points

Question 3

Which of the following statements is CORRECT?

Answer

A time line is not meaningful unless all cash flows occur annually.

Time lines are useful for visualizing complex problems prior to doing actual calculations.

Time lines cannot be constructed in situations where some of the cash flows occur annually but others occur quarterly.

Time lines cannot be constructed for annuities where the payments occur at the beginning of the periods.

Some of the cash flows shown on a time line can be in the form of annuity payments, but none can be uneven amounts.

2 points

Question 4

Which of the following statements is CORRECT?

Answer

The present value of a 3-year, $150 ordinary annuity will exceed the present value of a 3-year, $150 annuity due.

If a loan has a nominal annual rate of 8%, then the effective rate will never be less than 8%.

If a loan or investment has annual payments, then the effective, periodic, and nominal rates of interest will all be different.

The proportion of the payment that goes toward interest on a fully amortized loan increases over time.

An investment that has a nominal rate of 6% with semiannual payments will have an effective rate that is smaller than 6%.

2 points

Question 5

Which of the following investments would have the highest future value at the end of 10 years? Assume that the effective annual rate for all investments is the same and is greater than zero.

Answer

Investment A pays $250 at the beginning of every year for the next 10 years (a total of 10 payments).

Investment B pays $125 at the end of every 6-month period for the next 10 years (a total of 20 payments).

Investment C pays $125 at the beginning of every 6-month period for the next 10 years (a total of 20 payments).

Investment D pays $2,500 at the end of 10 years (just one payment).

Investment E pays $250 at the end of every year for the next 10 years (a total of 10 payments).

2 points

Question 6

Which of the following statements is CORRECT?

Answer

If you have a series of cash flows, each of which is positive, you can solve for I, where the solution value of I causes the PV of the cash flows to equal the cash flow at Time 0.

If you have a series of cash flows, and CF0 is negative but each of the following CFs is positive, you can solve for I, but only if the sum of the undiscounted cash flows exceeds the cost.

To solve for I, one must identify the val

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