Fin 221 Fall 2006 Exam 1

Multiple Choice
Identify the choice that best completes the statement or answers the question.

1) Which of the following could explain why a business might choose to operate as a corporation rather than as a sole
proprietorship or a partnership?
A. Corporations generally face fewer regulations.
B. Less of a corporation's income is generally subject to taxes.
C. Corporate shareholders are exposed to reduced liability, but this factor is offset by the tax
advantages of incorporation.
D. Corporate investors are exposed to unlimited liability.
E. Corporations generally find it easier to raise capital.

2) The primary operating goal of a publicly-owned firm interested in serving its stockholders should be to
A. Maximize its expected total corporate income.
B. Maximize its expected EPS.
C. Minimize the chances of losses.
D. Maximize the stock price per share over the long run, which is the stock's intrinsic value.
E. Maximize the stock price on a specific target date.

3) Which of the following statements is CORRECT?

A. A good goal for a firm's management is maximization of expected EPS.
B. Most business in the U.S. is conducted by corporations, and corporations' popularity
results primarily from their favorable tax treatment.
C. One example of an agency relationship is the one between stockholders and managers.
D. Corporations and partnerships have an advantage over proprietorships because a sole
proprietor is exposed to unlimited liability, but the liability of all investors in the other
types of businesses is more limited.
E. Firms in highly competitive industries are more likely to consciously exercise "social
responsibility" than are firms in oligopolistic industries.

4) How much would $1, growing at 5% per year, be worth after 100 years?
A. $141.05
B. $131.50
C. $164.52
D. $144.50
E. $155.94

5) Suppose a U.S. government bond promises to pay $2,249.73 three years from now. If the going interest rate on 3-
year government bonds is 6%, how much is the bond worth today?
A. $2,011.87
 B. $2,591.45
C. $2,324.89
D. $1,888.92
E. $2,854.13

6) The U.S. Treasury offers to sell you a bond for $613.81. No payments will be made until the bond matures 10
years from now, at which time it will be redeemed for $1,000. What interest rate would you earn if you bought this
bond at the offer price?
A. 5.91%
B. 6.71%
C. 7.10%
D. 5.59%
E. 5.00%

7) Your father is about to retire, and he wants to buy an annuity that will provide him with $50,000 of income a year
for 20 years, with the first payment coming immediately. The going rate on such annuities is 6%. How much
would it cost him to buy the annuity today?
A. $607,905.82
B. $416,110.34
C. $517,513.68
D. $615,976.84
E. $488,349.15

8) Your girlfriend just won the Power Ball lottery. She has the choice of $10,000,000 today or a 30-year annuity of
$500,000, with the first payment coming today. What rate of return is built into the annuity?
A. 2.71%
B. 3.08%
C. 4.10%
D. 3.59%
E. 3.91%

9) What annual payment would you have to receive in order to earn an 8% rate of return on a perpetuity that cost
$1,500?
A. $127.84
B. $134.54
C. $151.29
D. $120.00
E. $143.65

10) At a rate of 8%, what is the future value of the following cash flow stream? $0 at Time 0; $100 at the end of Year
1; $300 at the end of Year 2; $0 at the end of Year 3; and $500 at the end of Year 4?
 A. $907.91
B. $991.43
C. $943.46
D. $975.89
E. $968.40

11) Bank A offers to lend you $10,000 at a nominal rate of 7%, compounded monthly. The loan (principal plus interest)
must be repaid at the end of the year. Bank B also offers to lend you the $10,000, but it will charge 8%, with
interest due at the end of the year. What is the difference in the effective annual rates charged by the two banks?
A. 0.77%
B. 1.71%
C. 1.10%
D. 1.59%
E. 0.91%

12) You are buying your first house for $220,000, and are paying $30,000 as a down payment. You have arranged to
finance the remaining $190,000 30-year mortgage with a 7% nominal interest rate and monthly payments. What
are the equal monthly payments you must make?
A. $1,513
B. $1,110
C. $1,264
D. $1,976
E. $1,349

13) Your sister turned 30 today, and she is planning to save $3,000 per year for retirement, with the first deposit to be
made one year from today. She will invest in a mutual fund, which she expects to provide a return of 10% per year.
She plans to retire 35 years from today, when she turns 65, and she expects to live for 30 years after retirement, to
age 95. Under these assumptions, how much can she spend in each year after she retires? Her first withdrawal will
be made at the end of her first retirement year.
A. $78,976
B. $91,110
C. $88,513
D. $86,250
E. $83,049

14) It is now January 1, 2005. Tom and Jerry are cousins who were both born on January 1, 1975. Both turned 30
today. Their grandfather gave Tom $4,000 on his 25th birthday, January 1, 2000, putting the funds into a trust that
will be paid to Tom on his 70th birthday, January 1, 2045. Each year since 2000, the grandfather put an additional
$4,000 in the account on Tom's birthday, and the grandfather's own trustee will continue making the $4,000
payments until January 1, 2045, when a 46th and final $4,000 contribution will be made on Tom's 70th birthday.
The grandfather wants Tom to work, not be a "trust fund baby," but he also wants to insure that Tom is well
provided for in his old age.
 The grandfather has until now has been disappointed with Jerry, hence has not given him anything, but they
recently reconciled, and the grandfather has decided to make an equivalent provision for Jerry. He will make the
first payment to a trust for Jerry today, and he has instructed his trustee to make additional annual payments each
year until January 1, 2045, when the 41st and final payment will be made. If both trusts earn an annual return of
10%, how much must the grandfather put into Jerry's trust to enable him to receive the same amount as Tom on
January 1, 2045, when they reach age 70?
A. $6,110
B. $6,492
C. $7,513
D. $5,976
E. $8,349

15) You are analyzing the value of an investment by calculating the present value of its expected cash flows. Which of
the following would cause the investment to look better?
A. The discount rate decreases.
B. The cash flows are extended over a longer period of time, but the total amount of the cash
flows remains the same.
C. The discount rate increases.
D. The riskiness of the project's cash flows increases.
E. 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.

16) Which of the following statements regarding a 30-year (360-month) $100,000 fixed-rate mortgage is CORRECT?
(Ignore all taxes and transactions costs.)
A. The remaining balance after three years will be $100,000 less the total amount of interest
paid during the first 36 months.
B. The proportion of the monthly payment that goes towards repayment of principal will be
higher 10 years from now than it will be this year.
C. The monthly payment on the mortgage will steadily decline over time.
D. The outstanding balance gets paid off at a faster rate early in a loan's life, rather than later.
E. Because it is a fixed rate mortgage, the amount paid in interest per payment is constant.

17) Which of the following statements is CORRECT?

A. The NYSE does not exist as a physical location; rather it represents a loose collection of
dealers who trade stock electronically.
B. An example of a primary market transaction would be your uncle transferring 100 shares
of Wal-Mart stock to you as a birthday gift.
C. Capital market instruments include both long-term debt and common stocks.
D. If your uncle in New York sold 100 shares of Microsoft through his broker to an investor
in Los Angeles, this would be a primary market transaction.
E. While the two frequently perform similar functions, investment banks generally specialize
in lending money, whereas commercial banks generally help companies raise large blocks
of capital from investors.
18) Money markets are markets for
A. Foreign currencies.
B. Consumer automobile loans.
C. Corporate stocks.
D. Long-term bonds.
E. Short-term debt securities such a Treasury bills.

19) You recently sold to your brother 200 shares of Disney stock, and the transfer was made through a broker. This is
an example of:
A. A money market transaction.
B. A primary market transaction.
C. A secondary market transaction.
D. A futures market transaction.
E. An over-the-counter market transaction.

20) If the stock market is semistrong-form efficient, which of the following statements would be CORRECT?
A. The required returns on all stocks are the same, and the required returns on stocks are
higher than the required returns on bonds.
B. The required returns on stocks equal the required returns on bonds.
C. A trading strategy in which you buy stocks that have recently fallen in price is likely to
provide you with a return that exceed the return on the overall stock market.
D. If you have insider information about a particular stock, you cannot expect to earn an
above average return on this information because it is already incorporated into the
current stock price.
E. Even if a market is semistrong-form efficient, an investor could still earn a better return
than the market return if he or she had inside information.

21) Suppose the rate of return on a 10-year T-bond is currently 5.00% and that on a 10-year Treasury Inflation
Protected Security (TIP) is 2.10%. Suppose further that the MRP on a 10-year T-bond is 0.9%, that no MRP is
required on TIPs, and that no liquidity premiums are required on any T-bonds. Given this data, what is the expected
rate of inflation over the next 10 years? Disregard cross-product terms, i.e., if averaging is required, use the
arithmetic average.
A. 1.80%
B. 1.90%
C. 2.00%
D. 2.10%
E. 2.20%
22) Keys Corporation's 5-year bonds yield 6.50%, and 5-year T-bonds yield 4.40%. The real risk-free rate is r* = 2.5%,
the inflation premium for 5 years bonds is IP = 1.50%, the default risk premium for Keys' bonds is DRP = 0.50%
versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t -
1)*0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Keys' bonds?
A. 1.30%
B. 1.40%
C. 1.50%
D. 1.60%
E. 1.70%

23) Suppose 1-year Treasury bonds yield 3.0% while 2-year T-bonds yield 4.5%. Assuming the pure expectations
theory is correct and thus the maturity risk premium is zero, what should the yield be on a 1-year T-bond one year
from now?
A. 5.91%
B. 6.02%
C. 6.13%
D. 6.24%
E. 6.35%

24) Which of the following statements is CORRECT?

A. If the maturity risk premium (MRP) is greater than zero, the yield curve must be upward
sloping.
B. If the maturity risk premium (MRP) equals zero, the yield curve must be flat.
C. If inflation is expected to increase in the future and the maturity risk premium (MRP) is
greater than zero, the yield curve will be upward sloping.
D. If the expectations theory holds, the yield curve will never be downward sloping.
E. Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury
bonds will always be higher than yields on short-term T-bonds.

25) Which of the following factors would be most likely to lead to an increase in nominal interest rates?
A. Households reduce their consumption and increase their savings.
B. A new technology like electricity has just been introduced, and it increases investment
opportunities.
C. There is a decrease in expected inflation.
D. The economy falls into a recession.
E. The Federal Reserve decides to try to stimulate the economy.
Fin 221 Fall 2006 Exam 1
Answer Section

MULTIPLE CHOICE

1) E
2) D
3) C
4) B
5) D
6) E
7) A
8) B
9) D
10) D
11) A
12) C
13) D
14) B
15) A
16) B
17) C
18) E
19) C
20) E
21) C
22) D
23) B
24) C
25) B