Econ 156
Fall 2001

Second Test (75 minutes)
Answer all 10 questions, leaving tedious calculations undone. The test ends promptly at 4:00.

1. In 1996, a professor at the Cincinnati College of Business ranked business schools by comparing the cost of attending (including the lost wages while attending) with the increase in salary afterward from having an MBA from that school. The schools were ranked by the number of years it took for the cumulation of the higher salaries to payback the cost of business school. For example, at MIT (ranked fifth), the cost of attending was $159,800 and it took slightly more than 5 years for the cumulative additional salary to reach $159,800. What conceptual flaws do you see in a payback calculation such as this?

2. On October 31, 2001, the U.S. Treasury surprised financial markets by announcing that it would no longer issue 30-year bonds to finance the government debt. A fixed-income strategist at Merrill Lynch argued that, “The Treasury is trying to shorten the maturity of their debt, which makes sense given the current climate of low yields.” (At the time, interest rates on 2-year Treasury notes were about 2.4 percentage points less than interest rates on 30-year Treasury bonds.) Explain why a switch from 30-year to 2-year securities might not reduce the Treasury’s interest expense.

3. David Swensen uses mean-variance analysis to manage Yale’s endowment portfolio. Here are some assumptions he is currently using about the real returns from three assets:

Explain why you either agree or disagree with this critique: “These assumptions are inconsistent with mean-variance analysis. In a risk-averse world, no one would hold U.S. stocks if their expected return was smaller and their standard deviation larger than those on absolute-return assets. Clearly the market doesn’t think that U.S. stocks have a lower expected return and higher standard deviation than absolute-return assets.”

4. Here are some recent data for Microsoft:

a. What is the value of Tobin’s q for Microsoft?

b. If the market portfolio has a 4% risk-premium over a risk-free investment, use CAPM to estimate Microsoft’s risk-premium over a risk-free investment.

5. Suppose that Microsoft stock is priced to give shareholders a 10% return and that Microsoft’s earnings grow by 15% a year for 10 years, after which Microsoft begins paying half of its earnings out as dividends and its growth rate slows to 5% a year forever. If Microsoft’s price is always equal to fundamental value and these expectations are correct, what will be the annual percentage increase in the price of Microsoft stock (give a definite numerical answer)

a. each year for the next 10 years?

b. each year thereafter?

6. On December 21, 2001, it will be legal to trade futures on individual stocks. Use the data in the preceding exercises to estimate what the price of a one-year future for Microsoft stock would be if it were available today.

7. A Microsoft call option expiring a year from now with an exercise price of $65 is priced at $12.00; a Microsoft put option expiring a year from now with an exercise price of $65 is priced at $9.80. If the actual one-year Microsoft future price F were higher than the theoretical value determined in the preceding exercise, describe a risk-free position you could take involving only the future, put, and call that would earn a rate of return higher than the risk-free interest rate. What would your rate of return be?

8. Here are your annualized before-tax returns on 3 assets:

Assume that the tax rate on taxable bonds is 50% and that the tax rate on corporate stock is 30%. You are going to put half your savings in a tax-deferred account (TDA) and half in a conventional saving account (CSA). To maximize your overall after-tax return, which asset should you put in your TDA and which asset should you put in your CSA?

9. Professor Smith is considering buying a $1 million life insurance policy that will be in effect until his son Cory is 25. If Professor Smith dies, he wants the $1 million proceeds from the policy to be invested at the prevailing Treasury interest rate R, with a constant amount X given to Cory each year for n years until Cory is 25. For example, if Professor Smith dies when Cory is 15, the $1 million will be invested at R and Cory will be paid a constant amount X each year for 10 years. The value of X should be set so that the last payment to Cory exhausts the insurance proceeds plus interest. An advisor says that X = R($1,000,000) + $1,000,000/n.

a. Explain why the advisor’s formula does not accomplish Professor Smith’s objectives. Does the fund run out of money or have money left over when Cory reaches age 25?

b. What formula would you use to determine the value of X? Be specific.

10. Explain why the following explanation of a bond’s yield to maturity, or interest rate, is incorrect: "[A] $1,000 bond might carry a stated annual yield, known as the coupon, of 8 percent, meaning that it pays $80 a year to the bondholder. If that bond was bought at 87, the actual yield would be 9.2 percent ($80 annual interest on $870 of principal)."