1. A "seven-and-seven loan" has an interest rate that is 7 percentage points over the prime rate and has initial fees that are equal to 7% of the size of the loan. If the prime rate is 10%, what is the effective interest rate on a seven-and-seven 10-year loan with amortized monthly payments? (Just set up.) Explain why the effective interest rate would be higher or lower if this were a 5-year loan.

2. In November, Columbia/HCA Healthcare, the nation's largest for-profit hospital company, issued $200 million in 100-year debt, rated A3 by Moody's and BBB+ by Standard & Poor's. A Wall Street Journal article said that "most investors avoid 100-year bonds like the plague," forcing the company to offer a 7.5 percent yield, compared to the 6.25 percent yields then prevailing on 30-year Treasury bonds. The Journal asked, (a) "Why would investors buy the IOU of a company when chances are they won't live to see their principal returned?," and also pointed out that (b) "even though investors get interest every year, by the time they get their principal back, inflation, even at its current low levels, would have eroded the principal's value to virtually nothing." Explain why these two concerns are of little importance and identify two much more important risks.

3. In 1996, Ian MacKinnon, Senior Vice President of the Vanguard Fixed Income Group said that, "With...a yield of just over 2% on the Standard & Poor's 500 Index and nearly 7% on ten-year Treasury bonds--that's a gap of 400 to 500 basis points a year that the stockholder has to hope to make up by price appreciation and dividend increases." If we let x be the annual price appreciation and y be the annual dividend increase, does the phrase "price appreciation and dividend increases" mean (a) x - y = 400-to-500 basis points, or (b) x + y = 400-to-500 basis points? Explain your reasoning.

4. The following is a 1987 analysis of municipal bond prices:

Demand for the bonds of states, cities and public authorities, which offer tax-exempt interest payments, has been tremendous. So many have rushed to buy what bond houses advertise as the last tax shelter of the middle class that customary price differentials between tax-exempt and taxable bonds have narrowed. Crowd psychology rather than economics is at work.

5. Warren Buffett has described a "wonderful business" as one that grows without borrowing or retaining a substantial amount of earnings and the "worst business" as one that grows a lot, but does so by reinvesting virtually all of its earnings. Consider two companies that do not acquire other companies, issue new debt or equity, or engage in financial chicanery. How can a company that retains 20% of its earnings grow faster than one that retains all of its earnings?

6. Here is information about two companies:

7. Irving Fisher compared the 1929 stock market crash to a run on a bank that had issued paper bank notes whose value exceeded the gold in its vaults. In his analogy, the bank was U.S. industry, the bank's paper money was stock, and the bank's real assets were the country's factories and machines. Explain why this is not a good analogy.

8. Between March 1985 and March 1986, bond rates dropped by about three percentage points, while the economy "muddled along," with essentially unchanged profit expectations.
     a. Do you think Tobin's q went up or down during this period?
     b. Does this change in q foretell an increase or decrease in business investment spending?
     c. Why might businesses change their investment plans even if profit expectations are unchanged?

9. Here is an excerpt from a letter to the editor of Barron's:

I read with interest your tale of woe about Caprimex and the IMAC Currency Hedge Fund. In addition to having computer problems, Alex Herbage also cannot do interest arithmetic. An investment that produces a profit of 257% in 6 1/2 years (i.e., $100 grows to $357) has a rate of return of [ ..... ]%, not the 39.5% as quoted by Herbage....This calculation goes beyond the limits of reasonably puffery...and is certainly without significance.

10. The economic value added (EVA) model says that firms create value for their stockholders by earning profits that exceed the cost of capital. EVA "is the dollar amount by which profits in any given period exceed or fall short of the cost of capital used to produce these profits." (Al Ehrbar, EVA: The Real Key to Creating Wealth, Wiley, 1998, p. 3.) Suppose that a firm has no debt and that all earnings are paid out as dividends. It has assets A that earn an annual rate of return r, and shareholder's required rate of return is R. Which of these equations for the value of the firm is most consistent with EVA analysis? Explain your reasoning.
     a. P = (rK - RK)/R
     b. P = K + (rK - RK)/R
     c. P = K
     d. P = sum of (rK - RK)