2. An article in The Wall Street Journal claimed that a 9.25 percent annual interest rate, compounded daily, was more attractive than a 9.40 percent annual interest rate, compounded quarterly; a reader wrote in to say that his calculations showed just the opposite. Which rate is more attractive?

3. 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.

4. Microsoft currently pays no dividend. 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?

5. Peter Lynch, a legendary mutual fund manager, wrote that, “When you buy a share of stock, even a very risky stock, you are contributing something to the growth of the country. That’s what stocks are for.” When you buy 100 shares of Microsoft stock, is the money you spend on this stock used either to pay the company’s expenses or expand its operations?

6. A homeowner recently obtained a 30-year $300,000 amortized mortgage at a 6% APR with monthly payments of $1798.65. Immediately after obtaining this loan, she heard on the radio that she could refinance at a 5.75% interest rate and have exactly same monthly payments of $1798.65 and her mortgage would be fully paid off in 28 years. The savings of 2 years of monthly payments, 24*$1798.65 = $43,167 would far exceed the $10,000 in fees it would cost her to obtain this loan. Would you advise her to refinance or not? Explain exactly how you would decide.

7. A 1987 Business Week article was entitled “How to Double Your Shares Without Spending a Dime.” The secret was to buy a stock that splits 2-for-1. What’s the catch?

8. The Get Rich Investment Guide published by Consumers Digest discusses the fact that an investor who buys a stock ex-dividend doesn’t receive the latest dividend:

Obviously, one strategy is to know when the stock will go ex-dividend and buy a day or two before the cutoff. Then you can receive the dividends, and you can sell the shares as soon as you have [received the dividend].

What is the flaw in this strategy?

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 n = 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. The economic value added (EVA) model says that firms create value for their stockholders by earning profits that exceed the cost of capital. 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 = (rA – RA)/R

b. P = A + (rA – RA)/R

c. P = A

d. P = sum of (rA – RA)