Econ 156
Gary Smith
Fall 2009
Midterm Answers

1. The upward sloping term structure indicates that investors expect interest rates to increase over time. If so, rolling over short-term debt may be as expensive (or more so) than issuing long-term debt.

2.

a. This calculation incorrectly assumes that payments are made annually with no payment of principal until the very end.

b. The actual total interest is much less than the reported $300,000 in interest because payments are, in fact, monthly with a continual repayment of principal. You pay less than the reported $300,000 interest because you don't borrow $100,000 for all 30 years. (The monthly payments to be $877.57. The total payments are 360($877.57) = $315,925.20, implying that the total interest is $315,925.20 $100,000 = $215,925.20.)

3. If ρ = R, then there would be no economic value added, and V = A. Thus (a) and (d) must be incorrect and (c) is correct only in the special case ρ = R. The economic value added each period is the profits ρA minus the cost of capital, RA: EVA = (ρ - R)A. Using the present value of a perpetuity, the value of the firm is V = A + (ρ - R)A/R

4. She wants her investment in the 6-month and 2-year zeros to have the same duration as the 1-year zero, so that these two strategies will be affected equally by equal changes in interest rates. The 1-year zeros have a duration of 1 year. The duration of the other portfolio is α(0.5) + (1 – α)2.0. Equating the two durations,

5.

a. Leverage = assets/equity = 5/1

b. Its earnings would be very volatile with so much leverage.

6. Corporate bond rates are higher than Treasury bond rates because of the higher default risk. Thus, the use of a corporate bond rate reduced the size of the lump-sum payment.

7. If the Fed is certain to do something, it will presumably already be embedded in the term structure. Here, if it is certain that the Fed is going to increase interest rates in the future, current long-term rates will be be higher than short-term rates.

8. Using this present value equation,

the implicit APR is 115.73%.

9. Earnings are E = ρA = 0.20($40) = $8. A $4 dividend represents a d = 0.5 payout: d = D/E = $4/$8 = 0.5. Analyst 1 looks at the dividend yield D/P = $4/$80 = 0.05 and ignores the retained earnings which will increase future earnings and dividends. Analyst 2 looks at the firm’s E/P and ignores its payout/plowback policy. Analyst 3 does not take into account the price of the stock! Another approach is to estimate the growth rate as g = (1 – d) ρ = 0.50(0.20) = 0.10 and to estimate the shareholders’ return as

10. Tobin’s q = $80/$40 = 2.0. Since q > 1 implies that stock market values this firm’s assets at more than their cost (apparently ρ > R), the retention of earnings to finance expansion should raise the price of the firm’s stock.