1. The term structure and yield curve reflect the interest rate expectations that investors use to price assets. If these expectations turn out to be correct, then asset prices were "correct" and no one makes abnormal profits. Investors become billionaires by purchasing assets that (after the fact) turn out to have been greatly undervalued by the market because of very inaccurate predictions.

2. According to Williams (and others who attempt to gauge intrinsic value) the value of a security (not necessarily the price) is the expected stream of future dividends, discounted by the investor's required rate of return--which is not equal to the rate of inflation unless the investor's real required return is zero. A dollar tomorrow is worth less than a dollar today because a dollar can be invested.

3. This analysis is very similar to the discussion of immunization in the textbook.
     a. For a horizon of 25 years, the reinvestment risk is most important (the value of the bond is simply equal to its maturation value), and the terminal value is largest if interest rates rise to 10 percent.
     b. For a horizon of 1 year, there has been almost no reinvestment of coupons and the capital risk is most important. The terminal value is largest if interest rates fall to 6 percent.
     c. Chapter 18's discussion points out that the terminal value is (approximately) the same, regardless of whether interest rates go up or down (by small amounts) for a horizon that is equal to the duration of the bond. (The duration of a 25-year 8-percent bond is 11.2 years and, as expected, Bogle's graph shows the three terminal values to be equal at this point.)

4. The effects are approximately equal for small changes, but not for large changes. For example a 100% drop in the value of your portfolio is clearly more damaging than a 100% rise in prices. Here's the example given by the Journal: "If you have $100 to spend on cappuccino and your favorite cappuccino costs $1, you can buy 100 cups. What if your $100 then drops in value to $50? You can only buy 50 cups. And if the cappuccino's price instead rises to $1.50? If you divide $100 by $1.50, you'll find that you can still buy 66 cups, and even leave a tip."

5. The implicit assumption is that Freddie Mac will pay more than these old low-interest loans are worth. If these loans are fairly priced to give rates of return comparable to new loans, then there is no advantage to selling the old loans and making new ones.

6. Well, yes, assuming earnings stay constant. But the primary reason why price-earnings ratios differ across firms is differences in earnings expectations. Investors pay 40 times current earnings for one company's stock when they could pay 2 times earnings for another, because they expect the first company's future earnings to be much higher than its current earnings (and, with a p/e of 2, they probably expect the second company's earnings to be lower than its current earnings).

7. The conservation-of-value principle implies that selling shares for their market value is a nonevent. With the infusion of $40(2,000) = $80,000 in cash, the total market value of the company should increase from $400,000 to $480,000--implying a per-share market value of $480,000/12,000 = $40 as before. If they invest this $80,000 in ventures as unattractive as their current operations (with a q of 0.8), the $80,000 in cash will be converted into a project worth only 0.8($80,000) = $64,000. In this case, the total market value will be $464,000 and the value per share will be $464,000/12,000 = $38.67. However, if they use the $80,000 to expand into "a promising market," they may be able to convert $80,000 in cash into a project worth more than $80,000.

8. The appropriate future-value equation shows the return to be 21.63%:

9. The present value of a bond's future interest payments and principal repayment is its price. The duration is a present-value weighted average length of time until the coupons and maturation value are received. Money market funds do have a duration of essentially zero, the duration of a portfolio filled with 30-year Treasury bonds depends on whether they have coupons and, if so, the level of interest rates. A portfolio of 30-year Treasury zeros has a duration of 30 years.

10. a. Dividends payments compel shareholders to pay ordinary income taxes on the funds distributed by the company. With share repurchases, investors are not compelled to sell and, if they do sell, they will pay lower capital gains taxes on the distribution. Some who sell may even benefit from the favorable tax implications of realizing capital losses.
     b. Debt can be an effective tax shield that reduces the corporate taxes paid the IRS and consequently increases the funds available for expansion or distribution to the firm's bondholders and stockholders.
     c. They may be forced into an expensive bankruptcy if they cannot make the larger interest payments due on their increased debt.