2. You need $100,000 to start your new business. One lender requires 60 monthly payments of $2150, due at the end of each month (beginning a month from the signing of the loan papers). A second lender requires 20 quarterly payments of $6450, due at the beginning of each quarter (starting on the day the loan is signed). Which charges the higher loan rate? How much higher?

3. A Washington Times writer wrote that,

The money center banks are highly profitable indeed. Bankers Trust’s $371.2 million 1985 profit set a record, and for the seventh year in a row the bank was able to raise its cash dividend, then send its shareholders one share of stock for each one they owned.

Why does a bank’s profitability have little to do with its ability to send shareholders one share of stock for each one they owned? How much are these extra shares worth to stockholders?

4. In the 1960s, the U.S. government wanted to reduce long-term interest rates to stimulate corporate investment while raising short-term interest rates to improve the balance of payments. The Fed tried “Operation Twist,” trading in short- and long-term government securities to twist the term structure so that short-term interest rates would be higher than long-term interest rates. Should they have bought short-term bonds and sold long-term bonds, or vice-versa? What are the implications, if any, of the expectations hypothesis for Operation Twist?

5. “Firms that commanded [high/low] price-to-earnings ratios could purchase firms with [higher/lower] P/Es because in an equity exchange the buyer's EPS [earnings per share] increased. But the reverse transaction was anathema in the boardroom because it lowered earnings per share. This was the height of naiveté, since the combined firms were [worth more if the first firm did the acquiring/worth more if the second firm did the acquiring/worth exactly the same no matter who did the acquiring].” [Joel M. Stern, Forward to Al Ehrbar, EVA: The Real Key to Creating Wealth, John Wiley & Sons, 1998, p. 3.] Circle the correct words in each of the three bracketed parts of this quotation.

6.Explain the logic behind this assertion and then explain why it is misleading:
The essential difference between fixed- and adjustable-rate mortgages is the party at risk. In fixed mortgages, the lender takes all the risk, profiting or suffering from changes in the interest rate....With an ARM, the borrower, not the lender, is at the mercy of fluctuating interest rates.

7. Suppose two firms with no debt and these characteristics merge:

a. What is the theoretical total value of the post-merger company?

b. Explain why this total value is or is not equal to 100 + 200 = 300.

8. Suppose a stock’s price is equal to the present value of the after-tax dividends using a required rate of return R that is 2% higher than the after-tax interest rate on Treasury bonds: R = (1 - t)S + 0.02, where S is the before-tax interest rate on Treasury bonds and t is the tax rate on Treasury bonds. Use the constant-dividend-growth model to determine the percentage increase or decrease in the stock’s price if the tax rate on dividends were reduced from 0.40 to 0.15. (Assume that t, S, and the dividend cash flow do not change.)

9. In valuing a company’s stock, a handbook published by McKinsey & Company’s recommends adding a company-specific risk premium to a risk-free rate of return. For the risk-free return, they suggest the interest rate on government securities that have a duration comparable to that of stocks.

a. What kind of risk are government securities free of?

b. Why would the value of corporate stock depend on the interest rate on a government bond?

c. Why would you want to use a bond with a duration comparable to that on stocks?

d. Does the duration of T-bills or 10-year T-bonds more nearly match the duration of the S&P 500?

10. Of those major league baseball teams that win more than 100 out of 162 games in a season, 90 percent win fewer games the following season. How would you explain this statistical pattern?