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Question & Answer:

  • Define each of the following terms:
    a. Sole proprietorship; partnership; corporation
    b. Limited partnership; limited liability partnership; Professional Corporation
    c. Stockholder wealth maximization
    d. Money market; capital market; primary market; secondary market
    e. Private markets; public markets; derivatives
    f. Investment banker; financial service corporation; financial intermediary
    g. Mutual fund; money market fund
    h. Physical location exchanges; computer/telephone network
    i. Open outcry auction; dealer market; electronic communications network (ECN)
    j. Production opportunities; time preferences for consumption
    k. Real risk-free rate of interest, r*; nominal risk-free rate of interest, rRF
    l. Inflation premium (IP); default risk premium (DRP); liquidity; liquidity premium (LP)
    m. Interest rate risk; maturity risk premium (MRP); reinvestment rate risk
    n. Term structure of interest rates; yield curve
    o. “Normal” yield curve; inverted (“abnormal”) yield curve
    p. Expectations theory
    q. Foreign trade deficit

  • What are the three principal forms of business organization? What are the advantages and disadvantages of each?
  • What are the three primary determinants of a firm’s cash flow?
  • What are financial intermediaries, and what economic functions do they perform?
  • Which fluctuate more long-term or short-term interest rates? Why?
  • Suppose the population of Area Y is relatively young while that of Area O is relatively old, but everything else about the two areas is equal.
    a. Would interest rates likely be the same or different in the two areas? Explain.
    b. Would a trend toward nationwide branching by banks and savings and loans, and the development of nationwide diversified financial corporations, affect your answer to part a?
  • Suppose a new and much more liberal Congress and administration were elected, and their first order of business was to take away the independence of the Federal Reserve System, and to force the Fed to greatly expand the money supply. What effect would this have?
    a. On the level and slope of the yield curve immediately after the announcement?
    b. On the level and slope of the yield curve that would exist two or three years in the future?
  • Why is corporate finance important to all managers?
  • Describe the organizational forms a company might have as it evolves from a start-up to a major corporation. List the advantages and disadvantages of each form.
  • How do corporations “go public” and continue to grow? What are agency problems?
  • What should be the primary objective of managers?
  • Do firms have any responsibilities to society at large?
  • Is stock price maximization good or bad for society?
  • Should firms behave ethically?
  • The real risk-free rate of interest is 3 percent. Inflation is expected to be 2 percent this year and 4 percent during the next 2 years. Assume that the maturity risk premium is zero. What is the yield on 2-year Treasury securities? What is the yield on 3-year Treasury securities?
  • A Treasury bond that matures in 10 years has a yield of 6 percent. A 10-year corporate bond has a yield of 8 percent. Assume that the liquidity premium on the corporate bond is 0.5 percent. What is the default risk premium on the corporate bond?
  • The real risk-free rate is 3 percent, and inflation is expected to be 3 percent for the next 2 years. A 2-year Treasury security yields 6.2 percent. What is the maturity risk premium for the 2-year security?
  • The real risk-free rate is 3 percent. Inflation is expected to be 3 percent this year, 4 percent next year, and then 3.5 percent thereafter. The maturity risk premium is estimated to be 0.0005 = (t = 1), where t = number of years to maturity. What is the nominal interest rate on a 7-year Treasury security?
  • Assume that the real risk-free rate, r*, is 3 percent and that inflation is expected to be 8 percent in Year 1, 5 percent in Year 2, and 4 percent thereafter. Assume also that all Treasury securities are highly liquid and free of default risk. If 2-year and 5-year Treasury notes both yield 10 percent, what is the difference in the maturity risk premiums (MRPs) on the two notes; that is, what is MRP5 minus MRP2?
  • Due to a recession, the inflation rate expected for the coming year is only 3 percent. However, the inflation rate in Year 2 and thereafter is expected to be constant at some level above 3 percent. Assume that the real risk-free rate is r* _ 2% for all maturities and that there are no maturity premiums. If 3-year Treasury notes yield 2 percentage points more than 1-year notes, what inflation rate is expected after Year 1?