Multiple Choice Answers

Gomez Electronics needs to arrange financing for its expansion program. Bank A offers to lend Gomez the required funds on a loan where interest must be paid monthly, and the quoted rate is 8 percent. Bank B will charge 9 percent, with interest due at the end of the year. What is the difference in the effective annual rates charged by the two banks? (Points : 1)

Which of the following statements is correct? (Points : 1)
The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds.
Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds.
According to the market segmentation theory of the term structure of interest rates, we should normally expect the yield curve to slope downward.
The expectations theory of the term structure of interest rates states that borrowers generally prefer to borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and that as a result, the yield curve normally is upward sloping.
If the maturity risk premium was zero and the rate of inflation was expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope.

Allen Corporation can (1) build a new plant which should generate a before-tax return of 11 percent, or (2) invest the same funds in the preferred stock of FPL, which should provide Allen with a before-tax return of 9%, all in the form of dividends. Assume that Allen’s marginal tax rate is 25 percent, and that 70 percent of dividends received are excluded from taxable income. If the plant project is divisible into small increments, and if the two investments are equally risky, what combination of these two possibilities will maximize Allen’s effective return on the money invested? (Points : 1)
All in the plant project.
All in FPL preferred stock.
60% in the project; 40% in FPL.
60% in FPL; 40% in the project.
50% in each.

Carter Corporation has some money to invest, and its treasurer is choosing between City of Chicago municipal bonds and U.S. Treasury bonds. Both have the same maturity, and they are equally risky and liquid. If Treasury bonds yield 6 percent, and Carter’s marginal income tax rate is 40 percent, what yield on the Chicago municipal bonds would make Carter’s treasurer indifferent between the two? (Points : 1)

As a corporate investor paying a marginal tax rate of 34 percent, if 70 percent of dividends are excludable, what would be your after-tax dividend yield on preferred stock with a 16 percent before-tax dividend yield? (Points : 1)

Treasury securities that mature in 6 years currently have an interest rate of 8.5%. Inflation is expected to be 5% each of the next three years and 6% each year after the third year. The maturity risk premium is estimated to be 0.1%(t – 1), where t is equal to the maturity of the bond (i.e., the maturity risk premium of a one-year bond is zero). The real risk-free rate is assumed to be constant over time. What is the real risk-free rate of interest? (Points : 1)