Dr. P.V. Viswanath
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1. Please define the following terms briefly:
2. Please answer the following questions in brief (no more than five
3. Answer the following questions. Please show all computations.
1. a. An agency problem arises when there is a conflict of interests
in a principal-agency situation, i.e. when somebody (a principal) appoints/hire/relies
upon another person (an agent) to work on his behalf. Because of this
conflict of interests, suboptimal actions may be taken by the agent. An
example of this is the conflict of interest between the owners and management
of a firm.
2.a. Firms that have more cashflow generated than they have avenues to
reinvest in, profitably, are likely to pay more of their earnings out
3. a. If Myrtle has a debt ratio of 0.55, Debt ¸ Total Assets =
0.55; hence Debt ¸ Equity = 0.55/0.45 or 1.22. The equity multiplier
is 2.22 (1+ the debt-equity ratio).
1. What is the present value of $910 per year, at a discount rate of 10 percent, if the first payment is received 5 years from now and the last payment is received 25 years from now?
2. a. If your bank pays you $103.25 after 6 months, for an initial deposit of $100, what is the effective annual interest rate that it is paying?
2. b. Your bank has a general policy of lending at an interest rate 0.5% higher than the interest rate that it pays its customers on their deposits. If you wanted to borrow $250,000 from your bank, and you wanted to repay the loan in monthly instalments, how much would you have to pay the bank every month for 60 months? (Note: the first payment will start at the end of the month.)
Bonus: If you offered to start the payments right away (i.e. at the beginning of the month), what would your monthly payments be?
1. The present value of the payments at the beginning of year 5 (end of year 4) is simply the present value of an annuity: = $7870.31. Bringing it back to the beginning of year 1, we get 7870.31/(1.1)4 = $5375.53.
2a. The effective annual interest rate is [(103.25)/100]2-1=0.06606 or 6.606%.
2b. The lending rate is, therefore, 6.606 + .5 or 7.106%.
We now solve the equation: 250000 = , or C = $4936.65.
Bonus: If you offered to make the payments at the beginning of the month, you would solve the equation: 250,000 = C + , or C = $4908.49.
1. Mullineaux Co. issued 11-year bonds one year ago at a coupon rate of 7.50 percent. The bonds make semi-annual payments. If the yield to maturity on these bonds is 8.5 percent, what is the current bond price? If the bonds were issued without coupons (i.e. if the coupon rate were set at zero), how much larger would the bond issue have to be (measured in terms of the face value of the bonds sold), in order to raise the same amount of money?
2. You are examining whether your savings will be adequate to meeting your retirement needs. You saved $150 last month (which was your first month of saving), and you expect your annual savings to grow 1% a month for the next 15 years. If you can invest your money at an effective annual rate of 8%, how much would you expect to have at the end of the fifth year?
1. The coupon rate is 7.5%; with semi-annual coupon payments,
that makes for a dollar payment of $37.50. Since the bonds were issued
1 year ago, and they were originally 11 year bonds, they are now 10 year
bonds. Discounting the present value of all the coupons at the semi-annual
rate of 8.5/2.25%, we get a bond price of $933.5282 or $933.53, after
2. We can compute this by first obtaining the present value
of a growing annuity, and then computing the future value. We first compute
the effective monthly rate, which works out to 1.08(1/12) =
0.6434%. We can now compute the present value as
1. Please define any three of the following terms briefly (5 points each):
2. Please answer two of the following three questions in brief (no more
than half a page) (15 points each):
3. Answer the following questions:
a. Which of the two projects, A and B, will have a higher IRR? (Answer without using a calculator.) Explain. No points without an explanation. ( 10 points)
b. Which of the two projects will have a positive IRR? (5 points)
c. Consider the following two projects, and answer the questions below:
4. In one of your classes, your professor says that decimalization is bad for investors. Explain how he might be right (10 bonus points; no more than one page).
1. a. A specialist is a NYSE member acting as a dealer in a small number
of securities on the exchange floor. He is required to ensuring a smooth
and orderly price path.
2. a. Even if the stock has never paid a dividend before, a shareholder
might want to buy it for future dividends. It could be that dividends
were not been paid in the past because of reinvestment of earnings.
3. a. In this case, both A and B have an IRR = 0 because the sum of all
the cash inflows equals the initial investment. Normally, one might have
said that Project A would have a higher IRR because the total cashflow
for both projects is the same, while those cashflows occur sooner with
4. Decimalization could reduce liquidity. This is because market makers will have less of an incentive to place limit orders. When a market maker provides a quote for a stock, he is saying that I will stand ready to buy (or sell) a minimum number of shares at that price. If anybody wants to take away a potential sale/purchase (and the associated profits) from the market maker, they would have to improve on the price offered by the market maker. With decimalization, other traders could do this for the cost of a single cent per share. Hence the expected profit for the market maker from making a market (i.e. putting out a quote) is less; this means that he is less likely to do so under decimalization. This makes for higher bid-ask spreads, which means worse prices if an investor wants to buy or sell with a market order.