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Questions and Answers of
Corporate Finance
What is capital budgeting? Why are capital budgeting decisions crucial to the long-run financial health of a business enterprise?
Is an investment's average estimated net income used to compute its return on average investment the same thing as the incremental annual cash flows used to compute its net present value? Explain
What can be said about an investment proposal that has a net present value of zero?
Depreciation expense does not require payment in cash. However, it is an important consideration in the discounting of an investment's future cash flows. Explain why.
What are some types of capital investment projects in which nonfinancial factors may outweigh financial factors?
Why is it important to consider income tax consequences when deciding whether to replace an asset?
Identify some conditions where upper management might allow some divisions to have a lower required rate of return.
What is the major shortcoming of using the payback period as the only criterion in making capital budgeting decisions?
Discounting a future cash flow at 15 percent results in a lower present value than does discounting the same cash flow at 10 percent. Explain why.
What nonfinancial considerations should be taken into account regarding a proposal to install a fire sprinkler system in a finished goods warehouse?
Compute the price, the yield and the continuously compounded yield for the following Treasury bills. For the 1-year Treasury bill also compute the semi-annually compounded yield.(a) 4-week with 3.48%
Using the semi-annually compounded yield curve in Table 2.4, price the following securities:(a) 5-year zero coupon bond(b) 7-year coupon bond paying 15% semiannually(c) 4-year coupon bond paying 7%
Consider a 10-year coupon bond paying 6% coupon rate.(a) What is its price if its yield to maturity is 6%? What if it is 5% or 7%?(b) Compute the price of the coupon bond for yields ranging between 1
Today is May 15, 2000, and the current, semi-annually compounded yield curve is in Table 3.6. Compute the duration for the following securities:(a) 3-year zero coupon bond(b) 3 1/4-year coupon bond
Compute the Macaulay and modified duration for the same securities as in Exercise 1.Today is May 15, 2000, and the current, semi-annually compounded yield curve is in Table 3.6. Compute the duration
Using the yield curve in Table 3.6, compute the dollar duration for the following securities: (a) Long a 5-year coupon bond paying 4% semiannually (b) Short a 7-year zero coupon bond (c) Long a 3
You are standing on February 15, 1994: (a) What is the total value of the portfolio? (b) Compute the dollar duration of the portfolio.
You are worried about interest rate volatility. You decide to hedge your portfolio with a 3-year coupon bond paying 4% on a semiannual basis. (a) How much should you go short/long on this bond in
Assume that it is now May 13, 1994 and that the yield curve has changed accordingly (see Table 3.7).(a) What is the value of the unhedged portfolio now?(b) What is the value of the hedged
On May 15, 2000 the semi-annually compounded yield curve was as in Table 4.6. Calculate the convexity for the following securities: (a) 4-year zero coupon bond (b) 2 1/4-year coupon bond paying 5%
Rework Example 4.3 but using a 2-year zero coupon bond for hedging, instead of the 10 year zero coupon bond. How do the results in Table 4.2 change?
Using Tables 4.8 and 4.9, compute the factor duration of level, slope, and curvature, for each of the following securities on February 15, 1994:(a) 4-year zero coupon bond(b) 2 1/2-year coupon bond
As of December 2, 2008, the 30-year swap spread had been negative for a whole month. In particular, on that day, the 3-month repo rate was 0.5%, the LIBOR rate was 2.21%, the 30-year swap rate was
Table 5.8 contains the continuously compounded forward rates ((0, T - (, T), where ( = 0.25. The first entry is the current spot rate, as for T = 0.25 we have ((0, 0, 0.25) = r(0,0.25). Compute the
Consider Exercise 6. Six months have now passed so that today is November 15, 2000. You want to calculate the payoff from being long the forward contract. Using the data in Table 5.10 answer the
Today is May 5, 2008, and the (continuously compounded) yield curve is given in Table 5.12. Calculate the semi-annual swap rate for all maturities between 6 months and 2 years (every six months).
This exercise uses the data in Table 6.9. Suppose that on February 15, 1994 a firm wants to enter into a forward contract to purchase 5-year Treasuries, with coupon rate 6%, in two years:(a) Compute
Today is t = 0. You are given the following data: • The 6-month zero coupon bond is priced at $98.24 • The 9-month zero coupon bond is priced at $97.21 • Call option (European) on the 13 week
Consider the data in Table 6.11, where P(ut (t, T1) is the price of a 90-day Eurodollar futures contract expiring on April 14, 2008; ((t, T1, T2) is the time t forward rate for 90 day LIBOR at April
Consider again Exercise 4. Imagine that back on October 16, 2007, the firm decided to sell the equipment for $98.78 million receiving the cash in 6 months. The CFO looks at the 3-month LIBOR at the
On October 16, 2007, the firm from Exercise 4 decides to enter into a Eurodollar futures contract with expiration on April 14, 2008, so it buys 100 contracts (each is worth $ 1,000,000). The firm
Today is December 12, 2008 and TIPS prices are in Table 7.8.(a) Use the extended Nelson Siegel model in Equation 7.28 to calculate the real discount curve and real yield curve.(b) Your estimates for
An important feature of TIPS is that the principal amount cannot go below 100. In other words, if the index ratio goes under one this parameter is automatically set to one. This is important in cases
Mortgage backed securities make coupon payments on a monthly basis. This means that the yield curve should be estimated in this frequency. Unfortunately, Treasuries traded on a given day are not
Consider the following MBS pass through with principal $300 million. The original mortgage pool has a WAM = 360 months (30 years) and a WAC = 7.00%. The pass through security pays a coupon equal to
The following exercise is based on a series of investments made in 1993 by City Colleges of Chicago (CCC), a system of community colleges. Its treasurer decided to invest up to 70% of its portfolio
Consider the interest rate tree in Table 9.9. (a) Compute the expected 6-month Treasury rate E[r1]. (b) The 1-year Treasury bill is trading at P0(2) = 97.4845. What is the (continuously compounded)
The current 6-month and 1-year Treasury bills are trading at Pbill(0,0.5) = 97.531 and Pbill(0,1) = 95.1241, respectively. Consider now a binomial tree with root r1, u, and r1, d and r1, d as two
Using the past history of short-term interest rates, you estimated by regression the modelrn+dt =a + (rt + ut+dtSuppose that the parameter estimates generated the tree for interest rates in Table
Consider the tree in Table 9.10. You estimated the risk neutral probability to move up the tree to be p* = 1 / 2.(a) Compute the value of the zero coupon bonds maturing at time i = 1 and at i = 2.(b)
Suppose that you estimated the risk neutral tree for interest rates in Table 11.23, where there is equal risk neutral probability to move up or down the tree. Assume also for simplicity that each
Let today be November 3, 2008.(a) Use the LIBOR rate and the swap data on November 3, 2008 in Table 11.26 and fit the LIBOR curve.(b) From the LIBOR discount curve, fit the Ho-Lee model of the
Today is November 3, 2008, and the 3-month LIBOR, swap rates and cap prices are as in Table 11.26. (a) Fit the LIBOR curve (see Exercise 5). (b) Compute the implied volatilities from the simple BDT
Consider again the risk neutral tree for interest rates in Table 12.11, where there is equal risk neutral probability to move up or down the tree.(a) Compute the tree for an American swaption with
Mortgage backed securities. In this exercise we look at some features of the optimal time of exercise the prepayment option embedded in mortgage pools. To keep things simple, we consider a short
Today is June 7, 2007. Freddie Mac is issuing a 10-year Bermudan note on June 15 2007 under the terms described in Table 12.1410. A Bermudan security is like a callable security, but with call dates
Interest rate barrier options: An interest rate barrier option is a regular option whose payoff at maturity depends on whether or not a certain level of interest rate has been touched during the life
Consider the binomial tree and the mortgage backed securities obtained in that exercise. (a) On the tree, obtain the trigger rates ri such that prepayment occurs when ri < ri- (b) Use Monte Carlo
Consider the Vasicek model of interest rateLet r = 5%. Do the following: (a) Let r0 be the short term interest rate today (you can find this value on any financial newspaper or on the Federal Reserve
Consider the Vasicek model of interest rates. Download daily data on the one-month T-bill rate from the Federal Reserve web site and use these data to estimate γ, r and Ï. This
Let r follows the process drt = γ(r - rt)dt + σdXt Use Ito's Lemma to compute the law of motion of P = F(r), for F(X) given by (a) F(r) = A + B r where A, B are two constants. (b) F(r) = e A-B r
You have estimated the parameters for the Vasicek model, and the results are in Table 15.3, where the notation is the same as that used in this chapter. The current overnight rate is 2%.(a) Compute
The zero coupon bond pricing formula under the Vasicek model depends on three parameters: γ*, *, and σ, and the current short-term interest rates, ro. How does the spot rate r(r) = - ln (Z(r,
Rework the previous exercise, but using the Cox, Ingersoll, and Ross model, whose bond pricing formula is in Equation 15.70. Use the following parameters as a baseline case: γ* = 0.3807, r* = 7.2%,
Equation 15.38 reports the dynamics of the yield with time to maturity T. Its volatility is given by σ(τ) = B(τ)/τ σ, where B(τ) = (1-e-γ* τ)/(γ*). Plot the volatility with respect to time
Equation 15.28 reports the pricing formula for the Vasicek zero coupon bond (with $1 principal). Check that it satisfies the fundamental pricing equation (Equation 15.24). That is, take the partial
In Chapters 2 (Section 2.8) and 3 (Section 3.7) we analyzed the risk and return of the Orange County portfolio, using the building blocks of zero coupon bonds and duration in this exercise, we
Today is September 25, 2008. Table 15.4 in Chapter 15 contains the STRIPS data today. According to the Vasicek model, is there any trading opportunity? Fit the Vasicek model to the data, find pricing
Refer to Exercise 1 and set up the trading strategy, as shown in Example 16.1. Check that the one-step replication strategy works, according to the model, by replicating Table 16.2 for this
On September 25, 2008 a client asks you the price of a call option with maturity November 15, 2010, written on the STRIP maturing on November 15, 2015, and with strike price 82.(a) What is the price
On October 26, 2004, PiVe International Bank, a AAA company, issued a 10-year corridor note. This note has several features that make it rather hard to price: First, it accrues a coupon only so long
Consider the corridor note discussed in Exercise 6 of Chapter 17. Perform a risk analysis using Monte Carlo simulations at the 6-month horizon. Discuss the difficulties in computing the VaR for this
Consider the economic model in Section 18.3. The term structure of interest rates plotted in Figure 18.5 assumes agents' risk aversion is h = 104 and temporal discount is p = .1.(a) Consider
Today is November 3, 2008, and the 3-month LIBOR and (interpolated) swap rates are as in Table 19.4.(a) Obtain the LIBOR yield curve from the swap rates.7(b) Let σ be the historical volatility of
Today is November 3, 2008 and you have available only the cap data in Table 19.4. Consider a European, 1-year at-the-money swaption on a 3-year swap. (a) Use the Ho-Lee model to compute the price of
Today is November 3, 2008 and you have available only the cap data in Table 19.4. Consider an American 1-year at-the-money swaption on a 3-year swap. Select a model and price the American swaption.
Table 20.6 contains quotes for swaps, caps, floors, and European swaptions on November 3, 2008. The 3-month LIBOR was r4(0,0.25) = 2.8588% while the 6-month LIBOR was r2(0,0.5) = 3.0856%.(a)
You are trading caps, and your no arbitrage model provides the dollar prices for caps in Table 20.7. Convert the dollar prices into quoted flat volatilities.Table 20.7
In Chapter 11 we covered the Black, Derman, and Toy (BDT) model. In particular, in Section 11.3.2 we covered the notion of forward volatility implicit in caps and floors. To build the BDT tree, at
Section 21.6.1 contains the convexity adjustment needed to convert Eurodollar futures quotes into forward rates according to the Ho-Lee model. Follow the same steps to obtain the convexity adjustment
Today is November 3, 2008. Table 22.3 provides the caps and swap rates quotes on this date. Fit the two-factor Vasicek model to these data. Discuss the performance of the model in fitting both the
Today is November 3, 2008. Table 22.3 provides the caps and swap rates quotes on this date.(a) Fit the two-factor Hull-White model to the cap prices. Is there any gain compared to the one-factor
Choose the term within the parentheses that best matches each of the following descriptions. a. Expenditure on research and development (financing decision I investment decision) b. A bank loan
Is limited liability always an advantage for a corporation and its shareholders? Could limited liability reduce a corporation's access to financing?
Explain the differences between the CFO's responsibilities and the treasurer's and controller's responsibilities.
Give an example of an action that might increase short-run profits but at the same time reduce stock price and the market value of the firm.
Why do financial managers refer to the opportunity cost of capital? How would you find the opportunity cost of capital for a safe investment?
You may have heard big business criticized for focusing on short-term performance at the expense of long-term results. Explain why a firm that strives to maximize stock price should be less subject
Fritz is risk-averse and is content with a relatively low but safe return on his investments. Frieda is risk-tolerant and seeks a very high rate of return on her invested savings. Yet both
We claim that the goal of the firm is to maximize current market value. Could the following actions be consistent with that goal? a. The firm adds a cost-of-living adjustment to the pensions of its
Fill in the blanks in the following passage by choosing the most appropriate term from the following list (some of the terms may be used more than once or not used at all): expected return, financial
Which of the following are investment decisions, and which are financing decisions? a. Should we stock up with inventory ahead of the holiday season? b. Do we need a bank loan to help buy the
British Quince comes across an average-risk investment project that offers a rate of return of 9.5%. This is less than the company's normal rate of return, but one of Quince's directors notes that
In a stroke of good luck, your company has uncovered an opportunity to invest for 10 years at a guaranteed 6% rate of return. How would you determine the opportunity cost of capital for this
Pollution Busters Inc. is considering a purchase of 10 additional carbon sequesters for $ 100,000 apiece. The sequesters last for only 1 year before becoming saturated. Then the carbon is sold to the
Look at some of the practices described in the box on page 20. What, if any, do you believe are the ethical issues involved?
Sometimes lawyers work on a contingency basis. They collect a percentage of their clients' settlements instead of receiving fixed fees. Why might clients prefer this arrangement? Would the
One of the "Finance through the Ages" episodes that we cited is the 1993 collapse of Barings Bank, when one of its traders lost $1.3 billion. Traders are compensated in large part according to their
When a company's stock is widely held, it may not pay an individual shareholder to spend time monitoring managers' performance and trying to replace poor performers. Explain why. Do you think that a
Company A pays its managers a fixed salary. Company B ties compensation to the performance of the stock.
How do clear and comprehensive financial reports promote effective corporate governance?
Some commentators have claimed that the U.S. system of corporate governance is "broken" and needs thorough reform. What do you think? Do you see systematic failures in corporate governance or just a
Which of the following forms of compensation is most likely to align the interests of managers and shareholders? a. A fixed salary b. A salary linked to company profits c. A salary that is paid
What are agency costs? List some ways by which agency costs are mitigated.
As you drive down a deserted highway, you are overcome with a sudden desire for a hamburger. Fortunately, just ahead are two hamburger outlets; one is owned by a national brand, and the other appears
In some countries, such as Japan and Germany, corporations develop close long-term relationships with one bank and rely on that bank for a large part of their financing needs. In the United States,
Is there a conflict between "doing well" and "doing good"? In other words, are policies that increase the value of the firm (doing well) necessarily at odds with socially responsible policies (doing
It is sometimes suggested that instead of seeking to maximize shareholder value and, in the process, pursuing profit, the firm should seek to maximize the welfare of all its stakeholders, such as its
Read the following passage and fit each of the following terms into the most appropriate space: financing, real, bonds, investment, executive airplanes, financial, capital budgeting, brand names.
What do we mean when we say that corporate income is subject to double taxation?
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