Questions and Answers of Cost Of Capital In Managerial Finance

What portion of the income generated by municipal bonds is considered tax- exempt and what portion is taxable income? Why do you think United States' laws are structured in this way?
What types of financial instruments are most favored by tax laws?
What is meant by the term event risk (see the nearby Financial Developments feature)? What factors appear to contribute to an increase in a corporation's stock price? A decrease in its stock price?
How can a buyer of loan-backed assets reduce prepayment risk?
What is prepayment risk? What factors lead to an increase in prepayment risk?
What types of risk are encountered by purchasers of callable financial instruments?
What is a call privilege? Why is this privilege an advantage to a security issuer and a disadvantage to a buyer of financial instruments?
What are credit derivatives? What are their principal advantages and disadvantages?
Exactly what are junk bonds? Why are they issued? How does their actual yield compare to their degree of default risk? Why do you think this is so?
In what ways are security ratings designed to reflect default risk?
Explain the meaning of the term default risk. What factors appear to have the most influence upon the degree of default risk displayed by a financial asset?
What is the relationship between marketability and yield on a financial instrument?
What does the term marketability refer to? How does it differ from liquidity? Why is it important to the saver and the issuer of a loan or security?
What are the limitations of duration and the portfolio immunization technique?
What is portfolio immunization? How does it work?
Explain the meaning and importance of the concept of duration.
What is meant by the term convexity as it relates to the price of a financial asset? In what way could it be useful information to an investor?
What is the coupon effect? How would it figure into the assessment of selecting financial assets for an investment portfolio?
What is the price elasticity of a financial asset, and what useful information can it provide to an investor or portfolio manager?
What conclusions can you draw from recent research regarding the determinants of the yield curve? Which theory of the yield curve appears to be most supported by recent research studies?
What uses does the yield curve have? Why is each possible use of potential value to borrowers and lenders of funds?
What are the implications for investors and for public policy of each of the yield curve ideas mentioned in the preceding question?
Explain the difference between the expectations, market segmentation, preferred habitat, and liquidity premium views of the yield curve. What does each theory assume?
Explain the meaning of the phrase term structure of interest rates. What is a yield curve? What assumptions are necessary to construct a yield curve?
What are TIPS? What advantages do they offer investors? Any disadvantages?
In what ways might inflation cause the prices of corporate stock to rise or fall? How might the proxy effect appear to create an inflation-stock- price link?
Explain how nominal contracts may cause inflation to affect the stock prices of some firms differently than it affects the stock prices of other firms.
Explain how inflation affects interest rates. What is the Fisher effect? What does it assume?
What is inflation? Why is it important?
A commercial loan extended to CIBER-LAND Corporation for $2.5 million assesses an interest charge of $350,000 up front. Using the discount loan method of calculating loan rates, what is the effective
A depositor places $5,000 in a credit union deposit account for a full year but then withdraws $1,000 after 270 days. At the end of the year, the credit union pays her $300 in interest. What is this
You decide to take out a 30-year mortgage loan to buy the home of your dreams. The home's purchase price is $120,000. You manage to scrape together a $20,000 down payment and plan to borrow the
You have just placed $1,500 in a bank savings deposit and plan to hold that deposit for eight years, earning 5% percent per annum. If the bank compounds interest daily, what will be the total value
Calculate the bank discount rate of return (DR) and the YTM-equivalent return for the following money market instruments:a. Purchase price, $96; par value, $100; maturity, 90 days.b. Purchase price,
An investor is interested in purchasing a new 20-year government bond carrying a 10 percent annual coupon rate with interest paid twice a year. The bond's current market price is $875 for a $1,000
You plan to borrow $2,000 to take a vacation and want to repay the loan in a year. The banker offers you a simple interest rate of 12 percent with repayment of principal in two equal installments, 6
Preferred stock for XYZ corporation is issued at par for $50 per share. If stockholders are promised an 8 percent annual dividend, what was the stock's dividend yield at time of issue? If the stock's
Suppose a 10-year bond is issued with an annual coupon rate of 8 percent when the market rate of interest is also 8 percent. If the market rate rises to 9 percent, what happens to the price of this
How is the monthly payment that a home mortgage borrower must meet determined? Why is it that payments made early in the life of a typical home mortgage go largely to pay interest rather than repay
Explain the meaning of the following terms and, where a formula is involved, explain the components of each formula:a. Simple interestb. Add-on interestc. Discount loan methodd. APRe. Compound
What is the PE ratio? What could it signal about the market's expectations of future earnings for an individual firm?
Why is the dividend yield not the full return that an investor in a stock would expect to receive?
Can you explain the logic behind the stock price formula (6.18)? Does it still offer a way to assess the value of a share of stock for an investor, even if that investor does not plan to hold the
Why is it more difficult to determine the value of the payments received from holding a stock (i.e., dividends) than the payments received from a perpetual bond?
What is meant by a perpetual financial instrument? Give an example.
What is meant by the statement that a bond is selling above par? Below par?
When dealing in bonds, what are the differences between the bid price, the ask price, the coupon rate, and the ask yield?
Carefully explain why bond yields and bond prices are inversely related? What does this relationship tell you about the market value of a bond on a day when interest rates rise? Would you want to be
How does the holding-period yield on a debt security differ from the yield to maturity?
What assumptions underlie the calculation of the yield to maturity?
Explain the meaning of the interest rate measure known as the yield to maturity.
How does the holding-period yield differ from the ask yield?
What is the difference between the bid rate and the ask rate? Which one should always be higher? Why?
What is the difference between an investment rate and a bank discount rate? As an investor in a money market asset, which one represents your actual rate of return on your investment?
What is meant by the par value of an asset, and what does it mean when an asset is said to be sold at a discount to its par value?
What exactly is a basis point? Why is it an important interest rate measure?
What is different about interest rates, or the price of credit, from other prices in the economy?
Interest rates are often called the most important "price" within the financial markets. Why do you think this is so?
What are the implications of the rational expectations theory for those who try to forecast changes in market rates of interest? Based on this view of interest rates what would you recommend to
What assumptions underlie the rational expectations view of interest?
What, then, is the rational expectations theory of interest rates? How does it differ from the other interest-rate determination theories, discussed in this chapter?
Can you explain what is meant by rational expectations?
What does it take to have a permanently stable equilibrium interest rate under the loanable funds theory of interest? How does this differ from a temporary or partial equilibrium loanable funds rate?
Suppose the demand for loanable funds increases relative to the supply. What happens to the equilibrium rate of interest? Suppose, on the other hand, the supply of loanable funds expands with
Explain how the equilibrium loanable funds interest rate is determined. Draw a graph to illustrate what the equilibrium rate of interest might look like.
What factors make up the total demand for loanable funds? The total supply of loanable funds? List and define each of these demand and supply factors.
What are loanable funds? Why is this term important?
What are the principal limitations of the liquidity preference theory of interest?
What determines the equilibrium interest rate under the liquidity preference theory of interest? What forces cause the equilibrium interest rate to move?
What makes up the total demand for money? What is the shape of the relationship between the total demand for money and the market rate of interest?
What factors appear to determine the transactions demand for money? How about the precautionary motive for demanding and holding money? The speculative motive?
The demand for money is a critical element in the liquidity preference theory of interest. What are the three main components of the demand for money?
What are the origins of the liquidity preference theory of interest? What assumptions underlie this important idea about what determines market rates of interest?
Explain why the supply curve in the classical theory of interest rates has a positive slope. Why does the demand curve in the classical theory have a negative slope?
In the classical theory of interest rates, what forces determine the market rate of interest? What assumptions does the classical theory of interest rest upon?
If we could identify the forces shaping the risk-free or pure rate of interest, what advantage could this give us in explaining the many different interest rates we see every day in the real world?
Explain the meaning of the term pure or risk-free rate of interest. Why is this interest rate important and what is its relationship to other interest rates?
What are the functions or roles played by the rate of interest in the economy and financial system? Can you explain why each function is important to the well- being of individuals, businesses, and
How might the regulation of capital serve to limit and control risk-taking by financial institutions?
What are the advantages and the disadvantages of having government-sponsored insurance in the financial system? Why is moral hazard often a problem with a government-sponsored system?
What is functional regulation and why does it appear to be needed in the modern financial system?
Why are government regulations to enforce financial disclosure and a level playing field important to the success of the financial system?
What is the significance of the life-cycle hypothesis for the management of financial institutions? Of an aging population? Of ongoing changes in the basic family unit and the spread of universal
If you were managing a small bank or insurance agency in your local community, what current and future trends in financial services and institutions would likely have the greatest impact on your
What does a level playing field mean to financial institutions and the public?
What is privacy protection and why is it important to customers of financial institutions? To financial-service institutions themselves?
What is the financial disclosure issue and what is its significance?
Why was passage of the Gramm-Leach-Bliley (Financial Services Modernization) Act so important for American financial-service institutions?
What is happening to the global payments system today? What changes in the payments system seem likely for the future?
In what ways is regulation of the financial-service sector changing?
What exactly is meant by functional regulation? What are its advantages and disadvantages for financial institutions and their customers?
Why do you think consolidation and convergence are taking place today in the financial-services sector? What are the consequences for the managers of financial institutions and for the public?
What technological changes are likely to have the greatest impact on the production and delivery of financial services to the public in future years?
How might common capital rules among all financial institutions, improved risk- management tools, and greater disclosure to the public help promote public confidence in financial institutions?
How can the private marketplace work to control a financial institution's assumption of risk and promote greater public confidence in the financial system as a whole?
Can government-sponsored insurance help to preserve and protect public confidence in our financial institutions? What are its advantages and disadvantages?
In what ways can we promote and protect public confidence in the financial- service sector of the economy? Why is this important to the public and to financial institutions?
What are the principal types of risk encountered by financial institutions?
How can we reduce risk in the financial sector?
What is meant by the term homogenization? What do you think is motivating this trend toward service homogenization today?

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