1.

Solution Manual for CFIN 5th Edition by Besley and

Brigham ISBN 1305661656 9781305661653
Full download link at:
Test bank: https://testbankpack.com/p/test-bank-for-cfin-5th-edition-by-besley-and-brigham-isbn-
1305661656-9781305661653/
Solution manual: https://testbankpack.com/p/solution-manual-for-cfin-5th-edition-by-besley-and-
brigham-isbn-1305661656-9781305661653/ Chapter 05 The cost of money
Interest Rates

TRUEFALSE

1. Firms with the most profitable investment opportunities are willing and able to pay the most for
capital, so they tend to attract it away from less efficient firms or from those whose products are not
in demand.

(A) True (B)

False

Answer : (A)

2. The higher the perceived risk, the higher the required rate of return.

(A) True

(B) False

Answer : (A)

3. Inflation leads to increase in purchasing power of investors.

(A) True

(B) False

Answer : (B)

4. Bonds with higher liquidity have to offer higher interest rates in the market since they can be
easily converted into cash on short notice at or near the fair market value for that bond.

(A) True (B)

False

Answer : (B)

5. The real rate of interest is composed of a risk-free rate of interest plus the default premium and
liquidity premium that reflects the riskiness of the security
(A) True (B)

False

Answer : (B)
6. The expectations theory postulates that the term structure of interest rates is based on
expectations regarding future inflation rates.

(A) True (B)

False

Answer : (A)

7. The yield curve is downward sloping, or inverted, if the inflation rates are expected to increase.

(A) True

(B) False

Answer : (B)

8. If the Federal Reserve tightens the money supply, other things held constant, short-term interest
rates will be pushed upward, and this increase will probably be greater than the increase in rates in
the long-term market.

(A) True (B)

False

Answer : (A)

9. During or near peaks of business activity, yield curves that are flat or downward sloping (possibly
with humps) are prevalent.

(A) True (B)

False

Answer : (B)

10. If you have information that a recession is ending, and the economy is about to enter a boom,
and your firm needs to borrow money, it should probably issue long-term rather than short-term
debt.

(A) True (B)

False

Answer : (A)

11. As a country increases its borrowing to finance its foreign trade deficit, interest rates are driven
up.
(A) True (B)

False

Answer : (A)

12. Deficit trade balance hinders the Federal Reserve's ability to combat a recession by lowering
interest rates.

(A) True (B)

False

Answer : (A)

13. The value of an asset is the future value of the future cash flows that the asset is expected to
generate during its life.

(A) True (B)

False

Answer : (B)

14. In general, when rates in the financial markets increase, the prices (values) of financial assets
decrease.

(A) True (B)

False

Answer : (A)

MULTICHOICE

15. Investors with a will demand a higher rate of return.

(A) higher time preference for consumption

(B) lower exposure to economic risks

(C) lower access to production opportunities

(D) higher financial creditworthiness

(E) lower default premium

Answer : (A)
16. Production opportunity is one of the four fundamental factors that affect the:

(A) creditworthiness of investors.

(B) cost of money.

(C) liquidity of securities. (D)

inflation of an economy. (E)

maturity of an investment.

Answer : (B)

17. is the tendency of prices to increase over time.

(A) Maturity

(B) Recession

(C) Inflation

(D) Risk

(E) Liquidity

Answer : (C)

18. is the chance that a financial asset will not earn the return promised.

(A) Maturity

(B) Production opportunity

(C) Time preference for consumption

(D) Risk

(E) Inflation

Answer : (D)

19. can be negative if the value of the investment decreases during the period it is held.

(A) Risk

(B) Dividends

(C) Maturity

(D) Interests
(E) Capital gains

Answer : (E)

20. A bond purchased for $950 was sold for $980 after one year. The interest received during the
year is $25. The bond's yield is:

(A) 2.23%

(B) 5.79%

(C) 8.12%

(D) 5.25%

(E) 9.36%

Answer : (B)

21. Andrew purchased a stock for $175 and sold it for $250. If he earned a dividend income of $30,
the stock's yield is:

(A) 45%

(B) 53%

(C) 81%

(D) 60%

(E) 72%

Answer : (D)

22. The change in the market value of an asset over some time period is called the .

(A) yield

(B) maturity

(C) capital gain

(D) interest income

(E) dividend income

Answer : (C)

23. The higher the expected rate of inflation:

(A) the lower is the loss in purchasing power of investors.

(B) the higher is the required rate of return on investment.

(C) the lower is the maturity premium required by the investors.

(D) the higher is the money supply in the economy.

(E) the lower is the tax rate in the economy.

Answer : (B)

24. Which of the following indicates that the cost of money will increase?

(A) Increase in inflation of an economy

(B) Increase in liquidity of an asset

(C) Decrease in federal deficit of a country

(D) Increase in money supply in the market

(E) Decrease in tax rates for corporates

Answer : (A)

25. Your uncle would like to restrict his interest rate risk and his default risk, but he would still like
to invest in corporate bonds. Which of the possible bonds listed below best satisfies your uncle's
criteria?

(A) An AAA bond with 10 years to maturity.

(B) A BBB perpetual bond.

(C) A BBB bond with 10 years to maturity.

(D) A AAA bond with 5 years to maturity.

(E) A BBB bond with 5 years to maturity.

Answer : (D)

26. Which of the following statements is correct?

(A) The probability of default is higher on short -term bonds than on long-term bonds.

(B) Reinvestment rate risk is lower, other things held constant, on long-term than on short-term
bonds.

(C) According to the market segmentation theory, the yield curve is expected to slope downward.

(D) Borrowers prefer to borrow on a short-term basis, as a result, the yield curve is downward
sloping.
(E) If the inflation was expected to decrease in the future, then the yield curve would have an
upward slope.

Answer : (B)

27. Treasury securities that mature in 6 years currently have an interest rate of 8.5%. Inflation is
expected to be 5% in 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?

(A) 0.25%

(B) 0.50%

(C) 1.00%

(D) 1.75%

(E) 2.50%

Answer : (E)

28. You read in The Wall Street Journal that 30-day T-bills are currently yielding 8 percent. Your
brother-in-law, a broker at Kyoto Securities, has given you the following estimates of current
interest rate premiums:

Inflation premium 5%
Liquidity premium 1%
Maturity risk premium 2%
Default risk premium 2%
Based on these data, the real risk-free rate of return is:

(A) 0%.

(B) 1%.

(C) 2%.

(D) 3%.

(E) 4%.

Answer : (D)

29. Assume that the expected rates of inflation over the next 5 years are 4 percent, 7 percent, 10
percent, 8 percent, and 6 percent, respectively. What is the average expected inflation rate over this
5-year period?
(A) 6.5%

(B) 7.5%

(C) 8.0%

(D) 6.0% (E)

7.0%

Answer : (E)

30. Assume that the real risk-free rate, r*, is 4 percent, and that inflation is expected to be 9% in
Year 1, 6% in Year 2, and 4% thereafter. Also, assume that all Treasury bonds are highly liquid and
free of default risk. If 2-year and 5-year Treasury bonds both yield 12%, what is the difference in the
maturity risk premiums (MRPs) on the two bonds, i.e., what is MRP5 - MRP2?

(A) 2.1%

(B) 1.8%

(C) 5.0%

(D) 3.0%

(E) 2.5%

Answer : (A)

31. Assume that a 3-year Treasury note has no maturity premium, and that the real, risk-free rate of
interest is 3 percent. If the T-note carries a yield to maturity of 13 percent, and if the expected
average inflation rate over the next 2 years is 11 percent, what is the implied expected inflation rate
during Year 3?

(A) 7%

(B) 8%

(C) 9%

(D) 17%

(E) 18%

Answer : (B)

32. Assume that real risk-free rate (r*) = 1.0%; the maturity risk premium is found as MRP = 0.2% ×
(t - 1) where t = years to maturity; the default risk premium for AT&T bonds is found as DRP =
0.07% × (t - 1); the liquidity premium is 0.50% for AT&T bonds but zero for Treasury bonds; and
inflation is expected to be 7%, 6%, and 5% during the next three years and then 4% thereafter. What
is the difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds?
(A) 0.25%

(B) 0.50%

(C) 0.63%

(D) 1.00%

(E) 1.13%

Answer : (E)

33. You are given the following data:

r* = real risk-free rate 4%

Constant inflation premium (IP) 7%
Maturity risk premium (MRP) 1%
Default risk premium for AAA bonds 3%
(DRP)
Liquidity premium for long-term T-bonds 2%
(LP)

Assume that a highly liquid market does not exist for long-term T-bonds, and the expected rate of
inflation is a constant. Given these conditions, the rate on long-term Treasury bonds is .

(A) 23%

(B) 11%

(C) 14%

(D) 19%

(E) 27%

Answer : (C)

34. A corporate bond that yields 12% includes a risk-free rate of 7% and a default premium of 3%.
The bond's maturity risk premium is .

(A) 1%

(B) 10%

(C) 4%

(D) 2%

(E) 6%
Answer : (D)

35. Which of the following is the yield of a bond that offers a risk-free rate of 4% and a risk premium
of 2%?

(A) 2%

(B) 8%

(C) 12%

(D) 6%

(E) 9%

Answer : (D)

36. Which of the following statements is true?

(A) Treasury bonds have zero default risk.

(B) The longer the maturity of a bond, the less risky it is.

(C) The real risk-free rate incorporates inflation premium.

(D) Liquidity premium is included only for highly liquid securities.

(E) The default risk is high for AAA rated corporate bonds.

Answer : (A)

37. Which of the following bonds have the highest default risk for a given return?

(A) A U.S Treasury bond with a 2-year maturity.

(B) An AAA corporate bond with a 7-year maturity.

(C) A BBB corporate bond with a 3-year maturity.

(D) A CCC corporate bond with a 10-year maturity.

(E) An AAA corporate bond with a 3-year maturity.

Answer : (D)

38. Which of the following rates indicate the rate that will exist in an inflation-free world?

(A) Maturity risk-free rate

(B) Real risk-free rate

(C) Default risk-free rate

(D) Liquidity risk-free rate

(E) Target risk-free rate

Answer : (B)

39. Government securities that can be easily converted to cash in the market will have a:

(A) low liquidity premium.

(B) high maturity risk premium.

(C) high inflation premium.

(D) low budget risk premium.

(E) high real risk premium.

Answer : (A)

40. Other things held constant,:

(A) the "liquidity preference theory" would generally lead to an upward sloping yield curve.

(B) the "market segmentation theory" would generally lead to an upward sloping yield curve.

(C) the "expectations theory" would generally lead to an upward sloping yield curve.

(D) the yield curve under "normal" conditions would be horizontal (i.e., flat).

(E) a downward sloping yield curve would suggest that investors expect interest rates to increase in
the future.

Answer : (A)

41. If the expectations theory of the term structure of interest rates is correct, and if the other term
structure theories are invalid, and we observe a downward sloping yield curve, which of the
following is a true statement?

(A) Investors expect interest rates to be constant over time.

(B) Investors expect interest rates to increase in the future.

(C) Investors expect interest rates to decrease in the future.

(D) Investors require a positive maturity risk premium.

(E) The maturity risk premium must be positive.

Answer : (C)
42. Assume that the current interest rate on a 1-year bond is 8 percent, the current rate on a 2-year
bond is 10 percent, and the current rate on a 3-year bond is 12 percent. If the expectations theory of
the term structure is correct, what is the 1-year interest rate expected during Year 3? (Base your
answer on an arithmetic rather than geometric average.)

(A) 12.0%

(B) 16.0%

(C) 13.5%

(D) 10.5%

(E) 14.0%

Answer : (B)

43. If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury
coupon bond, relative to that on a 1-year T-bond?

(A) The yield on the 10-year bond is less than the yield on a 1-year bond.

(B) The yield on a 10-year bond will always be higher than the yield on a 1-year bond because of
maturity premiums.

(C) It is impossible to tell without knowing the coupon rates of the bonds.

(D) The yields on the two bonds are equal.

(E) It is impossible to tell without knowing the relative risks of the two bonds.

Answer : (A)

44. Assume that the current yield curve is upward sloping or normal. This implies that

(A) short-term interest rates are more volatile than long-term rates.

(B) inflation is expected to subside in the future.

(C) the economy is at the trough of a business cycle.

(D) long-term bonds are less attractive to investors than short-term bonds.

(E) short-term interest rates are lower than the long-term interest rates.

Answer : (E)

45. A normal yield curve that is upward sloping implies that:

(A) the returns on short-term securities are higher than the returns on long-term securities of similar
risk.
(B) the returns on long-term securities are equal to the returns on short-term securities of similar
risk.

(C) the returns on short-term securities are lower than the returns on long-term securities of similar
risk.

(D) the returns on bonds with higher maturity risks are lower than the returns on bonds with lower
maturity risks.

(E) the returns on bonds with a lower default risks are higher than the returns on bonds with higher
default risks.

Answer : (C)

46. Interest rates on 1-year, 2-year, and 3-year Treasury bills are 5%, 6%, and 7% respectively.
Assume that the pure expectations theory holds and that the market is in equilibrium. Which of the
following statements is correct?

(A) The maturity risk premium is positive.

(B) Interest rates are expected to fall over the next two years.

(C) The market expects one-year rates to be 7% one year from today.

(D) The default risk premium is highest for Year 2.

(E) The liquidity risk premium is highest for Year 1.

Answer : (C)

47. Assume that the expectations theory holds, and that liquidity and maturity risk premiums are
zero. If the annual rate of interest on a 2-year Treasury bond is 10.5 percent and the rate on a 1-year
Treasury bond is 12 percent, what rate of interest should you expect on a 1-year Treasury bond one
year from now?

(A) 9.0%

(B) 9.5%

(C) 10.0%

(D) 10.5%

(E) 11.0%

Answer : (A)

48. The existence of an upward sloping yield curve proves that the is correct, because an
upward sloping curve necessarily implies that lenders will lend short-term funds at lower rates than
they lend long-term funds.
(A) liquidity preference theory

(B) expectations theory

(C) market segmentation theory

(D) open market theory

(E) reinvestment theory

Answer : (A)

49. If the Federal Reserve sells $50 billion of short-term U.S. Treasury securities to the public, other
things held constant, what will this tend to do to short-term security prices and interest rates?

(A) Prices and interest rates will both rise.

(B) Prices will rise and interest rates will decline.

(C) Prices and interest rates will both decline.

(D) Prices will decline and interest rates will rise.

(E) There will be no changes in either prices or interest rates.

Answer : (D)

50. During periods of , the general tendency is toward higher interest rates.

(A) inflation

(B) recession (C)

contraction (D)

fiscal surplus (E)

securitization

Answer : (A)

51. During , both the demand for money and the rate of inflation tend to fall, which prompts the
Fed to increase the money supply, and as a result, interest rates decline.

(A) expansions

(B) a fiscal deficit

(C) recessions

(D) economic booms

(E) a foreign trade deficit

Answer : (C)

52. A federal deficit occurs when:

(A) a government issues securities to the public.

(B) stock prices of private companies decrease.

(C) social security benefits given to citizens are reduced.

(D) a government's expenses are more than its tax revenues.

(E) money supply in the market is low.

Answer : (D)

53. Other things constant, the larger the federal deficit,:

(A) the lower the level of expenses of a country.

(B) the higher the level of income of a country.

(C) the lower the level of tax rates.

(D) the lower the level of inflation rate.

(E) the higher the level of interest rates.

Answer : (E)

54. Which of the following factors will lead to an increase in interest rates?

(A) Deflation

(B) Federal deficit

(C) Contraction

(D) Recession

(E) Trade surplus

Answer : (B)

55. Which of the following actions of the Federal Reserve will reduce federal deficit?

(A) Lending more money.

(B) Purchase of securities.

(C) Printing money.

(D) Reduction of taxes.

(E) Increase expenditures.

Answer : (C)

56. When the economy is expanding too quickly and the Federal Reserve (Fed) wants to control
future growth in the economy, the Fed will:

(A) decrease the money supply.

(B) reduce the taxes levied on the public.

(C) increase the expenditure incurred in social benefits.

(D) purchase securities from the public.

(E) provide subsidies to the corporations.

Answer : (A)

57. Open market operations are operations in which:

(A) the municipal authorities bring out policies that provide better social security benefits.

(B) the government improves the infrastructure of the economy to attract foreign investors.

(C) the Federal Reserve buys or sells Treasury securities to expand or contract the U.S. money
supply.

(D) private companies establish agencies to trade their stocks in the market.

(E) the public establishes a non-profit entity to trade in the market on behalf of the community.

Answer : (C)

58. If the Federal Reserve loosens money supply then:

(A) inflation will decrease.

(B) interest rates will decrease.

(C) sale of Treasury securities will increase.

(D) credit supply will decrease.

(E) economic activity will decrease.

Answer : (B)
59. The Federal Reserve purchases U.S. Treasury securities to:

(A) loosen the money supply.

(B) reduce the credit availability.

(C) increase the interest rates.

(D) decrease the inflation.

(E) increase the tax rates.

Answer : (A)

60. If the U.S. runs a large foreign trade deficit, then the:

(A) sales of Treasury securities will decrease.

(B) interest rates will increase.

(C) government subsidies will increase.

(D) money supply will increase.

(E) tax revenue will decrease.

Answer : (B)

61. A foreign trade deficit occurs when a country's:

(A) imports are greater than its exports.

(B) tax revenue is greater than its expenditure.

(C) savings rate is higher than its borrowing rate.

(D) purchase of Treasury securities is more than sale of Treasury securities.

(E) cash reserves are higher than the expenses.

Answer : (A)

62. The value of an asset is determined by discounting the future cash flows generated by the asset
using the:

(A) tax rate.

(B) interest rate.

(C) inflation rate.

(D) deficit rate.

(E) surplus rate.

Answer : (B)

63. If a stock pays a dividend of $10 and the investors need 8% return on their investment, then the
investors should pay for the stock.

(A) $150

(B) $200

(C) $350

(D) $125

(E) $75

Answer : (D)