Chapter 1
An Overview of Corporate Finance and
The Financial Environment

ANSWERS TO END-OF-CHAPTER QUESTIONS




1-1 a. A proprietorship, or sole proprietorship, is a business owned by one individual. A partnership exists when two or more persons associate to conduct a business. In contrast, a corporation is a legal entity created by a state. The corporation is separate and distinct from its owners and managers.

b. In a limited partnership, limited partners’ liabilities, investment returns and control are limited, while general partners have unlimited liability and control. A limited liability partnership (LLP), sometimes called a limited liability company (LLC), combines the limited liability advantage of a corporation with the tax advantages of a partnership. A professional corporation (PC), known in some states as a professional association (PA), has most of the benefits of incorporation but the participants are not relieved of professional (malpractice) liability.

c. Stockholder wealth maximization is the appropriate goal for management decisions. The risk and timing associated with expected earnings per share and cash flows are considered in order to maximize the price of the firm’s common stock.

d. A money market is a financial market for debt securities with maturities of less than one year (short-term). The New York money market is the world’s largest. Capital markets are the financial markets for long-term debt and corporate stocks. The New York Stock Exchange is an example of a capital market. Primary markets are the markets in which newly issued securities are sold for the first time. Secondary markets are where securities are resold after initial issue in the primary market. The New York Stock Exchange is a secondary market.

e. In private markets, transactions are worked out directly between two parties and structured in any manner that appeals to them. Bank loans and private placements of debt with insurance companies are examples of private market transactions. In public markets, standardized contracts are traded on organized exchanges. Securities that are issued in public markets, such as common stock and corporate bonds, are ultimately held by a large number of individuals. Private market securities are more tailor-made but less liquid, whereas public market securities are more liquid but subject to greater standardization. Derivatives are claims whose value depends on what happens to the value of some other asset. Futures and options are two important types of derivatives, and their values depend on what happens to the prices of other assets, say IBM stock, Japanese yen, or pork bellies. Therefore, the value of a derivative security is derived from the value of an underlying real asset.

f. An investment banker is a middleman between businesses and savers. Investment banking houses assist in the design of corporate securities and then sell them to savers (investors) in the primary markets. Financial service corporations offer a wide range of financial services such as brokerage operations, insurance, and commercial banking. A financial intermediary buys securities with funds that it obtains by issuing its own securities. An example is a common stock mutual fund that buys common stocks with funds obtained by issuing shares in the mutual fund.

g. A mutual fund is a corporation that sells shares in the fund and uses the proceeds to buy stocks, long-term bonds, or short-term debt instruments. The resulting dividends, interest, and capital gains are distributed to the fund’s shareholders after the deduction of operating expenses. Different funds are designed to meet different objectives. Money market funds are mutual funds which invest in short-term debt instruments and offer their shareholders check writing privileges; thus, they are essentially interest-bearing checking accounts.

Physical location exchanges, such as the New York Stock Exchange, facilitate communication between buyers and sellers of securities. Each physical location exchange is a physical entity at a particular location and is governed by an elected board of governors. A computer/telephone network, such as Nasdaq, consists of all the facilities that provide for security transactions not conducted at a physical location exchange. These facilities are, basically, the communications network that links the buyers and sellers.

An open outcry auction is a method of matching buyers and sellers. In an auction, the buyers and sellers are face-to-face, with each stating the prices and which they will buy or sell. In a dealer market, a dealer holds an inventory of the security and makes a market by offering to buy or sell. Others who wish to buy or sell can see the offers made by the dealers, and can contact the dealer of their choice to arrange a transaction. In an ECN, orders from potential buyers and sellers are automatically matched, and the transaction is automatically completed.

j. Production opportunities are the returns available within an economy from investment in productive assets. The higher the production opportunities, the more producers would be willing to pay for required capital. Consumption time preferences refer to the preferred pattern of consumption. Consumer’s time preferences for consumption establish how much consumption they are willing to defer, and hence save, at different levels of interest.

k. The real risk-free rate is that interest rate which equalizes the aggregate supply of, and demand for, riskless securities in an economy with zero inflation. The real risk-free rate could also be called the pure rate of interest since it is the rate of interest that would exist on very short-term, default-free U.S. Treasury securities if the expected rate of inflation were zero. It has been estimated that this rate of interest, denoted by r*, has fluctuated in recent years in the United States in the range of 2 to 4 percent. The nominal risk-free rate of interest, denoted by rRF, is the real risk-free rate plus a premium for expected inflation. The short-term nominal risk-free rate is usually approximated by the U.S. Treasury bill rate, while the long-term nominal risk-free rate is approximated by the rate on U.S. Treasury bonds. Note that while T-bonds are free of default and liquidity risks, they are subject to risks due to changes in the general level of interest rates.

l. The inflation premium is the premium added to the real risk-free rate of interest to compensate for the expected loss of purchasing power. The inflation premium is the average rate of inflation expected over the life of the security. Default risk is the risk that a borrower will not pay the interest and/or principal on a loan as they become due. Thus, a default risk premium (DRP) is added to the real risk-free rate to compensate investors for bearing default risk. Liquidity refers to a firm’s cash and marketable securities position, and to its ability to meet maturing obligations. A liquid asset is any asset that can be quickly sold and converted to cash at its “fair” value. Active markets provide liquidity. A liquidity premium is added to the real risk-free rate of interest, in addition to other premiums, if a security is not liquid.

m. Interest rate risk arises from the fact that bond prices decline when interest rates rise. Under these circumstances, selling a bond prior to maturity will result in a capital loss, and the longer the term to maturity, the larger the loss. Thus, a maturity risk premium must be added to the real risk-free rate of interest to compensate for interest rate risk. Reinvestment rate risk occurs when a short-term debt security must be “rolled over.” If interest rates have fallen, the reinvestment of principal will be at a lower rate, with correspondingly lower interest payments and ending value. Note that long-term debt securities also have some reinvestment rate risk because their interest payments have to be reinvested at prevailing rates.

n. The term structure of interest rates is the relationship between yield to maturity and term to maturity for bonds of a single risk class. The yield curve is the curve that results when yield to maturity is plotted on the Y-axis with term to maturity on the X-axis.

o. When the yield curve slopes upward, it is said to be “normal,” because it is like this most of the time. Conversely, a downward-sloping yield curve is termed “abnormal” or “inverted.”

p. The expectations theory states that the slope of the yield curve depends on expectations about future inflation rates and interest rates. Thus, if the annual rate of inflation and future interest rates are expected to increase, the yield curve will be upward sloping, whereas the curve will be downward sloping if the annual rates are expected to decrease.

r. A foreign trade deficit occurs when businesses and individuals in the U. S. import more goods from foreign countries than are exported. Trade deficits must be financed, and the main source of financing is debt. Therefore, as the trade deficit increases, the debt financing increases, driving up interest rates. U. S. interest rates must be competitive with foreign interest rates; if the Federal Reserve attempts to set interest rates lower than foreign rates, foreigners will sell U.S. bonds, decreasing bond prices, resulting in higher U. S. rates. Thus, if the trade deficit is large relative to the size of the overall economy, it may hinder the Fed’s ability to combat a recession by lowering interest rates.

1-2 Sole proprietorship, partnership, and corporation are the three principal forms of business organization. The advantages of the first two include the ease and low cost of formation. The advantages of the corporation include limited liability, indefinite life, ease of ownership transfer, and access to capital markets.
The disadvantages of a sole proprietorship are (1) difficulty in obtaining large sums of capital; (2) unlimited personal liability for business debts; and (3) limited life. The disadvantages of a partnership are (1) unlimited liability, (2) limited life, (3) difficulty of transferring ownership, and (4) difficulty of raising large amounts of capital. The disadvantages of a corporation are (1) double taxation of earnings and (2) requirements to file state and federal reports for registration, which are expensive, complex and time-consuming.

1-3 The three primary determinants of a firm’s cash flows are: (1) sales revenues; (2) operating expenses, such as raw materials costs and labor costs; and (3) the necessary investments in operating capital, such as buildings, equipment, and inventory.

1-4 Financial intermediaries are business organizations that receive funds in one form and repackage them for the use of those who need funds. Through financial intermediation, resources are allocated more effectively, and the real output of the economy is thereby increased.

1-5 Short-term rates are more volatile because (1) the Fed operates mainly in the short-term sector, hence Federal Reserve intervention has its major effect here, and (2) long-term rates reflect the average expected inflation rate over the next 20 to 30 years, and this average does not change as radically as year-to-year expectations.

1-6 a. If transfers between the two markets were costly, interest rates would be different in the two areas. Area Y, with the relatively young population, would have less in savings accumulation and stronger loan demand. Area O, with the relatively old population, would have more savings accumulation and weaker loan demand as the members of the older population have already purchased their houses, and are less consumption oriented. Thus, supply/demand equilibrium would be at a higher rate of interest in Area Y.

b. Yes. Nationwide branching, and so forth, would reduce the cost of financial transfers between the areas. Thus, funds would flow from Area O with excess relative supply to Area Y with excess relative demand. This flow would increase the interest rate in Area O and decrease the interest rate in Y until the rates were roughly equal, the difference being the transfer cost.

1-7 a. The immediate effect on the yield curve would be to lower interest rates in the short-term end of the market, since the Fed deals primarily in that market segment. However, people would expect higher future inflation, which would raise long-term rates. The result would be a much steeper yield curve.

b. If the policy is maintained, the expanded money supply will result in increased rates of inflation and increased inflationary expectations. This will cause investors to increase the inflation premium on all debt securities, and the entire yield curve would rise; that is, all rates would be higher.





SOLUTIONS TO END-OF-CHAPTER PROBLEMS



1-1 r* = 3%; I1 = 2%; I2 = 4%; I3 = 4%; MRP = 0; rT-2 = ?; rT-3 = ?

r = r* + IP + DRP + LP + MRP.

Since these are Treasury securities, DRP = LP = 0.

rT-2 = r* + IP2
IP2 = (2% + 4%)/2 = 3%
rT-2 = 3% + 3% = 6%.

rT-3 = r* + IP3
IP3 = (2% + 4% + 4%)/3 = 3.33%
rT-3 = 3% + 3.33% = 6.33%.


1-2 rT-10 = 6%; rC-10 = 8%; LP = 0.5%; DRP = ?

r = r* + IP + DRP + LP + MRP.

rT-10 = 6% = r* + IP + MRP; DRP = LP = 0.

rC-10 = 8% = r* + IP + DRP + 0.5% + MRP.

Because both bonds are 10-year bonds the inflation premium and maturity risk premium on both bonds are equal. The only difference between them is the liquidity and default risk premiums.

rC-10 = 8% = r* + IP + MRP + 0.5% + DRP. But we know from above that r* + IP + MRP = 6%; therefore,

rC-10 = 8% = 6% + 0.5% + DRP
1.5% = DRP.


1-3 r* = 3%; IP = 3%; rT-2 = 6.2%; MRP2 = ?

rT-2 = k* + IP + MRP = 6.2%
rT-2 = 3% + 3% + MRP = 6.2%
MRP = 0.2%.

1-4 r = r* + IP + MRP + DRP + LP.
r* = 0.03.
IP = [0.03 + 0.04 + (5)(0.035)]/7 = 0.035.
MRP = 0.0005(6) = 0.003.
DRP = 0.
LP = 0.

r = 0.03 + 0.035 + 0.003 = 0.068 = 6.8%.


1-5 First, note that we will use the equation rt = 3% + IPt + MRPt. We have the data needed to find the IPs:

IP5 = = = 5%.

IP2 = = 6.5%.

Now we can substitute into the equation:

r2 = 3% + 6.5% + MRP2 = 10%. r5 = 3% + 5% + MRP5 = 10%.

Now we can solve for the MRPs, and find the difference:

MRP5 = 10% - 8% = 2%. MRP2 = 10% - 9.5% = 0.5%.

Difference = (2% - 0.5%) = 1.5%.

1-6 Basic relevant equations:

rt = r* + IPt + DRPt + MRPt + LPt.

But here IP is the only premium, so rt = r* + IPt.

IPt = Avg. inflation = (I1 + I2 + ...)/N.

We know that I1 = IP1 = 3% and r* = 2%. Therefore,

r1 = 2% + 3% = 5%. r3 = r1 + 2% = 5% + 2% = 7%. But,

r3 = r* + IP3 = 2% + IP3 = 7%, so

IP3 = 7% - 2% = 5%.

We also know that It = Constant after t = 1.

We can set up this table:

r* I Avg. I = IPt r = r* + IPt
1 2 3 3%/1 = 3% 5%
2 2 I (3% + I)/2 = IP2
3 2 I (3% + I + I)/3 = IP3 r3 = 7%, so IP3 = 7% - 2% = 5%.

Avg. I = IP3 = (3% + 2I)/3 = 5%
2I = 12%
I = 6%.


1-7 a. Real
Years to Risk-Free
Maturity Rate (r*) IP** MRP rT = r* + IP + MRP
1 2% 7.00% 0.2% 9.20%
2 2 6.00 0.4 8.40
3 2 5.00 0.6 7.60
4 2 4.50 0.8 7.30
5 2 4.20 1.0 7.20
10 2 3.60 1.0 6.60
20 2 3.30 1.0 6.30


**The computation of the inflation premium is as follows:

Expected Average
Year Inflation Expected Inflation
1 7% 7.00%
2 5 6.00
3 3 5.00
4 3 4.50
5 3 4.20
10 3 3.60
20 3 3.30

For example, the calculation for 3 years is as follows:


Thus, the yield curve would be as follows:






b. The interest rate on the Exxon bonds has the same components as the Treasury securities, except that the Exxon bonds have default risk, so a default risk premium must be included. Therefore,

rExxon = r* + IP + MRP + DRP.


For a strong company such as Exxon, the default risk premium is virtually zero for short-term bonds. However, as time to maturity increases, the probability of default, although still small, is sufficient to warrant a default premium. Thus, the yield risk curve for the Exxon bonds will rise above the yield curve for the Treasury securities. In the graph, the default risk premium was assumed to be 1.0 percentage point on the 20-year Exxon bonds. The return should equal 6.3% + 1% = 7.3%.

c. LILCO bonds would have significantly more default risk than either Treasury securities or Exxon bonds, and the risk of default would increase over time due to possible financial deterioration. In this example, the default risk premium was assumed to be 1.0 percentage point on the 1-year LILCO bonds and 2.0 percentage points on the 20-year bonds. The 20-year return should equal 6.3% + 2% = 8.3%.



SOLUTION TO SPREADSHEET PROBLEM



1-8 The detailed solution for the spreadsheet problem is available both on the instructor’s resource CD-ROM (in the file Solution for FM11 Ch 01 P08 Build a Model.xls) and on the instructor’s side of the textbook’s web site, http://brigham.swcollege.com.



MINI CASE




Assume that you recently graduated with a degree in finance and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firm’s clients is Michelle Dellatorre, a professional tennis player who has just come to the United States from Chile. Dellatorre is a highly ranked tennis player who would like to start a company to produce and market apparel that she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. Dellatorre is also very bright, and, therefore, she would like to understand, in general terms, what will happen to her money. Your boss has developed the following set of questions which you must ask and answer to explain the U.S. financial system to Dellatorre.


a. Why is corporate finance important to all managers?

Answer: Corporate finance provides the skills managers need to: (1) identify and select the corporate strategies and individual projects that add value to their firm; and (2) forecast the funding requirements of their company, and devise strategies for acquiring those funds.


b. Describe the organizational forms a company might have as it evolves from a start-up to a major corporation. List the advantages and disadvantages of each form.

Answer: The three main forms of business organization are (1) sole proprietorships, (2) partnerships, and (3) corporations. In addition, several hybrid forms are gaining popularity. These hybrid forms are the limited partnership, the limited liability partnership, the professional corporation, and the s corporation.
The proprietorship has three important advantages: (1) it is easily and inexpensively formed, (2) it is subject to few government regulations, and (3) the business pays no corporate income taxes. The proprietorship also has three important limitations: (1) it is difficult for a proprietorship to obtain large sums of capital; (2) the proprietor has unlimited personal liability for the business’s debts, and (3) the life of a business organized as a proprietorship is limited to the life of the individual who created it.
The major advantage of a partnership is its low cost and ease of formation. The disadvantages are similar to those associated with proprietorships: (1) unlimited liability, (2) limited life of the organization, (3) difficulty of transferring ownership, and (4) difficulty of raising large amounts of capital. The tax treatment of a partnership is similar to that for proprietorships, which is often an advantage.
The corporate form of business has three major advantages: (1) unlimited life, (2) easy transferability of ownership interest, and (3) limited liability. While the corporate form offers significant advantages over proprietorships and partnerships, it does have two primary disadvantages: (1) corporate earnings may be subject to double taxation and (2) setting up a corporation and filing the many required state and federal reports is more complex and time-consuming than for a proprietorship or a partnership.
In a limited partnership, the limited partners are liable only for the amount of their investment in the partnership; however, the limited partners typically have no control. The limited liability partnership form of organization combines the limited liability advantage of a corporation with the tax advantages of a partnership. Professional corporations provide most of the benefits of incorporation but do not relieve the participants of professional liability. S corporations are similar in many ways to limited liability partnerships, but LLPS frequently offer more flexibility and benefits to their owners.

c. How do corporations “go public” and continue to grow? What are agency problems?

Answer: A company goes public when it sells stock to the public in an initial public as the firm grows, it might issue additional stock or debt. An agency problem occurs when the managers of the firm act in their own self interests and not in the interests of the shareholders.



d. What should be the primary objective of managers?

Answer: The corporation’s primary goal is stockholder wealth maximization, which translates to maximizing the price of the firm’s common stock.


d. 1. Do firms have any responsibilities to society at large?

Answer: Firms have an ethical responsibility to provide a safe working environment, to avoid polluting the air or water, and to produce safe products. However, the most significant cost-increasing actions will have to be put on a mandatory rather than a voluntary basis to ensure that the burden falls uniformly on all businesses.





d. 2. Is stock price maximization good or bad for society?

Answer: The same actions that maximize stock prices also benefit society. Stock price maximization requires efficient, low-cost operations that produce high-quality goods and services at the lowest possible cost. Stock price maximization requires the development of products and services that consumers want and need, so the profit motive leads to new technology, to new products, and to new jobs. Also, stock price maximization necessitates efficient and courteous service, adequate stocks of merchandise, and well-located business establishments--factors that are all necessary to make sales, which are necessary for profits.


d. 3. Should firms behave ethically?

Answer: Yes. Results of a recent study indicate that the executives of most major firms in the United States believe that firms do try to maintain high ethical standards in all of their business dealings. Furthermore, most executives believe that there is a positive correlation between ethics and long-run profitability. Conflicts often arise between profits and ethics. Companies must deal with these conflicts on a regular basis, and a failure to handle the situation properly can lead to huge product liability suits and even to bankruptcy. There is no room for unethical behavior in the business world.


e. What three aspects of cash flows affect the value of any investment?

Answer: (1) amount of expected cash flows; (2) timing of the cash flow stream; and (3) riskiness of the cash flows.


f. What are free cash flows? What are the three determinants of free cash flows?

Answer: free cash flows are the cash flows available for distribution to all investors (stockholders and creditors) after paying expenses (including taxes) and making the necessary investments to support growth. Three factors determine cash flows: (1) current level and growth rates of sales; (2) operating expenses; and (3) capital expenses.


g. What is the weighted average cost of capital? What affects it?

Answer: The weighted average cost of capital (WACC) is the average rate of return required by all of the company’s investors (stockholders and creditors). It is affected by the firm’s capital structure, interest rates, the firm’s risk, and the market’s overall attitude toward risk.
h. How do free cash flows and the weighted average cost of capital interact to determine a firm’s value?

Answer: A firm’s value is the sum of all future expected free cash flows, converted into today’s dollars.



i. What are financial assets? Describe some financial instruments.

Answer: Financial assets are pieces of paper with contractual obligations. Some short-term (i.e., they mature in less than a year) are instruments with low default risk are u.s. treasury bills, banker’s acceptances, commercial paper, negotiable CDs, and eurodollar deposits. Commercial loans (which have maturities up to seven years) have rates that are usually tied to the prime rate (i.e., the rate that U.S. banks charge to their best customers) or LIBOR (the London Interbank Offered Rate, which is the rate that banks in the U.K. charge one another. U.S. treasury notes and bonds have maturities from two to thirty years; they are free of default risk. Mortgages have maturities up to thirty years. Municipal bonds have maturities of up to thirty years; their interest is exempt from most taxes. Corporate bonds have maturities up to forty years. Municipal and corporate bonds are subject to default risk. Some preferred stocks have no maturity date, some do have a specific maturity date. Common stock has no maturity date, and is riskier than preferred stock.



j. Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between savers and borrowers?

Answer: Households are net savers. Non-financial corporations are net borrowers. Governments are net borrowers, although the U.S. government is a net saver when it runs a surplus. Non-financial corporations (i.e., financial intermediaries) are slightly net borrowers, but they are almost breakeven. Capital is transferred through: (1) direct transfer (e.g., corporation issues commercial paper to insurance company); (2) an investment banking house (e.g., IPO, seasoned equity offering, or debt placement); (3) a financial intermediary (e.g., individual deposits money in bank, bank makes commercial loan to a company).





k. List some financial intermediaries.

Answer: Commercial banks, savings & loans, mutual savings banks, and credit unions, life insurance companies, mutual funds, and pension funds are financial intermediaries.


l. What are some different types of markets?

Answer: A market is a method of exchanging one asset (usually cash) for another asset. Some types of markets are: physical assets vs. financial assets; spot versus future markets; money versus capital markets; primary versus secondary markets.


m. How are secondary markets organized?

Answer: They are categorized by “location” (physical location exchanges or computer/telephone networks) and by the way that orders from buyers and sellers are matched (open outcry auctions, dealers (i.e., market makers), and electronic communications networks (ECNS).


m. 1. List some physical location markets and some computer/telephone networks.

Answer: Physical location exchanges include the NYSE, AMEX, CBOT, and Tokyo stock exchange. Computer/telephone networks include Nasdaq, government bond markets, and foreign exchange markets.


m. 2. Explain the differences between open outcry auctions, dealer markets, and electronic communications networks (ECNS).

Answer: The NYSE and AMEX are the two largest auction markets for stocks (NYSE is a modified auction, with a “specialist”). Participants have a seat on the exchange, meet face-to-face, and place orders for themselves or for their clients; e.g., CBOT. Some orders are market orders, which are executed at the current market price, some are limit orders, which specify that the trade should occur only at a certain price within a certain time period (or the trade does not occur at all). In dealer markets, “dealers” keep an inventory of the stock (or other financial asset) and place bid and ask “advertisements,” which are prices at which they are willing to buy and sell. A computerized quotation system keeps track of bid and ask prices, but does not automatically match buyers and sellers. Some examples of dealer markets are the Nasdaq national market, the Nasdaq small cap market, the London SEAQ, and the German Neuer market. ECNS are computerized systems that match orders from buyers and sellers and automatically execute the trades. Some examples are Instinet (US, stocks), Eurex (Swiss-German, futures contracts), sets (London, stocks). In the old days, securities were kept in a safe behind the counter, and passed “over the counter” when they were sold. Now the OTC market is the equivalent of a computer bulletin board, which allows potential buyers and sellers to post an offer. However, the OTC has no dealers and very poor liquidity.


n. What do we call the price that a borrower must pay for debt capital? What is the price of equity capital? What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy?

Answer: The interest rate is the price paid for borrowed capital, while the return on equity capital comes in the form of dividends plus capital gains. The return that investors require on capital depends on (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation.
Production opportunities refer to the returns that are available from investment in productive assets: the more productive a producer firm believes its assets will be, the more it will be willing to pay for the capital necessary to acquire those assets.
Time preference for consumption refers to consumers’ preferences for current consumption versus savings for future consumption: consumers with low preferences for current consumption will be willing to lend at a lower rate than consumers with a high preference for current consumption.
Inflation refers to the tendency of prices to rise, and the higher the expected rate of inflation, the larger the required rate of return.
Risk, in a money and capital market context, refers to the chance that a loan will not be repaid as promised--the higher the perceived default risk, the higher the required rate of return.
Risk is also linked to the maturity and liquidity of a security. The longer the maturity and the less liquid (marketable) the security, the higher the required rate of return, other things constant.
The preceding discussion related to the general level of money costs, but the level of interest rates will also be influenced by such things as fed policy, fiscal and foreign trade deficits, and the level of economic activity. Also, individual securities will have higher yields than the risk-free rate because of the addition of various premiums as discussed below.


o. What is the real risk-free rate of interest (r*) and the nominal risk-free rate (rRF)? How are these two rates measured?

Answer: Keep these equations in mind as we discuss interest rates. We will define the terms as we go along:

r = r* + IP + DRP + LP + MRP.

rRF = r* + IP.

The real risk-free rate, r*, is the rate that would exist on default-free securities in the absence of inflation.
The nominal risk-free rate, rrf, is equal to the real risk-free rate plus an inflation premium which is equal to the average rate of inflation expected over the life of the security.
There is no truly riskless security, but the closest thing is a short-term U. S. Treasury bill (t-bill), which is free of most risks. The real risk-free rate, r*, is estimated by subtracting the expected rate of inflation from the rate on short-term treasury securities. It is generally assumed that r* is in the range of 1 to 4 percentage points. The t-bond rate is used as a proxy for the long-term risk-free rate. However, we know that all long-term bonds contain interest rate risk, so the t-bond rate is not really riskless. It is, however, free of default risk.


p. Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Which of these premiums is included when determining the interest rate on (1) short-term U.S. treasury securities, (2) long-term U.S. treasury securities, (3) short-term corporate securities, and (4) long-term corporate securities? Explain how the premiums would vary over time and among the different securities listed above.

Answer: The inflation premium (IP) is a premium added to the real risk-free rate of interest to compensate for expected inflation.
The default risk premium (DRP) is a premium based on the probability that the issuer will default on the loan, and it is measured by the difference between the interest rate on a U.S. treasury bond and a corporate bond of equal maturity and marketability.
A liquid asset is one that can be sold at a predictable price on short notice; a liquidity premium is added to the rate of interest on securities that are not liquid.
The maturity risk premium (MRP) is a premium which reflects interest rate risk; longer-term securities have more interest rate risk (the risk of capital loss due to rising interest rates) than do shorter-term securities, and the MRP is added to reflect this risk.

1. Short-term treasury securities include only an inflation premium.

2. Long-term treasury securities contain an inflation premium plus a maturity risk premium. Note that the inflation premium added to long-term securities will differ from that for short-term securities unless the rate of inflation is expected to remain constant.

3. The rate on short-term corporate securities is equal to the real risk-free rate plus premiums for inflation, default risk, and liquidity. The size of the default and liquidity premiums will vary depending on the financial strength of the issuing corporation and its degree of liquidity, with larger corporations generally having greater liquidity because of more active trading.

4. The rate for long-term corporate securities also includes a premium for maturity risk. Thus, long-term corporate securities generally carry the highest yields of these four types of securities.


q. What is the term structure of interest rates? What is a yield curve?

Answer: The term structure of interest rates is the relationship between interest rates, or yields, and maturities of securities. When this relationship is graphed, the resulting curve is called a yield curve.


r. Suppose most investors expect the inflation rate to be 5 percent next year, 6 percent the following year, and 8 percent thereafter. The real risk-free rate is 3 percent. The maturity risk premium is zero for securities that mature in 1 year or less, 0.1 percent for 2-year securities, and then the MRP increases by 0.1 percent per year thereafter for 20 years, after which it is stable. What is the interest rate on 1-year, 10-year, and 20-year treasury securities? Draw a yield curve with these data. What factors can explain why this constructed yield curve is upward sloping?

Answer: Step 1: find the average expected inflation rate over years 1 to 20:

Yr 1: IP = 5.0%.

Yr 10: IP = (5 + 6 + 8 + 8 + 8 + ... + 8)/10 = 7.5%.

Yr 20: IP = (5 + 6 + 8 + 8 + ... + 8)/20 = 7.75%.

Step 2: find the maturity premium in each year:

Yr 1: MRP = 0.0%.

Yr 10: MRP = 0.1 ? 9 = 0.9%.

Yr 20: MRP = 0.1 ? 19 = 1.9%.

Step 3: sum the IPS and MRPS, and add r* = 3%:

Yr 1: rRF = 3% + 5.0% + 0.0% = 8.0%.

Yr 10: rRF = 3% + 7.5% + 0.9% = 11.4%.

Yr 20: rRF = 3% + 7.75% + 1.9% = 12.65%.

The shape of the yield curve depends primarily on two factors:
(1) expectations about future inflation and (2) the relative riskiness of securities with different maturities.
The constructed yield curve is upward sloping. This is due to increasing expected inflation and an increasing maturity risk premium.


s. At any given time, how would the yield curve facing an AAA-rated company compare with the yield curve for U. S. Treasury securities? At any given time, how would the yield curve facing a BB-rated company compare with the yield curve for U. S. Treasury securities? Draw a graph to illustrate your answer.

Answer: The yield curve normally slopes upward, indicating that short-term interest rates are lower than long-term interest rates. Yield curves can be drawn for government securities or for the securities of any corporation, but corporate yield curves will always lie above government yield curves, and the riskier the corporation, the higher its yield curve. The spread between a corporate yield curve and the treasury curve widens as the corporate bond rating decreases.





t. What is the pure expectations theory? What does the pure expectations theory imply about the term structure of interest rates?

Answer: The pure expectations theory assumes that investors establish bond prices and interest rates strictly on the basis of expectations for interest rates. This means that they are indifferent with respect to maturity in the sense that they do not view long-term bonds as being riskier than short-term bonds. If this were true, then the maturity risk premium would be zero, and long-term interest rates would simply be a weighted average of current and expected future short-term interest rates. If the pure expectations theory is correct, you can use the yield curve to “back out” expected future interest rates.


u. Finally, Dellatorre is also interested in investing in countries other than the United States. Describe the various types of risks that arise when investing overseas.

Answer: First, Dellatorre should consider country risk, which refers to the risk that arises from investing or doing business in a particular country. This risk depends on the country’s economic, political, and social environment. Country risk also includes the risk that property will be expropriated without adequate compensation, as well as new host country stipulations about local production, sourcing or hiring practices, and damage or destruction of facilities due to internal strife.
Second, Dellatorre should consider exchange rate risk. Dellatorre needs to keep in mind when investing overseas that more often than not the security will be denominated in a currency other than the dollar, which means that the value of the investment will depend on what happens to exchange rates. Two factors can lead to exchange rate fluctuations. Changes in relative inflation will lead to changes in exchange rates. Also, an increase in country risk will also cause the country’s currency to fall. Consequently, inflation risk, country risk, and exchange rate risk are all interrelated.