Chapter 2- Asset Classes and Financial Instruments

1.
A municipal bond carries a coupon of 6 % and is trading at par. What is the
equivalent taxable yield to a taxpayer in a combined federal plus state 34% tax
bracket?
The equivalent taxable yield is: 6.75% / (1 0.34) = 10.23%
2. The coupon rate on a tax- exempt bond is 5.6%, and the rate on a taxable bond is
8%. Both bonds sell at par. At what tax bracket marginal tax rate) would an investor
be indifferent between the two bonds?
If the after-tax yields are equal, then: 0.056 = 0.08 x (1 - t)
This implies that t = 0.30 =30%.

3. Why do most professionals consider the Wilshire 5000 a better index of the
performance of the broad stock market than the Dow Jones Industrial Average? ( LO
2- 2)
While the DJIA has 30 large corporations in the index, it does not represent the overall market
nearly as well as the more than 5000 stocks contained in The Wilshire index. The DJIA is just
too small.

4. What is meant by the LIBOR rate? The Federal funds rate? TED Spread? ( LO 2- 1)
The London Interbank Offer Rate (LIBOR) is the rate at which large banks in London are
willing to lend money among themselves. The Fed funds rate is the rate of interest on very shortterm loans among financial institutions in the U.S.
5. Why are corporations more apt to hold preferred stock than are other potential
investors? (LO 2-1)
Corporations may exclude 70% of dividends received from domestic corporations in the
computation of their taxable income.

6. A municipal bond carries a coupon rate of 6 % and is trading at par. What

would be the equivalent taxable yield of this bond to a taxpayer in a 35% tax
bracket? ( LO 2- 1)
Equivalent taxable yield = Rate on municipal bond/1-tax rate
= rm/1-t
=.0675/1-.35
=.1038 or 10.38%
7. Suppose that short- term municipal bonds currently offer yields of 4%, while
comparable taxable bonds pay 5%. Which gives you the higher after- tax yield if
your tax bracket is: ( LO 2- 1)

a. Zero
b. 10%
c. 20%
d. 30%
After-tax yield = Rate on the taxable bond x (1 - Tax rate)
a. The taxable bond. With a zero tax bracket, the after-tax yield for the taxable bond is the same
as the before-tax yield (5%), which is greater than the 4% yield on the municipal bond.
b. The taxable bond. The after-tax yield for the taxable bond is: 0.05 x (1 - 0.10) = 0.045 or
4.50%.
c. Neither. The after-tax yield for the taxable bond is: 0.05 x (1 - 0.20) = 0.4 or 4%. The after-tax
yield of taxable bond is the same as that of the municipal bond.
d. The municipal bond. The after-tax yield for the taxable bond is: 0.05 x (1 - 0.30) = 0.035 or
3.5%. The municipal bond offers the higher after-tax yield for investors in tax brackets above
20%.
8. Consider the three stocks in the following table. P t represents price at time t, and
Q t represents shares outstanding at time t. Stock C splits two- for- one in the last
period. ( LO 2- 2)

A
B
C

P0
90
50
100

Q0
100
200
200

P1
95
45
110

Q1
100
200
200

P2
95
45
55

Q2
100
200
400

a. Calculate the rate of return on a price- weighted index of the three stocks for
the first period ( t = 0 to t = 1).

At t = 0, the value of the index is: (90 + 50 + 100)/3 = 80

At t = 1, the value of the index is: (95 + 45 + 110)/3 = 83.333
The rate of return is: (83.333/80) 1 = 4.17%
b. What must happen to the divisor for the price- weighted index in year 2?

In the absence of a split, Stock C would sell for 110, so the value of the
index would be: 250/3 = 83.333
After the split, Stock C sells for 55.
Therefore, we need to find the divisor (d) such that: 83.333 = (95 + 45
+ 55)/d
d = 2.340
c. Calculate the rate of return of the price- weighted index for the second period ( t=
1 to t=2)

The return is zero. The index remains unchanged because the return for each
stock separately equals zero.

9. Using the data in the previous problem, calculate the first- period rates of return
on the following indexes of the three stocks: ( LO 2- 2)
a. A market value weighted index
Total market value at t = 0 is: ($9,000 + $10,000 + $20,000) = $39,000
Total market value at t = 1 is: ($9,500 + $9,000 + $22,000) = $40,500
Rate of return = ($40,500/$39,000) 1 = 3.85%
b. An equally weighted index
The return on each stock is as follows:
A r= (95/90) 1 = 0.0556
B r = (45/50) 1 = 0.10
C r= (110/100) 1 = 0.10
The equally-weighted average is: = (110/100) 1 = 0.10 [0.0556 + (-0.10) +
0.10]/3 = 0.0185 = 1.85%
10. Find the after-tax return to a corporation that buys a share of preferred stock at
$40, sells it at year-end at $40, and receives a $4 year-end dividend. The firm is in
the 30% tax bracket. (LO 2-1)
11. Preferred stock yields often are lower than yields on bonds of the same quality
because of: ( LO 2- 1)
a. Marketability
b. Risk
c. Taxation
d. Call protection