Chapter 1

Multiple Choice Questions

1. This book is mainly about
A) financial decisions made by households
B) financial decisions made by corporations
C) financial decisions made by governments
D) none of the above
Answer: B
Type: Easy
Page: 3

2. Finance, generally, deals with

A) money
B) markets
C) people
D) all of the above
Answer: D
Type: Easy
Page: 3

3. The following are examples of the United States-based corporations except:

A) General Motors
B) Microsoft
C) Bank of America
D) Unilever
Answer: D
Type: Easy
Page: 3

4. The following are examples of foreign-based corporations except:

A) British Petroleum
B) Volkswagen
C) General Electric
D) Sony
Answer: C
Type: Easy
Page: 3

5. Businesses can be organized as

A) sole proprietorships
B) partnerships
C) corporations
D) any of the above
Answer: D
Type: Easy
Page: 3

6. Generally, a corporation is owned by the:

A) Managers
B) Board of Directors
C) Shareholders
D) All of the above.
Answer: C
Type: Easy
Page: 3

7. Limited liability is an important feature of:

A) Sole proprietorships
B) Partnerships
C) Corporations
D) All of the above
Answer: C
Type: Easy
Page: 4

8. Corporations, potentially, have infinite life because:

A) of limited liability
B) of separation of ownership and management
C) it is a legal entity
D) none of the above
Answer: C
Type: Medium
Page: 4

9. The main disadvantage of organizing a business as a corporation in the United States is:
A) Limited liability
B) Separation of ownership and management
C) Double taxation.
D) None of the above
Answer: C
Type: Medium
Page: 4

10. A large number of United States corporations are incorporated in:

A) New York
B) California
C) Delaware
D) None of the above
Answer: C
Type: Easy
Page: 4

11. The following are examples of real assets except:

A) Machinery
B) Common stock
C) Office buildings
D) Inventory
Answer: B
Type: Medium
Page: 5

12. The following are examples of intangible assets except:

A) Machinery
B) Trade marks
C) Patents
D) Technical expertise
Answer: A
Type: Medium
Page: 5

13. The following are examples of financial assets except:

A) Common stocks
B) Bonds
C) Patents
D) Preferred stocks
Answer: C
Type: Medium
Page: 5

14. A firm's investment decision is also called the:

A) Financing decision
B) Capital budgeting decision
C) Liquidity decision
D) None of the above
Answer: B
Type: Medium
Page: 5

15. In finance, "short-term" means

A) less than three months
B) less than six months
C) less than one year
D) less than five years
Answer: C
Type: Easy
Page: 5

16. The following cities are also important financial centers of the world:
A) New York
B) London
C) Tokyo
D) All of the above
Answer: D
Type: Easy
Page: 6

17. The treasurer usually oversees the following functions of a corporation except:
A) Preparation of financial statements
B) Investor relationships
C) Cash management
D) Obtaining finances
Answer: A
Type: Difficult
Page: 6

18. The treasurer is usually responsible the following functions of a corporation except:
A) Raising new capital
B) Cash management
C) Banking relationships
D) Internal accounting
Answer: D
Type: Difficult
Page: 6

19. The controller is usually responsible for the following functions of a corporation except:
A) Preparation of financial statements
B) Internal accounting
C) Raising new capital
D) Taxes
Answer: C
Type: Difficult
Page: 6

20. The controller usually oversees the following functions of a corporation except:
A) Cash management
B) Tax management
C) Internal accounting
D) Preparation of financial statements
Answer: A
Type: Difficult
Page: 6

21. The Chief Financial Officer (CFO) of a corporation oversees:

A) Treasurer's functions
B) Controller's functions
C) Both A and B
D) None of the above
Answer: C
Type: Easy
Page: 7

22. The following are advantages of separation of ownership and management of corporations
except:
A) Corporations can exist forever.
B) Facilitate transfer of ownership without affecting the operations of the firm.
C) Hire professional managers
D) Incur agency costs
Answer: D
Type: Medium
Page: 7

23. Conflicts of interest between shareholders and managers of a firm result in:
A) Principal-agent problem
B) Increased agency costs
C) Both A and B
D) None of the above
Answer: C
Type: Medium
Page: 8

24. The financial goal of a corporation is to:

A) Maximize sales
B) Maximize profits
C) Maximize the value of the firm for the shareholders
D) Maximize managers' benefits
Answer: C
Type: Difficult
Page: 8

25. Agency costs are incurred by a corporation because:

A) managers may not attempt to maximize the value of the firm to shareholders
B) shareholders incur monitoring cost
C) separation of ownership and management
D) all of the above
Answer: D
Type: Medium
Page: 8

26. In the principal-agent framework:

A) Shareholders are the principals
B) Managers are the agents
C) Shareholders are the agents
D) Managers are the principals
E) A and B
Answer: E
Type: Medium
Page: 8

27. Costs associated with the conflicts of interest between the bondholders and a shareholders of a
corporation is called:
A) Legal costs
B) Agency costs
C) Administrative costs
D) Bankruptcy costs
Answer: B
Type: Difficult
Page: 8

28. The following groups are some of the claimants to a firm's income stream:
A) Shareholders
B) Bondholders
C) Government
D) Employees
E) All of the above
Answer: E
Type: Medium
Page: 8

29. Informational asymmetry refers to the differences in information regarding the value of a firm
among:
A) Shareholders
B) Managers
C) Bondholders
D) All of the above.
Answer: D
Type: Medium
Page: 8

True/False Questions
T

F 30. A corporation has a legal existence of its own and is based on "articles of incorporation."
Answer: True
Type: Easy
Page: 4

F 31. The board of directors is ultimately responsible for all large investment decisions.
Answer: True
Type: Medium
Page: 5

F 32. In large firms, there is usually a Chief Financial Officer (CFO) who oversees both the
treasurer's and controller's work.
Answer: True
Type: Easy
Page: 6

F 33. The controller's responsibilities include banking relations and cash management.
Answer: False
Type: Medium
Page: 6

F 34. The treasurer's responsibilities include preparation of financial statements.

Answer: False
Type: Medium
Page: 6

F 35. One distinctive feature of a corporation is that there is no separation of ownership and
control.
Answer: False
Type: Medium
Page: 7

F 36. In a sole proprietorship, the owner is also the manager, and hence, agency costs are at a
minimum.
Answer: True
Type: Medium
Page: 8

Short Answer Questions

37. Explain the term "corporation."
Answer: A corporation is a legal entity and has an existence of its own. Generally, large
businesses are organized as corporations.
Type: Easy
Page: 4

38. Briefly explain the advantages of a corporation as a form of business organization.

Answer:
Corporations have infinite life.
Corporations have very many owners called shareholders and therefore corporations can raise
funds more easily than other forms of business.
There is a separation of ownership and management that is helpful in running the corporation
on a day-to-day basis.
It is very easy to transfer ownership in a corporation.
Corporations have limited liability.
Type: Medium
Page: 4

39. Briefly explain the term limited liability.

Answer: The shareholders of a corporation cannot be held personally responsible for the debt of
the corporation. This is called limited liability. Hence a shareholder's loss is limited to the
amount he or she has invested in a corporation. This is an attractive feature for the investors.
Type: Medium
Page: 4

10

40. Briefly explain why a large number of corporations are incorporated in the state of Delaware:
Answer: Delaware has a well-developed system of corporate law. It is very supportive of
corporations.
Type: Medium
Page: 4

41. Briefly explain the sequence flow of cash between financial markets and the firm.
Answer:
Cash is raised by selling financial assets to investors.
Cash is invested in the firm's operation and used to purchase real assets.
Cash is generated by the firm's operations.
Cash is reinvested or returned to investors.
Type: Medium
Page: 6

42. Briefly discuss the role of the financial manager.

Answer:
Chief Financial Officer (CFO): Supervises the treasurer and the controller in a large corporation.
CFO is involved in corporate planning and financial policy.
Treasurer: Is responsible for obtaining funds, managing cash, banking relationships and investor
relationships.
Controller: Is responsible for accounting functions, payroll and taxes.
Type: Medium
Page: 7

43. Briefly discuss principal - agent problems as related to a corporation

Answer: Principal-agent problems arise in a corporation as a result of the separation of ownership
and management. Managers may not act in the best interests of the shareholders while making
decisions. Hence the shareholders incur monitoring and bonding costs which are a part of agency
costs. It also arises as result of informational asymmetry between managers and other
stakeholders of a firm. Agency costs tend to reduce the value of a firm.
Type: Medium
Page: 8

11

44. Briefly explain the term "web of contracts" in the context of a corporation
Answer: A corporation is a complex organization. All the claimants to the value of a corporation
are called stakeholders of a corporation. They are; shareholders, bondholders, employees,
managers, suppliers, customers, government and the community. A complex set interrelated
contracts governs their relationships. These contracts could be formal or informal. This complex
set of contracts can be thought of as "web of contracts."
Type: Medium
Page: 8

45. Briefly explain the term "Agency costs" as related to a corporation

Answer: Agency costs arise in a corporation as a result of principal-agent problems. For example;
managers may not act in the best interests of the shareholders while making decisions. Hence the
shareholders incur monitoring costs that are called agency costs. It also arises as result of
informational asymmetry between managers and other stakeholders of a firm. Agency costs tend
to reduce the value of a firm.
Type: Medium
Page: 8
Chapter 2
Multiple Choice Questions
1. The following are examples of tangible assets except:
A) Machinery
B) Warehouse
C) Office buildings
D) Patents
Answer: D
Type: Easy
Page: 13

2. The following are examples of intangible assets except:

A) Machinery
B) Trade marks
C) Patents
D) Technical expertise
Answer: A
Type: Easy
Page: 13

3. The following are examples of real assets except:

A) Machinery
12

B) Common stock
C) Inventory
D) Warehouse
Answer: B
Type: Easy
Page: 13

13

4. Present value of $110,000 expected to be received one year from today at an interest rate
(discount rate) of 10% per year is:
A) $121,000
B) $100,000
C) $110,000
D) None of the above
Answer: B
Type: Easy
Page: 14
Response: PV = (110,000) / (1.1) = 100,000
5. One year discount factor at a discount rate of 10% per year is:
A) 1.1
B) 1.0
C) 0.909
D) None of the above
Answer: C
Type: Easy
Page: 14
Response: Discount Factor = 1/1.1 = 0.909
6. Present Value of $100,000 expected to be received at the end of one year at a discount rate of
100% per year is:
A) $50,000
B) $200,000
C) $100,000
D) None of the above
Answer: A
Type: Easy
Page: 14
Response: PV = (100,000) / (1+1) = 50,000
7. The one-year discount factor at an interest rate of 25% per year is:
A) 1.25
B) 0.8
C) 0.25
D) None of the above
Answer: B
Type: Easy
Page: 14
Response: Discount factor = 1/(1.25) = 0.8

14

8. If the one-year discount factor is 0.7692, what is the discount rate (interest rate) per year?
A) 10%
B) 20%
C) 30%
D) None of the above
Answer: C
Type: Medium
Page: 14
Response: 1+r = 1/(0.7692) = 1.30; r = 30%
9. If the present value of $444 to be paid at the end of one year is $400, what is the one-year
discount factor?
A) 0.901
B) 1.11
C) 0.11
D) None of the above
Answer: A
Type: Medium
Page: 14
Response: Discount factor is = 400/444 = 0.901
10. If the one-year discount factor is 0.85, what is the present value of $120 to be received one year
from today?
A) $100
B) $102
C) $141.18
D) None of the above
Answer: B
Type: Medium
Page: 14
Response: PV = (120)(0.85) = 102
11. If the present value of $480 expected to be received one year from today is $400, what is the
discount rate?
A) 10%
B) 20%
C) 30%
D) None of the above
Answer: B
Type: Medium
Page: 14
Response: 1+r = 480 /400 = 1.2; r = 20%

15

12. If the present value of $300 expected to be received one year from today is $240, what is the one
year discount rate?
A) 15%
B) 20%
C) 25%
D) 30%
Answer: C
Type: Medium
Page: 14
Response: 1+r = (300)/(240) = 1.25; r = 25 %
13. The rate of return is also called:
A) Discount rate
B) Hurdle rate
C) Opportunity cost of capital
D) All of the above.
Answer: D
Type: Easy
Page: 15

14. The present value formula for one period cash flow is:
A) PV = C1(1 + r)
B) PV = C1/r
C) PV = C1/(1 + r)
D) None of the above
Answer: C
Type: Medium
Page: 15

15. The net present value formula for one period is:
A) NPV = PV cash flows/initial investment
B) NPV = C0/C1
C) NPV = C0+[C1/(1 + r)]
D) None of the above
Answer: C
Type: Medium
Page: 15

16

16. If the present value of a cash flow generated by an initial investment of $100,000 is $120,000,
what is the NPV of the project?
A) $120,000
B) $20,000
C) $100,000
D) None of the above
Answer: B
Type: Easy
Page: 15
Response: NPV= -100,000 + 120,000 = 20,000
17. An initial investment of $400,000 will produce an end of year cash flow of $450,000. What is the
NPV of the project at a discount rate of 10%?
A) $9090.90
B) $409,090.90
C) $0 (zero)
D) None of the above
Answer: A
Type: Medium
Page: 15
Response: NPV= -400,000 + (450,000/1.1) = 9090.90
18. An initial investment of $400 produces a cash flow $500 one year from today. Calculate the rate
of return on the project
A) 10%
B) 20%
C) 25%
D) none of the above
Answer: C
Type: Easy
Page: 16
Response: Rate of return = (500 400)/400 = 25%
19. The following statements regarding the NPV rule and the rate of return rule are true except:
A) Accept a project if its NPV > 0
B) Reject a project if its NPV < 0
C) Accept a project if its rate of return > 0
D) Accept a project if its rate of return > opportunity cost of capital
Answer: C
Type: Difficult
Page: 17

17

20. If the probability of a recession is 0.3, normal growth is 0.4 and a boom is 0.3, and the payoff in
the event of a recession is $100, normal growth is $300 and boom is $500, what is the expected
payoff?
A) $200
B) $300
C) $400
D) None of the above
Answer: B
Type: Medium
Page: 17
Response: Expected payoff = 100*0.3 + 300*0.4 + 500*0.3 = 300
21. The payoffs of an investment are dependent on the state of the economy. The economy can have
two states, recession or growth, with equal probability. If the payoff in the event of growth is
$140 and in the event of recession is $80, what is the expected payoff for the investment?
A) $100
B) $110
C) $120
D) None of the above
Answer: B
Type: Medium
Page: 17
Response: Expected payoff = 0.5*140 + 0.5*80 = 110
22. Current price of Company X's stock is $100. The table below gives the data on end of the year
prices and probabilities dependent on the state of the economy. Calculate the expected return for
the stock.
E conom y
G ro w th
R e c e s s io n

A)
B)
C)
D)

P ro b a b ility
.5
.5

E n d o f th e y e a r p ric e
$130
$ 90

10%
15%
20%
None of the above

Answer: A
Type: Medium
Page: 17
Response: Expected Price = 0.5*130 + 0.5*90 = 110; Expected return = (110 100)/100 = 10%

18

23. The opportunity cost of capital for a risky project is

A) The expected rate of return on a government security having the same maturity as the project
B) The expected rate of return on a well diversified portfolio of common stocks
C) The expected rate of return on a portfolio of securities of similar risks as the project
D) None of the above
Answer: C
Type: Difficult
Page: 18

24. Mr. Free has $100 dollars income this year and zero income next year. The market interest rate is
10% per year. If Mr. Free consumes $20 this year, and invests the rest in the market, what will be
his consumption next year?
A) $50
B) $100
C) $88
D) $55
Answer: C
Type: Medium
Page: 20
Response: Consumption next year = (100 = 88 (See Figure-1)

FIGURE-1
Next Year
$88

$100
This
Year
$80

19

25. Mr. Thomas has $100 income this year and zero income next year. The market interest rate is
10% per year. Mr. Thomas also has an investment opportunity in which he can invest $50 this
year and receive $70 next year. Suppose Mr. Thomas consumes $50 this year and invests in the
project. What will be his consumption next year?
A) $55
B) $70
C) $50
D) None of the above
Answer: B
Type: Medium
Page: 20
Response: Mr. Thomas' investment this year = 100 50 = 50. His income next year by taking the
investment opportunity is equal to 70
26. Mr. Dell has $100 income this year and zero income next year. The market interest rate is 10%
per year. Mr. Dell also has an investment opportunity in which he can invest $50 this year and
receive $70 next year. Suppose Mr. Dell consumes $50 this year and invests in the project. What
is the NPV of the investment opportunity?
A) $5
B) $13.64
C) $0 (zero)
D) None of the above.
Answer: B
Type: Difficult
Page: 20
Response: NPV = (70/1.1) 50 = 13.64
27. Mr. Crow has $100 income this year and zero income next year. The market interest rate is 10%
per year. Mr. Crow also has an investment opportunity in which he can invest $50 today and
receive $70 next year. Suppose Mr. Crow consumes $20 this year and invests in the project.
What will be his consumption next year?
A) $88
B) $103
C) $80
D) $100
Answer: B
Type: Difficult
Page: 20
Response: Consumption next year = (100-20-50)*1.1 +70 = 103

20

28. Ms. Venus has $100 income this year and $120 next year. The market interest rate is 10% per
year. Suppose Ms. Venus consumes $50 this year. What will be her consumption next year?
A) $175
B) $170
C) $120
D) None of the above
Answer: A
Type: Difficult
Page: 20
Response: Consumption next year = (100 - 50)*1.1 + 120 =175
29. Ms. Newcastle has $60,000 income this year and $30,000 next year. The market interest rate is
10% per year. Suppose Ms. Newcastle consumes $70,000 this year. What will be her
consumption next year?
A) $60,000
B) $30,000
C) $70,000
D) $19,000
Answer: D
Type: Difficult
Page: 20
Response: Borrow $10,000 this year to consume 60,000+10,000 = 70,000 Consumption next
year = 30,000 (10,000*1.1) = 19,000
30. Ms. Newcastle has $60,000 income this year and $30,000 next year. The market interest rate is
10% per year. Suppose Ms. Newcastle wishes to consume $63,000 next year. What will be her
consumption this year?
A) $60,000
B) $30,000
C) $70,000
D) $19,000
Answer: B
Type: Difficult
Page: 20
Response: Consumption this year = 60,000 (33,000/1.1) = 30,000

21

31. The line that connects the maximum that one can consume this year (now) and the maximum one
can consume next year:
A) Has a slope of (1+r)
B) Has a slope of -(1+r)
C) Has a slope of r
D) Has a slope of 1/r
Answer: B
Type: Difficult
Page: 20

32. Mr. Hopper has an income of $40,000 this year and $60,000 next year. He can invest in a project
that costs $20,000 this year, which generates an income of $23,000 next year. The market interest
rate is 10%. What will be his consumption next year, if Mr. Hopper invests in the project and
consumes $50,000 this year ?
A) $40,000
B) $50,000
C) $60,000
D) None of the above
Answer: B
Type: Difficult
Page: 20
Response: Consumption next year = [40,000 20,000 50,000]*1.1 + (60,000 + 23,000) = 50,000
33. According to the net present value rule, an investment in a project should be made if the:
A) Net present value is greater than the cost of investment
B) Net present value is greater than the present value of cash flows
C) Net present value is positive
D) Net present value is negative
Answer: C
Type: Difficult
Page: 21

34. Which of the following statements regarding the net present value rule and the rate of return rule
is not true?
A) Accept a project if NPV > cost of investment
B) Accept a project if NPV is positive
C) Accept a project if return on investment exceeds the rate of return on an equivalent
investment in the financial market
D) All of the above statements are true
Answer: A
Type: Difficult
Page: 21

22

35. According to the rate of return rule an investment in a risky project should be made if:
A) The return on investment exceeds the risk-free rate
B) The return on investment is positive
C) The return on investments exceeds the rate of return on an equivalent investment in the
financial market
D) None of the above statements are true
Answer: C
Type: Difficult
Page: 21
36. Which of the following statements regarding the net present value rule and the rate of return rule
is true?
A) Accept a project if the rate of return is positive
B) Accept a project the rate of return on a risky project exceeds the risk-free rate
C) Accept a project if the net present value is positive
D) None of the above statements are true
Answer: C
Type: Difficult
Page: 21

37. There are two reasons for discounting future cash flow. They are:
A) A dollar today is worth more than a dollar tomorrow (for positive interest rates)
B) A safe dollar is worth more than a risky one
C) The value of a dollar is changing all the time
D) A and B above
Answer: D
Type: Medium
Page: 21

38. The discount rate is used for calculating the NPV is:
A) Determined by the financial market
B) Found by the government
C) Found by the CEO
D) None of the above
Answer: A
Type: Easy
Page: 21

23

39. The financial goal of a corporation is to:

A) Minimize stockholder wealth
B) Maximize profit
C) Maximize value of the corporation to the stockholders
D) None of the above
Answer: C
Type: Easy
Page: 22

40. The managers of a firm can maximize stockholder wealth by:

A) Taking all projects with positive NPVs
B) Taking all projects with NPVs greater than the cost of investment
C) Taking all projects with NPVs greater than present value of cash flow
D) All of the above
Answer: A
Type: Medium
Page: 22

41. The following are some of the actions shareholders can take if the corporation is not performing
well:
A) Replace the board of directors in an election.
B) Force the board of directors to change the management team.
C) Sell their shares of stock in the corporation.
D) Any of the above
Answer: D
Type: Medium
Page: 23

42. Managers' actions are monitored by:

A) The board of directors
B) Commercial banks that have loaned funds to the firm
C) The Wall Street analysts
D) All of the above
Answer: D
Type: Medium
Page: 23

24

True/False Questions
T

F 43. A dollar today is worth more than a dollar tomorrow if the interest rate is positive.
Answer: True
Type: Easy
Page: 14

F 44. The present value of a future cash flow can be found by dividing it by an appropriate
discount factor.
Answer: False
Type: Medium
Page: 14

F 45. The discount rate, hurdle rate or opportunity cost of capital all mean the same.
Answer: True
Type: Medium
Page: 15

F 46. Net present value is found by subtracting the required investment from the present value
of future cash flows.
Answer: True
Type: Medium
Page: 15

F 47. A safe dollar is always worth less than a risky dollar because the rate of return on a safe
investment is generally low and the rate of return on a risky investment is generally high.
Answer: False
Type: Difficult
Page: 15

F 48. The opportunity cost of capital is higher for safe investments than for risky ones.
Answer: False
Type: Medium
Page: 15

25

F 49. "Accept investments that have positive net present values" is called the net present value
rule.
Answer: True
Type: Medium
Page: 17

F 50. Capital markets are perfectly competitive in theory and practice.

Answer: False
Type: Medium
Page: 19

F 51. The goal of a corporation should be to maximize profits.

Answer: False
Type: Medium
Page: 22

Short Answer Questions

52. Intuitively explain the concept of the present value.
Answer: If you have $100 today, you can invest it and start earning interest on it. On the other
hand, if you have to make a payment of $100 one year from today, you do not need to invest $100
today but a lesser amount. The lesser amount invested today plus the interest earned on it should
add up to $100. The present value of $100 one year from today at an interest rate of 10% is
$90.91. [PV = 100/1.1 = 90.91]
Type: Difficult
Page: 14

53. Briefly explain the term "discount rate."

Answer: Discount rate is the rate of return used for discounting future cash flows to obtain the
present value. The discount rate can be obtained by looking at the rate of return, an equivalent
investment opportunity in the capital market.
Type: Difficult
Page: 14

26

54. Briefly explain the concept of risk.

Answer: If the future cash flows from an investment are not certain then we call it a risky cash
flow. That means there is an uncertainty about the future cash flows or future cash flows could be
different from expected cash flows. The degree of uncertainty varies from investment to
investment. Generally, uncertain cash flows are discounted using a higher discount rate than
certain cash flows. This is only one method of dealing with risk. There are many ways to take
risk into consideration while making financial decisions.
Type: Difficult
Page: 15

55. State the "net present value rule."

Answer: Invest in projects with positive net present values. Net present value is the difference
between the present value of future cash flows from the project and the initial investment.
Type: Medium
Page: 17

56. State the " rate of return rule."

Answer: Invest as long as the rate of return on the investment exceeds the rate of return on
equivalent investments in the capital market.
Type: Medium
Page: 17
57. Briefly explain how individuals can adjust their preferences for current and future consumption
Answer: Individuals can adjust their preferences for consumption by borrowing or lending in the
financial market.
The appropriate balance between present and future consumption that each individual will choose
depends on personal preferences. But individuals with different preferences can adjust their
preferences using financial market.
Type: Difficult
Page: 19

58. Explain why "maximization of shareholders' wealth" is the appropriate goal of the firm.
Answer: Under perfect market conditions, everyone can borrow or lend at the same interest rate.
This implies that differences in consumption patterns can be adjusted in the capital markets.
Given this, all investors will agree that they are better off if the firm maximizes their current
wealth, i.e. maximize shareholders' wealth.
Type: Difficult
Page: 22

27

59. Briefly explain how a financial manager's task is simplified by the presence of a well functioning
financial market.
Answer: In the presence a well-functioning financial market, shareholders can adjust their
preferences by borrowing and lending. Shareholders prefer more consumption to less. Therefore
managers need not worry about shareholders' preferences but concentrate on increasing the
market value of the firm by taking all projects with positive net present value.
Type: Difficult
Page: 22

60. Briefly explain how the concept of net present value allows for efficient separation of ownership
and management.
Answer: A manager who invests in projects with positive net present value serves the best
interests of each and every shareholder by increasing the value of the firm. This is true regardless
of individual preferences of shareholders. For example, there is no need for mangers to follow a
specific investment policy to match the time preferences of shareholders' consumption.
Shareholders can always use the financial market for that. Thus there is an efficient separation of
ownership and management. It is important to note that the net present values are meaningful
only in the presence of a well-functioning financial market.
Type: Difficult
Page: 22

61. Briefly explain some of the institutional arrangements that ensure that managers work toward
increasing the value of a firm.
Answer:
The board of directors who are elected by the shareholders scrutinizes managers' actions.
Competition among managers
The threat of takeover that brings a new management team.
Incentive schemes that are tied to the value of the firm like stock options.
Type: Medium
Page: 25
Chapter 3
Multiple Choice Questions
1. Present Value is defined as:
A) Future cash flows discounted to the present at an appropriate discount rate
B) Inverse of future cash flows
C) Present cash flow compounded into the future
D) None of the above
Answer: A
Type: Easy
Page: 33

28

2. The present value of $100 expected in two years from today at a discount rate of 10% is:
A) $90.91
B) $110.00
C) $100.00
D) $82.64
E) None of the above
Answer: D
Type: Easy
Page: 33
Response: PV = 100 / (1.1^2) = 82.64
3. If the interest rate is 15%, what is the 2- year discount factor?
A) 0.7561
B) 0.8697
C) 1.3225
D) None of the above
Answer: A
Type: Easy
Page: 33
Response: DF = 1 / (1.15^2) = .7561
4. The absence of money machines means there are:
A) No opportunities for arbitrage
B) No opportunities for investment
C) No opportunities for borrowing
D) All of the above
Answer: A
Type: Medium
Page: 34

29

5. If the 2-year discount factor is 0.5102, what is the rate of interest (in APR)?
A) 10%
B) 25%
C) 40%
D) None of the above.
Answer: C
Type: Medium
Page: 34
Response: 0.5102 = 1/(1+r)^2; (1+r)^2 = 1.96; 1+r = 1.40; r = 40%
6. If the present value of the cash flow X is $200, and the present value cash flow Y $150, than the
present value of the combined cash flow is:
A) $200
B) $150
C) $50
D) $350
E) None of the above
Answer: D
Type: Easy
Page: 34
Response: PV (x + y) = PV (x) + PV (y) = 200 + 150 = 350
7. What is the present value of the following cash flow at a 12% discount rate?
Year 1
$ 1 0 0 ,0 0 0

A)
B)
C)
D)

Year 2
$ 1 5 0 ,0 0 0

Year 3
$ 2 0 0 ,0 0 0

$351,221
$450,000
$493,440
None of the above

Answer: A
Type: Medium
Page: 34
Response: PV = (100,000/1.12) + (150,000/(1.12^2)) + 200,000/(1.12^3) = 351,221

30

8. What is the net present value of the following cash flows at a discount rate on 12%?
t = 0
- 2 5 0 ,0 0 0

A)
B)
C)
D)

t = 1
1 0 0 ,0 0 0

t= 2
1 5 0 ,0 0 0

t= 3
2 0 0 ,0 0 0

$101,221
$200,000
$142,208
None of the above

Answer: A
Type: Medium
Page: 34
Response: NPV = -250,000 + (100,000/1.12) + (150,000/(1.12^2)) + 200,000/(1.12^3) = 101,221
9. What is the present value of the following cash flow at a discount rate of 12% APR?
t= 1
- 1 0 0 ,0 0 0

A)
B)
C)
D)

t= 2
3 0 0 ,0 0 0

$185,000
$200,000
$149,872
None of the above

Answer: C
Type: Medium
Page: 34
Response: PV = (-100,000/1.12) + (300,000/(1.12^2)) = 149,872
10. What is the net present value of the following cash flow at a discount rate of 15%?
t= 0
- 1 2 0 ,0 0 0

A)
B)
C)
D)

t= 1
3 0 0 ,0 0 0

t= 2
-1 0 0 ,0 0 0

$65,255
$80,000
$26,300
None of the above

Answer: A
Type: Medium
Page: 34
Response: NPV = -120,000 + (300,000/1.15) - (100,000/(1.15^2)) = 65,255

31

11. A perpetuity is defined as:

A) Equal cash flows at equal intervals of time forever
B) Equal cash flows at equal intervals of time for a specific period
C) Unequal cash flows at equal intervals of time forever
D) None of the above
Answer: A
Type: Easy
Page: 37

12. What is the present value of $10,000 per year perpetuity at an interest rate of 5%?
A) $10,000
B) $100,000
C) $200,000
D) None of the above
Answer: C
Type: Easy
Page: 37
Response: PV = (10,000/0.05) = 200,000
13. You would like to have enough money saved to receive a $60,000 per year perpetuity after
retirement so that you and your family can lead a good life. How much would you need to save
in your retirement fund to achieve this goal (assume that the perpetuity payments start one year
from the date of your retirement. The interest rate is 10%)?
A) $7,500,000
B) $750,000
C) $600,000
D) None of the above
Answer: C
Type: Medium
Page: 37
Response: PV = (60,000/0.1) = 600,000

32

14. You would like to have enough money saved to receive a $100,000 per year perpetuity after
retirement so that you and your family can lead a good life. How much would you need to save
in your retirement fund to achieve this goal (assume that the perpetuity payments start one year
from the date of your retirement. The interest rate is 10%)?
A) $1,000,000
B) $10,000,000
C) $100,000
D) None of the above
Answer: A
Type: Medium
Page: 37
Response: PV = (100,000/0.1) = 1,000,000
15. You would like to have enough money saved to receive a growing perpetuity, growing at a rate of
4% per year, the first payment being $60,000, after retirement so that you and your family can
lead a good life. How much would you need to save in your retirement fund to achieve this goal
(assume that the growing perpetuity payments start one year from the date of your retirement.
The interest rate is 8%)?
A) $7,500,000
B) $1,500,000
C) $600,000
D) None of the above
Answer: B
Type: Difficult
Page: 37
Response: PV = (60,000/(0.08-0.04)) = 1,500,000
16. You would like to have enough money saved to receive a growing perpetuity, growing at a rate of
5% per year, the first payment being $100,000, after retirement so that you and your family can
lead a good life. How much would you need to save in your retirement fund to achieve this goal
(assume that the growing perpetuity payments start one year from the date of your retirement.
The interest rate is 10%)?
A) $1,000,000
B) $10,000,000
C) $2,000,000
D) None of the above
Answer: C
Type: Difficult
Page: 37
Response: PV = (100,000/(0.1-0.05)) = 2,000,000

33

17. You would like to have enough money saved to receive a $60,000 per year perpetuity after
retirement so that you and your family can lead a good life. How much would you need to save
in your retirement fund to achieve this goal (assume that the perpetuity payments starts on the day
of retirement. The interest rate is 8%)?
A) $7,500,000
B) $810,000
C) $600,000
D) None of the above
Answer: B
Type: Difficult
Page: 37
Response: PV = (60,000/0.08)(1.08) = 810,000
18. You would like to have enough money saved to receive a $100,000 per year perpetuity after
retirement so that you and your family can lead a good life. How much would you need to save
in your retirement fund to achieve this goal (assume that the perpetuity payments starts on the day
of retirement. The interest rate is 10%)?
A) $1,000,000
B) $1,100,000
C) $2,000,000
D) None of the above
Answer: B
Type: Difficult
Page: 37
Response: PV = (100,000/0.1)(1.1) = 1,100,000
19. An annuity is defined as
A) Equal cash flows at equal intervals of time forever
B) Equal cash flows at equal intervals of time for a specific period
C) Unequal cash flows at equal intervals of time forever
D) None of the above
Answer: B
Type: Easy
Page: 38

34

20. If the five-year present value annuity factor is 3.791 and four-year present value annuity factor is
3.170, what is the present value at the $1 received at the end of five years?
A) $0.621
B) $1.61
C) $0.315
D) None of the above
Answer: A
Type: Difficult
Page: 39
Response: PV = (3.791 3.170)*(1) = 0.621
21. If the three-year present value annuity factor is 2.723 and two-year present value annuity factor is
1.859, what is the present value of $1 received at the end of the 3 years?
A) $0.157
B) $0.864
C) $1.00
D) None of the above
Answer: B
Type: Difficult
Page: 39
Response: PV = (2.723-1.859) *(1) = 0.864
22. What is the present value annuity factor at a discount rate of 13% for 10 years?
A) $5.4262
B) $8.514
C) $8.13
D) None of the above
Answer: A
Type: Medium
Page: 39
Response: PV annuity factor = (1/0.13) (1/((0.13)(1.13^10))) = 5.4262
23. What is the present value annuity factor at an interest rate of 11% for 5 years?
A) 8.514
B) 6.145
C) 3.6959
D) None of the above
Answer: C
Type: Medium
Page: 39
Response: PV annuity factor = (1/0.11) (1/((0.11)(1.11^5))) = 3.6959

35

24. What is the present value of $1000 per year annuity for ten years at an interest rate of 10%?
A) $6145
B) $8514
C) $2594
D) None of the above
Answer: A
Type: Medium
Page: 39
Response: PV annuity factor = [(1/0.10) (1/((0.10)(1.10^ 10)))]*1000 = 6145
25. What is the present value of $2000 per year annuity at a discount rate of 15% for 15 years?
A) $8,137
B) $11,695
C) $17,028
D) None of the above
Answer: B
Type: Medium
Page: 39
Response: PV = [(1/0.15) (1/((0.15)(1.15^15)))]*2000 = 11,695
26. After retirement, you expect to live for 20 years. You would like to have $80,000 income each
year. How much should you have saved in the retirement to receive this income, if the interest is
10% per year (assume that the payments start one years after the retirement)?
A) $681,085
B) $1,600,300
C) $538,200
D) None of the above
Answer: A
Type: Difficult
Page: 39
Response: PV = [(1/0.10) (1/((0.10)(1.10^20)))]*80,000 = 681,085
27. After retirement, you expect to live for 20 years. You would like to have $80,000 income each
year. How much should you have saved in the retirement to receive this income, if the interest is
10% per year (assume that the payments start on the day of retirement)?
A) $681,085
B) $749,194
C) $538,200
D) None of the above
Answer: B
Type: Difficult
Page: 39
Response: PV = [[(1/0.10) (1/((0.10)(1.10^20)))]*80,000]*(1.1) = 749,194.

36

28. If the present annuity factor is 3.89, what is the present value annuity factor for an equivalent
annuity due if the interest rate is 9%?
A) 3.57
B) 4.24
C) 3.89
D) None of the above.
Answer: B
Type: Difficult
Page: 39
Response: annuity due factor = 3.89 * 1.09 = 4.24
29. If the present value annuity factor for 10 years at 10% interest rate is 6.71, what is the present
value annuity factor for an equivalent annuity due?
A) 7.38
B) 6.10
C) 6.71
D) None of the above
Answer: A
Type: Difficult
Page: 39
Response: Annuity due: 6.71 * 1.1 = 7.38
30. John House has taken a $150,000 mortgage on his house at an interest rate of 7% per year. If the
mortgage calls for twenty equal annual payments, what is the amount of each payment?
A) $14,158.94
B) $10,500.00
C) $16,882.43
D) None of the above
Answer: A
Type: Difficult
Page: 39
Response: (Use a financial calculator) PV = 150,000; I -= 7%; N = 20; FV = 0; Compute PMT =
$14,158.94

37

31. John House has taken a $150,000 mortgage on his house at an interest rate of 7% per year. What
is the value of the mortgage after the payment of the fifth annual installment?
A) $128,958.41
B) $479,205.30
C) $97,500.00
D) None of the above
Answer: A
Type: Difficult
Page: 39
Response: 150,000/10.594 = 14,158.94; 14,158.94(9.1070) = $128,958.41
32. If the present value of $1.00 received n years from today at an interest rate of r is 0.621, then
what is the future value of $1.00 invested today at an interest rate of r% for n years?
A) $1.00
B) $1.61
C) $1.70
D) Not enough information to solve the problem
Answer: B
Type: Difficult
Page: 40
Response: FV = 1/(0.621) = 1.61
33. If the present value of $1.00 received n years from today at an interest rate of r is 0.270, then
what is the future value of $1.00 invested today at an interest rate of r% for n years?
A) $1.00
B) $3.70
C) $1.70
D) Not enough information to solve the problem
Answer: B
Type: Difficult
Page: 40
Response: FV = 1/(0.270) = 3.70
34. If the future value of $1 invested today at an interest rate of r% for n years is 2.5937, what is the
present value of $1 to be received in n years at r% interest rate?
A) $0.3855
B) $1.00
C) $0.621
D) None of the above
Answer: A
Type: Difficult
Page: 40
Response: PV = 1/2.5937 = 0.38555

38

35. If the present value annuity factor at 12% APR for 5 years is 3.605, what is the equivalent future
value annuity factor?
A) 6.353
B) 2.046
C) 1.762
D) None of the above
Answer: A
Type: Difficult
Page: 40
Response: FV annuity factor = 3.605*(1.12^5) = 6.353
36. If the future value annuity factor at 10% and 5 years is 6.1051, calculate the equivalent present
value annuity factor
A) 6.1051
B) 3.7908
C) 9.8323
D) none of the given ones
Answer: B
Type: Difficult
Page: 40
Response: PV = 6.1051/(1.1)^5 = 3.7908
37. If the present value annuity factor at 8% APR for 10 years is 6.71, what is the equivalent future
value annuity factor?
A) 3.108
B) 14.486
C) 2.159
D) None of the above
Answer: B
Type: Difficult
Page: 40
Response: FV annuity factor = 6.21*(1.08^5) = 14.486
38. If the present value annuity factor at 10% APR for 10 years is 6.1446, what is the equivalent
future value annuity factor?
A) 3.108
B) 15.9374
C) 2.159
D) None of the above
Answer: B
Type: Difficult
Page: 40
Response: FV annuity factor = 6.21*(1.08^5) = 14.486

39

39. Which of the following statements is true?

A) Present value of an annuity due is always less than the present value of an equivalent annuity
factor for a given interest rate
B) The present value of an annuity approaches the present value of a perpetuity as n goes to
infinity for a given interest rate
C) Both A and B are true
D) Both A and B are false
Answer: B
Type: Difficult
Page: 40

40. Which of the following statements is true?

A) Present value of an annuity is always greater than the present value of equivalent annuity for
a given interest rate.
B) The future value of an annuity factor is always greater than the future value of an equivalent
annuity at the same interest rate.
C) Both A and B are true
D) Both A and B are false
Answer: C
Type: Difficult
Page: 40

41. Mr. Hopper is expected to retire in 30 years and he wishes accumulate $1,000,000 in his
retirement fund by that time. If the interest rate is 12% per year, how much should Mr. Hopper
put into the retirement fund each year in order to achieve this goal?
A) $4,143.66
B) $8,287.32
C) $4,000
D) None of the above
Answer: A
Type: Difficult
Page: 40
Response: Future value annuity factor = [(1/0.12) (1/(0.12*1.12^30)]*(1.12^30) = 241.3827;
payment = 1,000,000/241.3327 = 4143.66

40

42. Mr. Hopper is expected to retire in 30 years and he wishes accumulate $750,000 in his retirement
fund by that time. If the interest rate is 10% per year, how much should Mr. Hopper put into the
retirement fund each year in order to achieve this goal?
A) $4,559.44
B) $2,500
C) $9,118.88
D) None of the above
Answer: A
Type: Difficult
Page: 40
Response: Future value annuity factor = [(1/0.10) (1/(0.10*1.10^30)]*(1.10^30) = 164.494;
payment = 750,000/164.494 = 4559.44
43. If you invest $100 at 12% APR for three years, how much would you have at the end of 3 years
using simple interest?
A) $136
B) $140.49
C) $240.18
D) None of the above
Answer: A
Type: Medium
Page: 40
Response: FV = 100 + (100*0.12*3) = $136
44. If you invest $100 at 12% APR for three years, how much would you have at the end of 3 years
using compound interest?
A) $136
B) $140.49
C) $240.18
D) None of the above
Answer: B
Type: Medium
Page: 40
Response: FV = 100*(1.12^3) = $140.49

41

45. Which of the following statements regarding simple interest and compound interest are true?
A) Problems in finance generally use the simple interest concept
B) Problems in finance generally use the compound interest concept
C) It does not really matter whether you use simple interest or compound interest for solving
problems in finance
D) None of the above
Answer: B
Type: Medium
Page: 40

46. Which of the following statements is true?

A) The process of discounting is the inverse of the process of compounding
B) Ending balances using simple interest is always greater than the ending balance using
compound interest at positive interest rates.
C) Present value of an annuity due is always less than the present value of an equivalent annuity
at positive interest rates
D) All of the above are true
Answer: A
Type: Difficult
Page: 41

47. John House has just taken out a $150,000 mortgage at an interest rate of 8% per year. If the
mortgage calls for equal monthly payments for twenty years, what is the amount of each
payment? (Assume monthly compounding or discounting.)
A) $1254.70
B) $1625.00
C) $1263.06
D) None of the above are true
Answer: A
Type: Difficult
Page: 43
Response: PMT = 150,000/[(1/0.006667) 1/((0.006667*((1+.006667)^240)))] = $1254.70

42

48. Mr. Anton expects to retire in 30 years and would like to accumulate $1 million in the pension
fund. If the annual interest rate is 12% per year, how much should Mr. Anton put into the pension
fund each month in order to achieve his goal? Assume that Mr. Anton will deposit the same
amount each month into his pension fund and also use monthly compounding.
A) $286.13
B) $771.60
C) $345.30
D) None of the above
Answer: A
Type: Difficult
Page: 43
Response: PMT = 1,000,000/ {[(1/0.01)-(1/(0.01*(1.01^360)))]*(1.01^360)}= $286.13
49. An investment at 12% nominal rate compounded monthly is equal to an annual rate of:
A) 12.68%
B) 12.36%
C) 12%
D) None of the above
Answer: A
Type: Medium
Page: 43
Response: EAR = ((1.01)^12)-1 = 0.12681 = 12.68%
50. An investment at 10.47% effective rate compounded monthly is equal to a nominal (annual) rate
of:
A) 10.99%
B) 9.57%
C) 10%
D) None of the above
Answer: C
Type: Medium
Page: 43
Response: NOM = [((1.1047)^(1/12)-1]*12 = 0.1 = 10.00%

43

51. An investment at 10% nominal rate compounded continuously is equal to an equivalent annual
rate of:
A) 10.250%
B) 10.517%
C) 10.381%
D) None of the above
Answer: B
Type: Difficult
Page: 43
Response: (e^(0.1))-1 = 0.10517 = 10.517%
52. The present value of a $100 per year perpetuity at 10% per year interest rate is $1000. What
would be the present value if the payments were compounded continuously?
A) $1000.00
B) $1049.21
C) $1024.40
D) None of the above
Answer: B
Type: Difficult
Page: 43
Response: (e^r) = 1.1r = ln(1.1) = 0.09531; PV = 100/0.09531 = $1049.21
53. If the nominal interest rate per year is 10% and the inflation rate is 4%, what is the real rate of
interest?
A) 10%
B) 4%
C) 5.8%
D) None of the above
Answer: C
Type: Easy
Page: 46
Response: 1+rreal = (1+rnominal)/(1+rinflation) = 1.1/1.04 =1.058; rreal = 5.8%
54. Mr. X invests $1000 at 10% nominal rate for one year. If the inflation rate is 4%, what is the real
value of the investment at the end of one year?
A) $1100
B) $1000
C) $1058
D) None of the above
Answer: C
Type: Medium
Page: 46
Response: Real investment = (1000*1.1)/(1.04) = $1058

44

55. A 5-year treasury bond with a coupon rate of 8% has a face value of $1000. What is the annual
interest payment?
A) $80
B) $40
C) $100
D) None of the above
Answer: A
Type: Easy
Page: 47
Response: Annual interest payment = 1000(0.08) = $80
56. A 3-year bond with 10% coupon rate and $1000 face value yields 8% APR. Assuming annual
coupon payment, calculate the price of the bond.
A) $1051.54
B) $951.96
C) $1000.00
D) $857.96
Answer: A
Type: Medium
Page: 47
Response: PV = (100/1.08) + (100/(1.08^2)) + (1100/(1.08^3)) = $1051.54
57. A three-year bond has 8.0% coupon rate and face value of $1000. If the yield to maturity on the
bond is 10%, calculate the price of the bond assuming that the bond makes semi-annual coupon
interest payments.
A) $949.24
B) $857.96
C) $1057.54
D) $1000.00
Answer: A
Type: Difficult
Page: 47
Response: PV = (40/1.05) + (40/(1.05^2)) +. . . + (1040/(1.05^6)) = $949.24

45

58. A four-year bond has an 8% coupon rate and a face value of $1000. If the current price of the
bond is $878.31, calculate the yield to maturity of the bond (assuming annual interest payments).
A) 8%
B) 12%
C) 10%
D) 6%
Answer: B
Type: Difficult
Page: 48
Response: Use trial and error method. (80/1.12) + (80/(1.12^2)) + (80/(1.12^3)) + (1180/(1.12^4))
= $870.51. Therefore, yield to maturity is 12%. Or use a financial calculator: PV = -878.31; N =
4; PMT = 80; FV = 1000; COMPUTE: I = 12%
True/False Questions
T

F 59. The two-year discount factor must be greater than the one-year discount factor for a given
discount rate.
Answer: False
Type: Easy
Page: 34

F 60. Forward rate cannot be negative.

Answer: True
Type: Medium
Page: 35

F 61. If the term structure of interest rate is flat the nine-year interest rate is equal to the tenyear interest rate.
Answer: True
Type: Medium
Page: 35

F 62. The rate of return on a perpetuity is equal to the cash flow divided by the price.
Answer: True
Type: Medium
Page: 37

46

F 63. In the case of a growing perpetuity, the present value of the cash flow is given by:
[C1/(r-g)] where r>g.
Answer: True
Type: Difficult
Page: 38

F 64. An equal-payment home mortgage is an example of an annuity.

Answer: True
Type: Medium
Page: 38

F 65. The value of a five-year annuity is equal to the sum of two perpetuities. One makes its
first payment in year 1, and the other makes its first payment in year 6.
Answer: False
Type: Difficult
Page: 38

F 66. Compound interest assumes that you are reinvesting the interest payments at the rate of
return.
Answer: True
Type: Medium
Page: 40

F 67. The relationship between nominal interest rate and real interest rate is given by:
1 + rnominal = (1 + rreal)(1+inflation rate)
Answer: True
Type: Medium
Page: 46

F 68. In the US, most bonds make coupon payments annually.

Answer: False
Type: Easy
Page: 47

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Short Answer Questions

69. Discuss why a dollar tomorrow cannot be worth less than a dollar the day after tomorrow.
Answer: If a dollar tomorrow is worth less than a dollar a day after tomorrow, it would be
possible to earn a very large amount of money through "money machine" effect. This is only
possible, if someone else is losing a very large amount of money. These conditions can only exist
for a short period of time, and cannot exist in equilibrium as the source of money is quickly
exhausted. Thus a dollar tomorrow cannot be worth less than a dollar the day after tomorrow.
Type: Difficult
Page: 34

70. Define the concept of the term structure of interest rates.

Answer: The relationship between the interest rates and maturity is called the term structure of
interest rates.
Type: Medium
Page: 35

71. Define the term "perpetuity."

Answer: A perpetuity is defined as the same cash flow each year occurring forever.
Type: Medium
Page: 37

72. State the assumption required for using the formula for the present value of a growing perpetuity.
Answer: We have to assume that the growth rate is less than the discount rate. Then only we get
reasonable values for the present value of a growing perpetuity. Otherwise the formula will not
work.
Type: Difficult
Page: 37

73. What algebraic technique is used to find the present value of a perpetuity and the present value of
an annuity?
Answer: The technique is called the sum of a geometric series. This is a standard algebraic
technique.
Type: Difficult
Page: 37

48

74. What is the difference between simple interest and compound interest?
Answer: When money is invested at compound interest, each interest payment is reinvested to
earn more interest in subsequent periods. In the simple interest case, the interest is paid only on
the initial investment.
Type: Medium
Page: 40

75. Briefly explain, "continuous compounding."

Answer: As frequency of compounding is increases, the effective rate on an investment also
increases.
In case of continuous compounding the frequency of compounding is infinity. In this case, the
nature of the function also changes. The effective interest rate is given by (e r 1), where the value
of e = 2.718. e is the base for natural logarithms.
Type: Difficult
Page: 43

76. Define the terms, "real interest rate."

Answer: Real interest rate is the inflation adjusted nominal interest rate. We do not observe this
directly. The relationship between the two is given by: 1 + r nominal = (1 + rreal rate)(1+inflation
rate). (An approximate formula that works for low values is: rnominal = rreal rate + Inflation rate)
Type: Medium
Page: 45

77. Define the term "nominal interest rate."

Answer: Nominal interest rate is what we observe in the market. Expected inflation rate is
incorporated into the nominal interest rate. The relationship between the two is given by:
1 + rnominal = (1 + rreal rate)(1+inflation rate).
(An approximate formula that works for low values is: r nominal = rreal rate + Inflation rate)
Type: Medium
Page: 45

78. Discuss the importance of taking inflation into consideration when making financial decisions.
Answer: Financial decisions involve money, and inflation reduces the purchasing power of
money. So inflation is a critical element of financial decisions.
Type: Medium
Page: 45

49

79. Briefly explain the cash flows associated with a bond to the investor
Answer: Bonds provide two types of cash flows: interest payments and the principal payment.
Interest payments occur each period, usually annually or semi-annually. Periodic interest
payments are also called coupon payments. Thus this forms an annuity. Principal payment occurs
at the time of maturity of the bond and is a lump sum payment.
Type: Easy
Page: 47

80. Define the term "yield to maturity" of a bond.

Answer: Yield to maturity is the effective interest rate on the bond. It is the rate used for
discounting the cash flows from a bond. As yield to maturity increases the price of a bond falls
and vice-versa.
Type: Medium
Page: 48

81. What is the relationship between the price and the yield to maturity of a bond?
Answer: The relationship between the price and the yield to maturity of a bond is an inverse one.
As yield to maturity increases the price of a bond falls and vice-versa.
Type: Medium
Page: 48

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