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d. Based on the information about the corporate bond provided in part b, calculate yields and then construct a new yield curve graph that shows both the Treasury and the corporate bonds.

b.Suppose you are considering two possible investment opportunities: a 12-year Trea- sury bond and a 7-year, A-rated corporate bond. The current real risk-free rate is 4%; and inflation is expected to be 2% for the next 2 years, 3% for the following 4 years, and 4% thereafter. The maturity risk premium is estimated by this formula: MRP 1⁄4 0.1 (t – 1)%. The liquidity premium for the corporate bond is estimated to be 0.7%. Finally,you may determine the default risk premium, given the company’s bond rating, from the default risk premium table in the text. What yield would you predict for each of these two investments?

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Related questions

1.Consider the following four debt securities, which areidentical in every characteristic except as noted:
?W: A corporate bond rated AAA
?X: A corporate bond rate BBB
?Y: A corporate bond rated AAA with a shorter time to maturity thanbonds W and X
?Z: A corporate bond rated AAA with the same time to maturity asbond Y that trades in a more liquid market than bonds W, X, orY
List the bonds in the most likely order of the interest rates(yields to maturity) of the bonds from highest to lowest. Explainyour work.

2.Explain how an economist could use the slope of the yield curveto analyze the probability that a recession will occur and why thespread may matter.
3.One year ago, you bought a bond for $10,000. You receivedinterest of $400 at the end of the year, as well as your $10,000principal. If the inflation rate over the last year was fivepercent, calculate the real return. Show your work.
4.Suppose that the price of a stock is $50 at the beginning of ayear and $53 at the end of the year, and it pays a dividend of $2during the year. Calculate the stock’s current yield, capital-gainsyield, and the return. Show your work for three separatecalculations.
5.Use the capital-asset pricing model to predict the returns nextyear of the following stocks, if you expect the return to holdingstocks to be 12 percent on average, and the interest rate onthree-month T-bills will be two percent. Calculate a stock with abeta of -0.3, 0.7, and 1.6. Show your work for three separatecalculations.

You have been asked by an investor to value a local restaurant. In the most recent year, the restaurant earned a pretax operating income of $300,000. Income has grown an average of 4% annually during the last five years, and it is expected to continue growing at that rate into the foreseeable future. By introducing modern management methods, you believe the pretax operating-income growth rate can be increased to 6% beyond the second year and sustained at that rate through the foreseeable future. The investor is willing to pay a 10% premium to reflect the value of a control. The beta and debt-to-equity ratios for publicly traded firms in the restaurant industry are 2 and 1.5, respectively. The business target debt-to-equity ratio is 1, and its pretax cost of borrowing, based on its recent borrowing activities, is 7%. The business-specific risk for firms of this size is estimated to be 6%. The investor concludes that the specific risk of this business is less than other firms in this industry due to its sustained profit growth, low leverage, and high return on assets compared to similar restaurants in this geographic area. Moreover, per capita income in this region is expected to grow more rapidly than elsewhere in the country, adding to the growth prospects of the restaurant business. At an estimated 15%, the liquidity risk premium is believed to be relatively low due to the excellent reputation of the restaurant. Since the current chef and the staff are expected to remain if the business is sold, the quality of the restaurant is expected to be maintained. The ten-year Treasury bond rate is 5%, the equity risk premium is 5.5%, and the federal, state and local tax rate is 40%. The annual change in working capital is $20,000, and capital spending for maintenance exceeded depreciation in the prior year by $15,000. Both working capital and the excess of capital spending over depreciation are projected to grow at the same rate as operating income. What is the business worth?

1. The opportunity cost of money is

a) growth rate of prices.

b) real GDP.

c) interest rate.

d) none of the above

2. Household wealth affects the equilibrium yield on bonds due to its impact on

a) the supply of bonds

b) the demand for bonds.

c) inflation has no effect on bond yields.

d) the supply and demand for bonds.

3. A bank takes deposits and uses the funds to make home loans. Hence, the _____ increases.

a) level of capital

b) ROA

c) quantity of reserves

d) none of the above

4. A decrease in the government budget deficit causes the _____ bonds to shift and equilibrium interest rates to _____.

a) demand for, rise

b) supply of, rise

c) demand for, fall

d) supply of, fall

5.The yield on a one-year bond is currently 4% and the expected yield on one-year bonds for the next two years is 5% and 6%. If the liquidity premium is 0.5%, what is the yield on a bond with two years to maturity?

a) 5.5%

b) 5%

c) 6%

d) 4.5%

6. The too big to fail€ policy exacerbates the moral hazard problem between:

a) banks and borrowers.

b) regulators and banks

c) politicians and regulators

d) the public and politicians.

7. ARMs

a) force lenders to assume interest rate risk

b) became more prevalent during the Great Inflation.

c) both of the above.

d) neither of the above

8. Which of the following types of money are not self-equilibrating?

a) commodity

b) representative

c) all are self-equilibrating

d) fiat

9. Technology has helped to make possible which of the following innovations?

a) ATM

b) credit cards

c) mortgage-backed securities

d) all of the above

10. All of the following EXCEPT one would have a strong propensity to initiate a financial crisis. Which is the exception?

a) banking panics

b) government fiscal deficits

c) exchange rate appreciation

d) increases in interest rates

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